The Securities and Exchange Commission (SEC) is a U.S. federal agency that deals with enforcing federal securities laws and regulating the securities area as well as stock and options exchanges.
When it comes to securities, SEC’s jurisdiction is quite wide since it includes the questions of issuance, sale, and trading of securities, along with investor protection and safeguarding a fair and efficient market.
What does all of this have to do with crypto? If you frequently read crypto-related news, you have probably noticed that the SEC has taken on many enforcement actions against crypto companies, and that the agency claims that many crypto assets are indeed securities.
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VisitFor example, when the SEC determines a cryptocurrency or token is a security and falls under its regulatory purview, there are several implications for the issuers. The issuer must comply with SEC regulations that come with extensive reporting and transparency requirements.
On the other hand, DeFi has been the centre of regulatory attention several times as well. To find out more about the regulation of decentralised finance (DeFi), why not read this article: 'Will DeFi be regulated? How DeFi can comply with old school compliance'.
As defined by the U.S. Securities Act of 1933 and the Securities Exchange Act of 1934, securities include traditional investments such as stocks, bonds, and notes, but may also apply to other investment contracts if they meet the required criteria.
To determine whether a financial instrument is an investment contract and therefore a security under U.S. federal law, the U.S. Supreme Court guided the 1946 decision in the case of SEC c. W.J. Howey Co.
The Howey Test stipulates that an investment contract exists if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
The entire matter of whether particular crypto assets can qualify as securities revolves around the application of the Howey test. The debate revolves around the fact that many cryptocurrencies function on decentralised networks and blockchain technology which raises questions about how traditional legislation can apply to new technological solutions.
When it comes to the question of whether cryptocurrencies can be defined as securities, either on their own or during Initial Coin Offerings (ICOs), the U.S. Securities and Exchange Commission took the standing that nearly all cryptocurrencies are securities, with Bitcoin as the only known exception.
According to the federal agency, Bitcoin can be deemed a commodity rather than a security since it doesn’t represent an investment in a single enterprise as well as it doesn’t provide owners with a claim on future profits.
Other cryptocurrencies, especially those offered through Initial Coin Offerings (ICOs) or token sales, can be defined as securities if they meet the requirements established by the Howey Test.
The categorisation of cryptocurrencies as securities has a significant influence on their regulatory status. In other words, if a cryptocurrency is deemed a security, it needs to be registered with the SEC, along with the need for cryptocurrency exchanges to be compliant with the SEC’s regulatory requirements.
The balance between regulatory oversight and the fostering of technological innovation will be essential in determining the long-term status and growth of the blockchain and the broader cryptocurrency market.
The Securities and Exchange Commission (SEC) noted that better regulation of crypto assets and the crypto space could reduce volatility, boost market integrity and efficiency, reduce tax evasion, and protect investors. On the other hand, there is a need to introduce a balanced regulatory approach that would foster innovation instead of hindering it.
In February 2024, the SEC adopted new rules that extend the definition of ‘dealer’ and ‘government securities dealer’ under the 1934 Securities Exchange Act that requires registration of market participants that significantly provide liquidity.
As noted in the SEC Adopting Release adopting Rules 3a5-4 and 3a44-2 under the Exchange Act, also known as New Rules, the federal agency wants to primarily deal with certain market participants, such as proprietary trading funds and private funds that act as dealers without registration. However, these regulatory documents could have important implications for all market players, including crypto assets.
In simple terms, the New Rules turn particular groups of traders or customers into securities dealers by defining the phrase ‘as a part of regular business’ to identify, but not limit, particular activities that would cause persons engaging in such activities to be dealers or government securities dealers, and therefore, subject to registration requirements.
The New Rules effectively turn certain traders or customers into securities dealers. The concern over the expanded description of the concept of “dealer” is particularly acute when evaluated in light of the SEC’s adoption of rules related to private fund advisers, short position and short activity reporting, and securities lending disclosure.
To sum it up, the New Rules require covered market participants to register with the SEC, become members of a self-regulatory organisation such as the Financial Industry Regulatory Authority (FINRA), and comply with federal securities laws and regulations.
What does this mean for the crypto space? The extended definition includes persons and businesses that utilise automated and algorithmic trading technology to execute trades and provide liquidity. This regulatory move was instantly criticised by the crypto community as industry experts stated that it could cripple the decentralised finance (DeFi) industry in the long run.
For many years, the U.S. Exchange Act has limited the dealer definition and excluded traders or any person that buys and sells securities for such a person's account, but not as a part of a regular business.
The Securities and Exchange Commission (SEC), under Chair Gensler, became concerned with particular market players whose market share in providing liquidity was significant and stood outside the existing dealer regime.
The Commission has expressed many concerns that markets are lacking investor protection as well as the absence of regulatory oversight that would help in promoting market integrity and stability.
All of these concerns resulted in the adoption of new rules extending the definition of a dealer and requiring registration for the mentioned active market participants.
Even though the analysis in the Adopting Release identifies only a few persons that would be subject to New Rules, advancements in electronic trading of digital assets could make other market participants fall into this category as well.
The scope of SEC’s proposal is extensive – it includes all securities involving equities, treasuries, fixed income, municipal securities and crypto assets deemed as securities. Additionally, any person or business that has or controls total assets of at least $50 million and satisfies one of two novel qualitative standards must register as a dealer and comply with legal requirements.
There are growing concerns that the introduction of qualitative standards provides the SEC with an extended ability to determine who falls under the new standard. The crypto community noted that there is an uncertainty whether the New Rules apply to crypto platforms such as decentralised exchanges (DEXs) and their Automated Market Maker (AMM) technology.
