Is playing dumb a good regulatory strategy?

Feb 15, 2022

Hello fellow nerds! This newsletter (which is neither a letter nor does it typically convey news) has now surpassed 1,000 subscribers! Thank you so much for entertaining my idle musings. Please do send it to friends who you think might like it as word of mouth is the only way it keeps growing, and growth motivates me to keep blathering.

Today we tackle a regulatory conundrum, which is my favorite kind of conundrum.

The SEC recently proposed a regulatory change to expand the universe of entities that would qualify as regulated securities exchanges. This proposed change may have potential implications for DeFi, and in particular decentralized exchange even though there isn’t even a hint of the words DeFi, crypto, or anything of the kind in the proposal.

Exchange Act Rule 3b-16 currently states that one is a regulated exchange under the Act if one:

(1) Brings together the orders for securities of multiple buyers and sellers; and (2) Uses 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 the SEC’s regulatory proposal is finalized as currently drafted, it would amend Rule 3b-16 to read like so (changed parts in bold):

(1) Brings together buyers and sellers of securities using trading interest; and (2) Makes available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of a trade.

Do you see the difference? Today you’re on the hook for registering with the SEC as an exchange or ATS if you bring together “the orders for securities” of multiple buyers and sellers and do so “using” certain methods for matching orders to result in a trade. That is, if you’re engaged in the pretty specific conduct of taking orders, matching those orders, and executing trades. In contrast, the standard under the new rule doesn’t require this same kind of clear conduct. Instead, you’d be a regulated exchange if you bring together not orders, but buyers and sellers expressing trading interest and you also make available to them protocols* by which they can interact and agree to trade with each other.

As I understand it, the proposal is mainly aimed at something like a Bloomberg Terminal through which buyers and sellers can find each other using chat functionality that includes the ability to express non-firm interest in certain transactions at certain prices and then agree with each other (through the system) to a trade. I have no opinion if expanding the rule to cover this kind of system is justified or not. However, the language of the new proposed rule is written so broadly that it’s difficult to see how it wouldn’t cover decentralized exchange even though, again, neither DeFi nor crypto nor anything related is mentioned in the proposal.

SEC Commissioner Hester Peirce pointed out as much at the end of her dissent from the proposal:

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. Even if you have nothing to do with government securities or even fixed-income, or with traditional securities, read this release. Preferably as soon as it is published on the Commission’s website. It covers a lot of ground, and you should not assume that it has nothing to do with you, because it probably does.

Yes, of course it does. It’s right there in black and white. Bringing together buyers and sellers by “making available” protocols which they can use to find each other and agree to trades, an SEC lawyer could easily argue, is what a DEX protocol developer does. So, of course, we’ll be engaging in this proceeding.


Isn’t it weird that in none of the proposal’s 654 pages is decentralized exchange or crypto mentioned? And isn’t it weird that, as Peter has pointed out, the proposal states that the Commission estimates that only 22 protocol systems will be affected by the rule change? It really seems like they never intended this change to cover DeFi at all. It seems like it really was aimed just at a small, specific universe of trading systems.

What to make of that? Is this a devious plan by the Commission to sneak through a rule change aimed at DEX by dressing it up as something else?

I doubt it. Even if its potential application to DEX wasn’t lost on some folks at the SEC, a proposal like this is serious business with a lot of process.** Additionally, the law is set up precisely to prevent such a sneak attack. This is well put:

Screen Shot 2022-02-14 at 1.57.49 PM.png

If the SEC adopts this rule as is, and the next day brings an enforcement action against the developer of a DEX protocol, that developer could argue in court that the SEC didn’t follow proper administrative procedure because it did not give any notice whatsoever that DEX would be covered and, as noted above, that its economic analysis didn’t consider DEX or anything crypto-related.

There’s a catch, however.

If we and others file comment letters in the proceeding for this proposed rule and bring up DEX and DeFi and crypto, then the SEC will be obligated to respond to those comments when they finalized the rule. That would be the first Commission statement ever on DEX and they would likely say, yeah, it fits the new broad definition and we think people who “make available” such protocols need to register as exchanges. As a result of filing comments that bring up DEX, therefore, the community would be soliciting a response that does away with the procedural argument that there was no fair warning.***

This reality has led some to wonder whether it might make more sense for the crypto community not to file in this proceeding at all. The argument is that if the Commission didn’t realize that the rule change would cover DEX, or at least is pretending it didn’t realize, then the crypto community might be best served by equally pretending to be just as ignorant in order to preserve procedural challenges in court. I don’t think that makes much sense and here’s why.

First is the simple fact that there is no way to control what the community will do and it’s inevitable that someone will file a comment about DEX. Indeed, folks already have. As I said about the blowback that the VC-led push to rebrand crypto as “web3”, crypto a movement, not just an industry, and an open-source one at that, which means that while consensus is possible, unanimity never will be.

Second, I’m not sure getting a Commission statement on DEX is such a bad idea. I keep hearing folks say they don’t want regulation by enforcement. Well, the alternative is regulation by rulemaking, which is what this proceeding is doing. If we can get a clear statement from the Commission that its new rule will cover DEX protocol developers, then those developers should have the grounds to immediately sue the SEC themselves. Depending on how broadly the Commission were to say the rule applies, one could imagine a community-funded suit brought by a solo open-source smart contract developer on First Amendment grounds. (👀)

Finally, let’s not be cynical. Given the fact that we have an administrative state, we shouldn’t give up the only means we have to keep its policymaking accountable: commenting in regulatory proceedings. I know the world today can lead one to give up hope, but it’s not impossible that data and arguments shared via the comment process could lead the Commission to reconsider its rule and make valuable changes. It’s not like the SEC is a monolith. Right now the chairman is being challenged by the two other Democratic commissioners on one of his top priorities–the new ESG rules—handing the Biden Administration another humiliating setback.

Various and Sundry

Because life is short, I only produce two podcasts and this time I’ve got one of each to share with you.

On Tangents from Coin Center, Peter and I recently discussed how we explain "staking" to policymakers who sometimes are confused about how that word is used in different cryptocurrency contexts.

And on Worker & Parasite, my book discussion podcast with Stably, we discussed Against Everything: Essays by Mark Greif.

* FWIW the proposal also deleted the word “multiple” so that presumably you could have just one buy and one seller being brought together.

** BTW, whether it’s a devious scheme or a total coincidence ultimately doesn’t matter. The proposed black letter rule is the same.

*** That said, unless they redo it, which they might well do or pretend to do, I’d think the economic analysis argument would still be available.

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