The U.S. Securities and Exchange Commission recently reopened public comment on its proposal to expand the definition of an "exchange," clarifying that it intends to capture decentralized finance (DeFi) exchanges. On June 13th, 2023, Circle responded to and urged the SEC not to finalize the proposal due to its broad, likely adverse, implications for the broader cryptoasset industry and investors.
Circle supports the prudent and measured regulation of DeFi. In fact, we recently supported regulation that would make it easier for regulated financial institutions to use DeFi and for additional measures that would protect DeFi users. However, in this case, Circle urges the SEC to further consider the complexities that DeFi raises and cautions against over-applying traditional financial regulation to this innovative space.
Circle’s Key Points
The SEC has not fully considered important questions about how DeFi should be regulated.
The SEC does not appear to have considered how all of its other regulations would apply to DeFi exchanges. The SEC has not addressed, among other questions:
- Would a DeFi exchange’s registration as an alternative trading system (ATS) require it to become custodial due to broker-dealers’ obligations under the Customer Protection Rule?
- Who does the SEC envision will register a decentralized exchange if parties involved in the provision of services do not or cannot coordinate?
- How will the SEC regulate immutable protocols?
DeFi is a new technology with novel, user-beneficial characteristics that do not exist in the traditional financial sector. These include the ability to self-custody assets or the ability to disaggregate the provision of financial services. If the SEC is going to regulate DeFi, we believe it must carefully analyze these benefits and ensure they are preserved in any new regulatory structure.
The SEC’s economic analysis is incomplete.
Regulatory agencies are required to consider the economic costs and benefits of their rules. This analysis helps base rulemaking in empirical evidence, to the best of an agency’s ability, and it makes the rulemaking process fair. In this proposal, though, Circle does not believe the SEC has conducted a complete economic analysis of the important questions before it. For example, despite abundant market data, the SEC says it is unable to provide any estimate of the total trading volume on crypto exchanges. While we agree there may be confounding factors, such as wash trading volume, we don’t think this is a sufficient impediment to warrant declining to provide any estimate at all.
The SEC also asserts that the rule would not have a significant economic effect on a substantial number of small entities, a condition that would invoke certain other obligations of the SEC. Given the number of startups that are likely affected by this rule, we think this is inaccurate.
The SEC should not redefine the definition of “exchange” as proposed. But if it does so, the final rule should eliminate ambiguities that might hinder U.S. markets and economic competitiveness.
First, the SEC should explicitly exclude independent software developers from a “group of persons” that may be running an exchange. Though the proposal says that the SEC “may be less likely” to consider such developers to be within its jurisdiction, the SEC should be declarative that it would not seek to capture open source developers. Only a concrete statement of intent will provide the clarity needed by software developers to continue publishing free code for public benefit.
Second, we suggest that the SEC clarify that no specific legal provision prohibits the offering of pairs trading. Pairs trading — the practice of pricing trades for one cryptoasset in another cryptoasset such as BTC or USDC — is prevalent in the cryptoasset industry because of cryptoassets’ increased utility and investor preference. It’s also a necessity for any DeFi exchange that is not connected to legacy payment rails. The SEC says, as an empirical observation, that securities exchanges do not currently offer trades quoted in or paid for with non-U.S. Dollar instruments, but it’s not clear what, if any, regulation prohibits the practice. To the contrary, Dodd-Frank established a joint regulatory regime for situations like this. The SEC’s proposal assumes that the practice would need to end without providing an explanation for why that would be the case.
DeFi is new; regulation of new technology is not.
One irony of the SEC’s proposed rule is that it envisions DeFi exchanges would register as ATSs under a 1998 regulation that was issued in response to the internet’s effect on financial markets. Then, the SEC worked with Congress and industry for almost five years to analyze the markets and establish a new regulatory structure that would, as it said in 1998, “better integrate these systems into our national market system structure, and make the benefits of these systems available to more investors.” We think the SEC and Congress should undertake a similar process today.
You can read our full comment letter here.