SEC Proposes to Redefine “Exchange”—New Definition Could Subject Blockchain Crypto Platforms to SEC Regulation

The Securities and Exchange Commission (“SEC” or “Commission”) has released a proposal to amend Exchange Act Rule 3b-16, Regulation ATS, and Regulation SCI.1  Criticized by SEC Commissioner Hester Peirce as “too wide-ranging” and “unwieldy” with too short of a comment period,2 the proposed rule, which actually includes amendments to three separate SEC regulations, spans 654 pages, contains 224 separate requests for comment (not including subparts), allows only 30 days for public comment, and seeks to bring about a significant expansion of the SEC’s regulatory authority.  In addition to extending Regulation ATS’s and Regulation SCI’s reach to Alternative Trading Systems that trade in government securities,3 the proposed rule includes amendments to Exchange Act Rule 3b-16 that could subject currently unregulated trading venues to SEC jurisdiction by redefining “exchange” for purposes of § 3(a)(1) of the Securities Exchange Act of 1934.4  Under the proposed amendments to Rule 3b-16,

  • exchanges are defined in terms of buyers and sellers with trading interest as opposed to orders;
  • exchanges include organizations, associations, or groups of persons that simply make available—rather than use—established, non-discretionary methods that allow for interaction and agreement on the terms of trades; and
  • exchanges include, not only organizations, associations, or groups of persons that provide trading facilities or set rules, but also include organizations, associations, or groups of persons that merely provide communication protocols.

These proposed amendments, which deformalize the criteria for being an exchange, have clear and potentially profound implications for decentralized finance (“DeFi”).  Under the proposed definition of exchange, an organization, association, or group of persons that passively makes available a communication protocol under which buyers and sellers with trading interest can interact and agree on the terms of trades is an exchange.  The new definition of exchange, if adopted as proposed, could sweep in currently unregulated blockchain-based cryptocurrency platforms and subject them to all of the regulatory requirements that flow from being an exchange.  In short, the SEC is proposing a potentially transformative regulatory change that could create existential risks for DeFi platforms or, at the very least, fundamentally change the way they operate.

This Client Alert details:

  • the proposed amendments to the definition of exchange in Rule 3b-16; and
  • the potential avenues for challenging the proposed amendments to Rule 3b-16—either through public comment or litigation.

The Proposed Redefinition of Exchange

Currently, Rule 3b-16(a) contains the following definition for exchange:

(a) An organization, association, or group of persons shall be considered to constitute, maintain, or provide ‘a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,’ as those terms are used in section 3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such organization, association, or group of persons:

  1. Brings together the orders for securities of multiple buyers and sellers; and
  2. Uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.5

The SEC is proposing significant amendments to subsections 1 and 2 of Rule 3b-16(a).  The new regulatory text proposed by the SEC reads:

(a) An organization, association, or group of persons shall be considered to constitute, maintain, or provide a ‘market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,’ as those terms are used in section 3(a)(1) of the Act (15 U.S.C. 78c(a)(1)), if such organization, association, or group of persons:

  1. Brings together buyers and sellers of securities using trading interest; and
  2. Makes available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of the trade.6

In addition, the SEC is proposing to add a new subsection (e) to Rule 3b-16 to define trading interest:

(e) For the purposes of this section, the term trading interest means an order as the term is defined under paragraph (c) of this section or any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price.7

The shift to non-firm trading interest and the addition of communication protocols are intended to reach Communication Protocol Systems because “[i]n the Commission’s experience, Communication Protocol Systems . . . generally offer the use of non-firm trading interest and establish protocols to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade without relying solely on the use of orders.”8  Similarly, “makes available” is substituted for “uses” because “[i]n contrast to the term ‘uses,’ the Commission believes the term ‘makes available’ would be applicable to Communication Protocol Systems because such systems take a more passive role in providing to their participants the means and protocols to interact, negotiate, and come to an agreement.”9

