So-called decentralized finance (DeFi) platforms are facing heightened scrutiny as U.S. securities regulators plan to include them in the legal definition of ‘exchange’ systems.
On Friday, the U.S. Securities and Exchange Commission (SEC) formally reopened the comment period for its proposed expansion of what legally constitutes an exchange. The proposal, first issued in January 2022, would amend Exchange Act Rule 3b-16 to include “systems that bring together buyers and sellers of securities that offer the use of non-firm trading interest and provide another type of nondiscretionary method (i.e., communication protocols).”
The SEC extended its initial comment period last year due to the volume of submissions, many of which wondered how the proposed changes would impact DeFi apps. The SEC confirmed Friday that the reopening release “reiterated the applicability of existing rules to platforms that trade crypto asset securities, including so-called ‘DeFi’ systems.” Individuals or entities wishing to submit comments to the SEC must do so within the next 30 days.
SEC chairman Gary Gensler hosted an open meeting Friday morning in which commissioners voted 3-2 in favor of the revised proposal. Gensler, who has long insisted that existing securities rules apply to digital assets, noted during the meeting that simply declaring one’s business a DeFi platform “is not an excuse to defy the securities laws.”
Gensler added that crypto trading platforms “match orders of multiple buyers and sellers of crypto securities using established nondiscretionary methods. That’s the definition of exchange, and today, most crypto trading platforms meet it.”
Commissioner Hester Peirce, the SEC’s most prominent crypto advocate and one of Friday’s ‘no’ votes, expressed the usual concerns regarding the alleged “ambiguity” of the SEC’s regulatory approach. Peirce claimed the proposed rule changes “could significantly reduce the extent to which the system is decentralized,” adding that it seemed “perverse to me that we would be encouraging centralization.”
However, as Binance founder Changpeng ‘CZ’ Zhao told Hong Kong’s Web3 Festival attendees this week, centralization occurs the moment any two individuals decide to form a DeFi project team. While CZ is traditionally the last person we’d look to as an oracle of truth, decentralization is indeed a myth, and DeFi’s centralized points of failure are probably why its platforms present such tempting targets.
Anyone who doubts the sentiments above needs to travel back in time only a couple of weeks to the Arbitrum fiasco. The supposedly decentralized autonomous organization conducted a member vote on a proposed funding allocation, only to reveal after the fact that it had already initiated the allocation, and thus the results of the vote—which went the other way—would be ignored by the few individuals who were actually in control.
Read it and weep
The 166-page recap of responses to the previous round of comments to the SEC’s proposed rule changes largely echoes Gensler’s view. The document states plainly that “certain trading systems for crypto assets, including so-called DeFi systems, operate like an exchange as defined under federal securities laws—that is, they bring together orders of multiple buyers and sellers using established, nondiscretionary methods (by providing a trading facility, for example) under which such orders interact and the buyers and sellers entering such orders agree upon the terms of a trade.”
The SEC further notes that DeFi systems rely on “electronic messages that are exchanged between buyers and sellers so that they can agree upon the terms of a trade without negotiations. If these electronic messages constitute a firm willingness to buy or sell a security, including a crypto asset security, the messages would meet the definition of orders under existing Rule 3b-16(c).”
The SEC adds that “the exchange framework is based on the functions performed by a trading system, not on its use of technology. Notwithstanding how an entity may characterize itself or the technology it uses, a functional approach…will be applied when assessing whether the activities of a trading system meet the definition of an exchange.”
“The statutory definition of ‘exchange’ is written in the disjunctive: ‘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 that term is generally understood.’ Thus, if an organization, association, or group of persons constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities, it would be an ‘exchange.'”
“The existence of smart contracts on a blockchain does not materialize in the absence of human activity or a machine (or code) controlled or deployed by humans … a single organization constitutes, maintains, or provides the market place or facilities for bringing together buyers and sellers of securities or otherwise performs with respect to securities the functions commonly performed by a stock exchange.”
The SEC further stabs at the decentralization myth by noting that “the ability to exercise control over a market place or facilities is not limited solely to the operational control.” For instance, “significant holders of governance or other tokens, for example, could also be considered part of the group of persons and thus an exchange if they can control certain aspects of it.” (That sound you just heard was everyone at the token-hoarding a16z and Digital Currency Group swallowing hard.)
One commenter claimed DeFi was immune to exchange regulation because they don’t ‘custody’ assets. But the SEC states that nothing in the existing rules nor the proposed amendments “requires an organization, association, or group of persons to provide custodial services to be considered an exchange…thus, custodial services generally is not a relevant factor to the exchange analysis.”
While Friday’s 3-2 vote does indicate some level of uncertainty regarding Gensler’s desire to bring DeFi to heel, Gensler appears to have just enough support to proceed down the ‘daddy’s home’ path he’s chosen. Crypto bros can cry ‘freedummmmm’ all they want, but the collective personal cost of the scandals of the past several years clearly indicates the need for adult supervision.
‘Can you show me on the doll where Gary touched you?’
Earlier in the week, Gensler was sent a letter by Patrick McHenry (R-NC), chairman of the House of Representatives Committee on Financial Services, and Bill Huizenga (R-MI), chair of the Subcommittee on Oversight and Investigations. The strident letter takes Gensler to task for allegedly slow-rolling the SEC’s response to requests for further information on the demise of the FTX digital assets exchange.
FTX founder Sam Bankman-Fried was scheduled to testify remotely from the Bahamas to McHenry’s committee last December but was arrested the night before on criminal and civil charges related to last November’s implosion of FTX, its affiliated market-maker Alameda Research and the rest of SBF’s former empire.
Republicans quickly formulated conspiracy theories that Gensler was attempting to hide some nefarious connection to SBF, part of a wider theory in which the U.S. Department of Justice (DOJ) sought to silence SBF regarding some alleged perks he allegedly enjoyed as a result of being a major donor to Democratic election campaigns. (It’s worth remembering that SBF-sycophancy was a bipartisan affair, even if Rep. Tom Emmer (R-MN) doesn’t want to admit signing that letter telling Gensler to Leave. Sam. Alone.)
This week’s letter accused the SEC of ignoring deadlines to respond to the Committee’s request for documents related to the civil charges the SEC filed against SBF last December. McHenry and Huizenga have given Gensler until 5 p.m. on April 17 to produce the requested documents. Failure to do so “could result in the Committee considering using compulsory process, if necessary, to obtain the requested information.” And hey, if that fails, there’s always Guantanamo.
Watch: Law & Order Regulatory Compliance for Blockchain & Digital Assets
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