SEC’s DeFi rulemaking do-over falls short.
In April, the U.S. Securities and Exchange Commission (SEC) reopened the comment period for a proposed set of rules that would redefine various blockchain protocols as U.S. regulated securities exchanges. This is their second attempt at regulating decentralized finance (DeFi) starting in early 2022. Members of the public have until Tuesday, June 13 to submit their comments. Everyone should comment because the flaws of this proposal have only been made worse in the latest version.
Alongside the SEC’s enforcement-first mindset, this attempt at rulemaking serves as compelling evidence that new U.S. legislation is needed. Perhaps something like the recently published market structure bill sponsored by House Financial Services Committee Chair Patrick McHenry and Agriculture Committee Chair Glenn “GT” Thompson is sorely needed.
Bill Hughes is senior counsel and director of global regulatory matters at ConsenSys.
Torturing the securities laws
The central problem with the SEC’s proposal is that trying to treat blockchain protocols as regulated exchanges simply cannot be reconciled with the Exchange Act of 1934, existing exchange regulations, or a correct understanding of blockchain technology. What would it mean for something like Ethereum to be treated as a securities exchange?
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Laws regarding securities exchanges were passed to address the risks inherent in intermediated systems that bring together the orders of actual buyers and sellers. The U.S. Congress sought to regulate exchanges only insofar as they were centralized entities that possess a uniquely important role in setting market prices and otherwise affecting market conditions.
The SEC’s latest rulemaking proposal treats exchanges as any system that merely sets up potential buyers and sellers, allowing them to find and negotiate transactions with each other. However, the SEC fails to properly consider what an exchange does. In order to be an exchange, the law typically requires that an entity conduct functions commonly performed by a stock exchange. But the SEC disagrees, having apparently misapplied the standard statutory interpretation. Worse, the agency does not identify a single function a blockchain protocol performs that is akin to a stock exchange.
If this was not enough, the proposal trips over itself explaining who may be considered part of an exchange. It lists a few “important factors” of indeterminate weight that offer no real notice and only raise more questions as to what all this actually means for anyone participating in the blockchain ecosystem.
In particular, the proposal does not explain the threshold of “significant” token ownership at which blockchain users suddenly obtain sufficient control over the system to assume regulatory responsibilities. Nor does it address the circumstances when a service provider or third-party vendor begins exercising enough control to become responsible – alongside its clients – for a protocol or application.
Making matters more complicated, groups who participate in protocols will almost always involve persons based outside the United States. That matters because U.S. securities laws generally do not apply extraterritorially. The SEC recognizes this circumstance in passing, yet offers no analysis of how its proposal would affect groups that include overseas actors. This is a serious uncertainty that greatly distorts blockchain participation around the world.
Most blockchain-related comments on the 2022 proposal exhaustively covered the multiplicity of ways the SEC was vague – including the fact that in this initial version, the SEC seemed to be writing about blockchain but did not actually name it.
The 2023 draft, other than clarifying that, yes, the rules would apply to blockchain, cures almost none of long-standing problems. Relabeling “communication protocols” as “negotiation protocols” is just pasting a fresh label on the same, contaminated bottle. Chanting “facts and circumstances” like a mantra explains practically nothing.
As the Supreme Court itself has observed, rules are invalid where they rest on “terms so vague that men of common intelligence must necessarily guess at [their] meaning.”
This proposal places the responsibility on the blockchain industry to correctly interpret the rules, which means that anyone who guesses incorrectly – from software companies such as ConsenSys to individual software developers who use their products – could face significant penalties. Essentially, the SEC can retroactively punish individuals for breaking rules.
It gets worse under the 2023 proposal, as software developers who publish or republish code independently and for free, and who are not establishing an exchange, may still face registration obligations if their code is later repurposed for use by an exchange. This is a way to discourage the development of free, open-source software.
The proposed rulemaking is essentially a disguised ban on blockchain technology in the U.S.
Trying to comply with the proposed rules in good faith would be very difficult.
Wait, the old rule already applies?
The 2023 proposal also adds to the confusion by making highly debatable statements about the extent of its current regulation, specifically how the current definition of “exchange” in SEC regulations already applies to blockchain protocols.
This off-handed statement raises fundamental questions for stakeholders in the crypto industry about whether they are already regulated, or at risk of future regulation, or somewhere in between.
See also: DeFi Unfazed by SEC’s Classification of Tokens as Securities
As Hester Peirce, one of the five SEC commissioners, accurately put it: the proposal “embraces stagnation, urges expatriation, and welcomes extinction of new technology.”
What benefits? At what cost?
As part of standard practice, the SEC must discuss the benefits and costs of their proposal and compare them. However, little attention is given to this in the proposal. The SEC confidently states that the main benefit is the expanded regulatory jurisdiction, as if that was all the reason one needs. The proposal only meekly suggests that the fines would not be impossible to pay, and it is silent on their relative weight, which is a statutory requirement.
Any analysis from someone with a working knowledge of blockchain would quickly show that the benefits would be illusory and the costs immense.
The proposal underestimates the number of blockchain protocols that would be affected, and does not recognize that these regulatory burdens are magnified for ordinary individuals who participate in the blockchain ecosystem, such as validators, DAO members, and liquidity providers.
First Amendment concerns and rules that chill to the bone
The SEC’s proposed rules have constitutional issues with how they regulate speech. By suggesting that software developers may be liable for their code, including those who develop software for non-business, purely expressive, and often explicitly political reasons, the proposal has a clear chilling effect, given that computer code is speech.
One would hope that the commission’s goal is not to broadly chill blockchain innovation, as that is not legally permissible. However, the evidence suggests otherwise, including the SEC’s change of stance on working with the blockchain industry to develop a regulatory framework, the learning sessions that turned into enforcement investigations, the backflip from “we need congressional action” to figuratively shouting down a discussion draft of new market structure legislation proposed by two House committee chairmen, and especially SEC Chair Gary Gensler’s publicized hostility towards the blockchain ecosystem (in interviews, op-eds, and even Twitter posts).
See also: Gary Gensler’s Evolving Position on Crypto – in Quotes
Recently, the Chair of a regulatory agency, known for being “non-partisan,” stated that there is no need for more digital currency. This statement is noteworthy in light of the fact that the 2023 proposal dismisses the concerns of many commenters in a curt manner. The proposal’s apparent lack of concern for inhibiting innovation and causing market participants to leave the U.S. or go out of business is evident. Essentially, this attempt at rulemaking is a disguised ban on blockchain technology in the U.S. The commission should either completely withdraw this proposed rule or explicitly exempt blockchain technology from it. As it stands, the proposal is illegal.