Although “the proposed amendments to Exchange Act Rule 3b-16(a) would scope Communication Protocol Systems into the definition of ‘exchange,’”10 the SEC never defines Communication Protocol Systems.  Instead, in the proposed rule’s preamble, the SEC provides only “a non-exhaustive list of some Communication Protocol Systems.”11  The SEC’s examples include Request-for-Quote systems that allow participants to obtain quotes by sending messages to other participants, “stream axe” systems that electronically display firm or non-firm trading interest in a security or type of security, conditional order systems that allow participants to post trading interest that may not be executable without some further action by the participants, and negotiation systems that allow participants to display non-firm trading interest and then engage with other participants to negotiate trades.12

In addition, the SEC provides an example of which systems are not Communication Protocol Systems: “systems that passively display trading interest, such as systems referred to in the industry as bulletin boards, but do not provide means for buyers and sellers to contact each other and agree to the terms of the trade on the system would not be encompassed by Rule 3b-16(a) as proposed to be amended.”13  Beyond the examples, the SEC indicates only that “the Commission would take an expansive view of what would constitute “communication protocols” under . . . Rule 3b-16(a)”14 and “the determination of whether the system meets Rule 3b-16(a)(2) would depend on the particular facts and circumstances of each system.”15

Options to Challenge the Redefinition of “Exchange”

The Commission provided the public with only 30 days to comment on the proposed redefinition of exchange.  The comment period will close 30 days after the proposed rule’s publication in the Federal Register, although commenters may begin submitting comments before the proposed rule’s official publication.  Thirty days is an exceedingly short comment period but unfortunately is becoming the norm for SEC rulemaking.16

Despite the brevity of the comment period, “broad public input through a transparent regulatory (not enforcement) process” is vital.17  Indeed, studies of agency responsiveness have found that agencies are influenced by public comment.18

Notwithstanding how impactful public comment can be, legal challenges to federal rules are commonplace and often necessary.19  The proposed redefinition of exchange—given the brevity of the comment period relative to the size and scope of the proposed rule in which the redefinition appears—may be vulnerable to challenge under the Administrative Procedure Act (“APA”).20

Under the APA, federal agencies are required to provide the public with adequate notice of a proposed rule followed by a meaningful opportunity to comment on the rule’s content.21  Although there is no minimum period of time during which a federal agency—here, the SEC—is required to accept public comment, the executive branch has recommended that federal agencies provide comment periods of at least 60 days.22  Moreover, the legislative history of the APA suggests that “[matters] of great importance, or those where the public submission of facts will be either useful to the agency or a protection to the public, should naturally be accorded more elaborate public procedures.”23

Here, despite the breadth and scope of the proposed rule in which the redefinition of exchange appears, the Commission has determined that it is appropriate to provide the public with only 30 days to read, understand, consider, consult, identify, model, assess, and discuss the proposed rule, which includes significant amendments to not only Rule 3b-16, but also to Regulation ATS and Regulation SCI.  Indeed, trading venues never before regulated by the SEC will be subject to SEC regulation if the proposed rule is adopted.  Further, as noted by Commissioner Pierce in her Dissenting Statement on the Proposal to Amend Regulation ATS, the Commission faces “no emergency in these markets that compels us to limit comments to 30 days.”24  By providing only 30 days for public comment, a court could determine that the Commission acted arbitrarily and capriciously by failing to provide a meaningful opportunity for public participation, under the Executive Branch’s own standards.

Tellingly, Chair Gensler acknowledged during the open meeting at which the rulemaking was considered that there is currently a publication backlog in the Federal Register, ranging between six to eight weeks.  Consequently, he suggested that interested persons should initiate the comment process before the proposed rule’s publication in the Federal Register, thereby creating a de facto comment period of closer to 60 days or more.  The proposed solution may not withstand judicial scrutiny, however, given the APA’s clear command that the comment period should begin only after notice of the proposed rulemaking is published in the Federal Register.25  Given the text of the APA, a court may find dubious the proposition that a comment period should be determined based on a backlog in the Federal Register.

Source: National Law Review

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