Does the SEC's ATS proposal impact the crypto ecosystem?

Issue: Does the SEC’s new proposal impact the crypto ecosystem?

Short answer: Most likely, yes, if the assets being traded are deemed securities and orders are accepted on a non-discretionary basis.

What happened: The SEC proposed an amendment to the Exchange Act Rule 3b-16 that would eliminate the current exemption in Regulation ATS that excludes “systems that merely route orders to other facilities for execution” from registering as an Alternative Trading System (ATS). The proposed amendments would include “Communication Protocol Systems” within the definition of an “exchange.”

What is a Communication Protocol System?

The proposed definition of a Communication Protocol System is any system that brings together buyers and sellers, or maintains a marketplace that facilitates the bringing together of buyers and sellers, that makes any type of security available for trading. It’s a very broad definition, by design. “The definition is designed to be flexible enough to accommodate the evolving technology.” See Proposal p. 33.

The Communication Protocol System definition Includes:

• Anything that uses various technologies and connectivities to offer a show of a trading interest, and prompts buyers and sellers to communicate, negotiate, and agree to the terms of a trade without the use of a traditional firm order.

• The Request-for-Quote system, which is designed to allow people to obtain quotes for a security by sending messages to one or multiple potential buyers simultaneously.

• A system that electronically displays continuous firm or non-firm trading interests in a security, that can serve as a starting point for negotiation between parties.

• Systems that bring buyers and sellers together through the use of bilateral negotiation protocols and non-firm trading interest to see a displayed non-firm trading interest, access liquidity, find a counterparty, and negotiate a trade through the use of a communication technology. “For example, if an entity makes available a chat feature, which requires certain information to be included in a chat message (e.g., price, quantity) and sets parameters and structure designed for participants to communicate about buying or selling securities, the system would have established communication protocols.” SeeProposal p. 43.

• Systems that have become electronic, perform the function of a marketplace, and have become a preferred method for market participants to discover prices, find a counterparty, and execute a trade.

Why add Communication Protocol Systems to the definition of an Exchange and require them to register as an Alternative Trading System?

The SEC believes that by not regulating these systems it has created a disparity among similar markets where some are registered and regulated, while others are not. This creates a competitive imbalance and lack of investor protections.

A few of the proposed language changes include:

Registration

Communication Protocol Systems may decide between registering as a national securities exchange or, the lighter regulatory requirements of registering as a broker dealer and complying with Regulation ATS. An ATS is not subject to Section 6 of the Exchange Act, and can list securities that are only traded over-the-counter.

To register, a Communication Protocol System would need to file Form BD with the SEC and complete FINRA’s process for new members, and this must be done within 210 days after the effective date of any final rule.

What does this mean for the crypto ecosystem?

While the proposed rule doesn’t mention anything about the crypto ecosystem, the definition could certainly be used to include a lot of crypto trading activity, if the assets being traded are considered securities.

As Gabriel Shapiro pointed out in his excellent newsletter titled,“Urgent Considerations of Impact on Blockchain/Defi of the SEC’s Proposed Regulation ATS Amendment,” there are some major problems with the application of this proposed rule if the SEC attempted to use the definition to require decentralized exchanges and DeFi systems to register as ATSs. He said even a block explorer like etherscan could be argued to be a communications protocol because SEC Chair Gensler said the definition is meant to cover platforms for all kinds of asset classes.

What assets are securities?

This topic deserves its own blog, but a quick overview as to what crypto assets constitute securities or not is a matter of facts and circumstances, and still primarily depends on the Howey Test factors. Some additional considerations include (1) whether the asset is sufficiently decentralized, (2) the way it was launched, (3) if it has a useful purpose, (4) if it was launched prior to the SEC’s first intervention in 2017, (5) whether the asset is considered a good or service (NFT), and a number of other considerations.

Examining which coins are listed on the large US-based custodial exchanges can also be helpful in the analysis because we know they have engaged in ongoing dialogues with the SEC, so their listing decisions can provide at least some insight into the SEC’s view of each particular asset.

Commissioner Peirce put together a safe harbor 2.0 proposal that addresses some of the challenges and potential solutions for making this securities determination.

What does this mean for Bitcoin?

Bitcoin is not viewed as a security, so ultimately this expansive proposal should not interfere with the current ecosystem built around Bitcoin. If the SEC attempted to regulate communication protocols interacting with Bitcoin, Justin Whales and Richard Ovelmen created a great law review article outlining all the arguments as to why Bitcoin should be considered speech, and protected under the first amendment.

30-day comment period.

SEC Commissioner Hester Pierce, aka #CryptoMom wrote a beautiful dissent to this proposed amendment, raising concerns that “the potentially cataclysmic risks of inadvertently making things worse through sloppy or rushed rule making that introduces uncertainty for market participants or that deprives the public and the Commission the opportunity to devote careful attention to thinking through the full implications of the proposed rules.” She noted that the proposal is 650 pages long and has 220 separate comment requests, and only an [unconscionably reckless] 30 day comment period. An ominous warning, “A final message to those who operate any service that is designed to facilitate any communication between potential buyers and sellers of any type of security: Read this release.”

The crypto community could consider submitting comments requesting clarification that the definition of communication protocol systems is not meant to implicate our industry, and that rules impacting this growing movement should be carefully considered, properly noticed, narrowly tailored, fit for the intended purpose, and weigh the cost of regulation against the potential benefits to be achieved. Clarity on which crypto market participants are being regulated, what activities are intended to be regulated, and guidance as to how the industry could conceivably comply with the proposed regulation would also be helpful.

Conclusion.

Regulating global, decentralized, non-custodial, anonymous market participants is likely a daunting challenge for the SEC. As demonstrated by the Ether Delta Order, the SEC is able to assess fines to creators of non-registered exchanges, but thus far has been unsuccessful at shutting down any truly decentralized network.

This tweet by @dergigi accurately depicts the nature of a decentralized system. Without a central actor, it’s an unstoppable force.

By Sasha Hodder, Crypto Attorney & Bitcoin Enthusiast