SEC takes aim at crypto platforms as unregistered exchanges

July 5, 2023 – The United States Securities and Exchange Commission (“SEC”) recently has ramped up its enforcement efforts in the crypto platform space, bringing a trio of actions against so-called unregistered national securities exchanges. With its aggressive focus on crypto trading platforms, dissenters of the SEC’s approach say the SEC poses an existential threat to the industry in the U.S. If the Commission prevails, it potentially could preclude buying and selling of cryptocurrencies in the U.S. without having written any rules.

Even so, rulemakings are in the works; the enforcement actions — against Bittrex, Binance, and Coinbase — come on the tail of the SEC’s 3-2 party-line vote to reopen the comment period for the SEC’s proposed amendments to Rule 3b-16 under the Securities Exchange Act to expand the definition of an “exchange” (the “Proposed Rules”).

In announcing the reopening, the SEC warned that it believes some trading platforms, including decentralized finance (“DeFi”), constitute an “exchange” under current definitions and could be the subject of enforcement actions:

“[C]urrently certain trading systems for crypto assets, including so-called “DeFi” systems, operate like an exchange as defined under federal securities laws.”

The SEC’s three enforcement actions following the Reopening Release leave no doubt that it has made it an enforcement priority to police crypto platforms. The Reopening Release also forecasts expanded scrutiny of platforms. With the reopened comment period now closed, the SEC could adopt the expanded definition any day, sweeping more crypto platforms into its regulatory ambit.

I. “Exchanges” and the consequences of operating as an unregistered exchange

Under the current version of Rule 3b-16, an organization, association, or group of persons is considered an exchange or providing an exchange if it: “(1) [b]rings together the orders for securities of multiple buyers and sellers; and (2) [u]ses 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.”

If an organization, association, or group of persons qualifies as an exchange, then it must either register with the SEC as an exchange or register as a broker-dealer and comply with Regulation ATS.

To comply with Regulation ATS, an organization must satisfy the definition of an alternative trading system (ATS) — an organization, association, group of persons, or system that (1) constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities; and (2) does not: (i) set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading; or (ii) discipline subscribers other than by exclusion from trading.

Failure to register as an exchange or as a broker-dealer may result in operating as an unregistered exchange in violation of Section 5 of the Exchange Act. For an unregistered exchange, the SEC is empowered to bring a civil action to obtain damages including disgorgement, civil penalty and prejudgment interest.

II. The Proposed Rules’ broadened scope of “exchange”

The Proposed Rules would make several changes to expand the definition of “exchange”:

The Proposed Rules define “trading interest” to encompass “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.” Additionally, the Proposed Rules would alter the definition of “exchange” to capture not only actual orders placed on securities exchanges but also conditional offers and exploratory solicitations.

The Proposed Rules’ inclusion of “communication protocols” as an example of an established, non-discretionary method under which buyers and sellers can interact would also broaden the scope of “exchange.” Communication protocols “generally use non-firm trading interest as opposed to orders to prompt and guide buyers.”

The Reopening Release provides the following example of a communication protocol: “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 … the system would have established communication protocols.”

III. Crypto trading platforms as “exchanges”

Chair Gary Gensler’s and Commissioner Caroline Crenshaw’s statements accompanying the reopening of the comment period make clear the SEC’s position that the current definition of “exchange” applies to numerous crypto trading platforms. Gensler reinforced this view during recent testimony on April 18, 2023, before the U.S. House of Representatives Committee on Financial Services, when he stated that “the vast majority of crypto tokens are securities” and that, therefore, “many crypto intermediaries are transacting in securities and have to register.”

The Reopening Release asserts that certain platforms “operate like an exchange” as currently defined because they “bring together orders of multiple buyers and sellers using established, non-discretionary methods.”

The Proposing Release estimated the number of trading platforms that would be impacted by the Proposed Rules. The Reopening Release, however, states that upon further consideration the SEC determined that “[m]any of the entities operating such trading systems… may be subject to existing federal securities laws and registration requirements, including the requirement to register as an exchange.”

As a result, the SEC believes that it may have originally “over-estimat[ed]” the number of respondents that may be subject to the Proposed Rules. The Reopening Release ultimately estimates that the Proposed Rules would lead to “15-20 New Rule 3b-16(a) Systems that trade crypto asset securities.”

IV. The impact of the SEC’s targeting of crypto trading platforms

As Commissioner Hester Peirce noted in her dissenting statement issued in April 2023, the SEC has ostensibly taken the position that it will pursue enforcement actions against unregistered crypto trading platforms rather than helping them figure out how to register as exchanges:

“Today’s Commission treats the notice-and-comment rulemaking process not as a conversation, but as a threat.”

Even assuming the feasibility of registering, there are monetary costs of compliance. The Reopening Release admits that the SEC “has a greater degree of uncertainty in its analysis of the costs that the Proposed Rules would impose on market participants for crypto asset securities than it did in its discussion of costs for non-crypto asset securities.” Consequently, “actual costs may be higher than these estimates.”

There are also implications to the broader market beyond the financial costs borne by individual platforms. Commissioner Peirce forecasts that the Proposed Rule will “embrace stagnation, force centralization, urge expatriation, and welcome extinction of new technology.”

Multiple commenters on the Proposed Rules share Commissioner Peirce’s fears:

•”Digital Assets and DeFi represent a great opportunity for the United States … This rule as proposed would stymie development in the Digital Asset space and reduce the United States’ competitiveness.”

•”These regulations are hurried, overly broad, and stifling of emerging technology which stands to benefit millions.”

V. Key takeaways

It is crucial to consult legal counsel to determine whether your business, as a crypto trading platform, currently constitutes an exchange or would constitute such under the Proposed Rules. To make this determination, counsel can help determine whether securities are traded on your platform.

Importantly, crypto assets are not per se securities. Rather, the analysis is governed by the four-pronged Howey test: (1) investment of money (2) in a common enterprise (3) with an expectation of profits (4) solely on the efforts of others. SEC v. W.J. Howey Co., (U.S. Supreme Court 1946). This means that whether or not a particular transaction involving crypto assets constitutes the offer and sale of a security will depend on the facts and circumstances. Legal counsel can also help platforms think creatively about how to structure their businesses in light of Rule 3b-16 and Regulation ATS.

Finally, it is imperative not to delay in seeking guidance. Among other reasons, the longer a trading platform operates as an unregistered exchange, the more its profits may increase, which could lead to a higher disgorgement amount resulting from any enforcement action, and that could, in turn, lead to a higher prejudgment interest figure as well.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.