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VisitIf we take a look at the 2022 SEC’s proposal of the dealer definition that consists of 200 pages, we can spot that it doesn’t mention decentralised finance (DeFi) at all but hold your horses – digital assets are mentioned in a footnote which states that the proposed rule 3a5-4 would apply to securities and government securities, including any digital asset that is a security or government security.
As the New Rules state, a person that is engaged in buying and selling securities or government securities for their own account is engaged in such activity as a part of a regular business.
Such definitions typically include technical terms associated with the trading space. To learn more about crypto assets and crypto trading, we recommend selecting one of our courses at the Learn Crypto Academy.
Therefore, a person must register as a dealer if they engage in a regular pattern of buying and selling securities or government securities that has the effect of providing liquidity to other market participants by regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a manner that makes it accessible to other market participants or earns revenue primarily from capturing bid-ask spreads or from capturing any incentives provided by trading platforms to liquidity-supplying trading interest.
This is a long and complex legal definition so let’s break it down into parts. All of these are referred to as qualitative factors that will be used in examining potential dealer activity.
What does it mean to express trading interest? The first qualitative factor doesn’t mention any particular method of communication, yet depends on the trading activity as a whole. The SEC doesn’t think it is relevant whether the market participant has customers or not because the statutory text doesn’t include the term ‘customers. Therefore, a market player doesn’t need to express trading interest all the time or be profitable to fall under the dealer category.
The second qualitative factor mentions an activity that has the effect of providing liquidity. The trading interest in the light of the second factor refers to an order or any non-firm indication of a willingness to buy or sell a security.
Additionally, the trading interest doesn’t need to be expressed simultaneously on both sides of the market, which could impact persons utilising trading strategies relying on bids on a central limit order book.
The SEC uses the term ‘regularly’ to capture market participants expressing trading interest that is communicated and represented in a manner that makes it accessible to other market participants.
The agency didn’t define this term, yet stated that it doesn’t aim to catch isolated expressions of trading interest. On the other hand, a market participant doesn’t need to express it continuously to engage in a regular business.
All this regularity mentioned by the SEC shall also depend on the liquidity and depth of the security in question since the agency stated that, in markets associated with depth and liquidity, the trading interest would have to occur more frequently. If you wonder how frequently it should occur, the answer is still unclear.
A person shall be also considered a dealer if that person engages in a regular pattern of buying and selling securities with the effect of providing liquidity to other market participants by earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives provided by trading venue to liquidity-supplying trading interest. This definition presents the Primary Revenue Factor.
Let’s break down this definition into components as well. First, we have the term ‘primarily’ which illustrates a situation where a person derives the majority of their revenue from the described sources. Thereby, if a person earns more revenue from let’s say, the appreciation of its securities portfolio, it wouldn’t meet this requirement.
However, the person would need to examine the frequency of trading and market’s depth and liquidity to be sure that it doesn’t fall into the dealer category.
The SEC further noted that the mentioned trading strategies don’t need to be profitable to define someone as a dealer.
Yes, there are three exceptions – in the Adopting Release, the SEC mentioned that three categories of persons shall be excluded from the extended definition: persons that have or control total assets valued below $50 million, investment companies registered under the 1940 Investment Company Act, as well as central banks, international financial institutions, and sovereign entities.
However, the New Rules don’t exclude any types of securities so crypto asset securities are captured under the new definition.
The New Rules caused a lot of confusion; even though the final rules are narrower than the 2022 proposal, they are still being criticised for broadly extending the dealer definition.
These rules raised the question of which market players will be captured by the novel regulatory regime as well as the issue of compliance with a new legal status. Market participants who could be identified as dealers will have to think about whether they want to register as such or change their business activities.
Compliance with the New Rules could be challenging for some market participants based on their existing business model as they will be subject to, for example, minimum net capital and relevant financial accountability requirements as well the requirement to file financial reports frequently.
The confusion also stems from the SEC’s statement that there is no presumption that a person is not a dealer only because they don’t satisfy the requirements of the New Rules. In other words, even if market participants believe, according to the requirements, that they don't fall within the regulatory interpretation, the SEC could define them as a dealer.
Any decentralised exchange that fits the new criteria under the proposal and that didn’t register with the SEC could be declared an unregistered dealer, which is a felony offence under securities law.
The crypto community didn’t react well to the New Rules. Once the SEC confirmed the application of the New Rules to those engaged in crypto asset securities and refused to set out an exemption for DeFi products and activities related to the use of AMMs, smart contracts, and peer-to-peer execution protocols, the crypto community referred to the new piece of legislation as a sneak attack.
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VisitSeveral industry experts considered that the enforcement of these rules could hinder innovation or as they said - ‘kill the tech’.
The New Rules could bring all liquidity providers and AMMs with more than $50 million in total assets under the regulatory umbrella of the Securities and Exchange Commission (SEC) and therefore, subject to its registration and compliance requirements.
In case a decentralised exchange fits the new requirements and doesn’t register accordingly, it would be deemed an unregistered dealer which presents a felony offence under securities law.
The tension between the U.S. SEC and the crypto industry has been going on for a while. It started when the agency first wanted to qualify cryptocurrency as securities, and the matter culminated following the extended dealer definition – on 23 April 2024, two crypto industry groups, the Blockchain Association and the Crypto Freedom Alliance of Texas sued the agency challenging the new dealer rule.
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VisitThe suit was filed in the District Court for the Northern District of Texas claiming that the SEC didn’t engage with the feedback it received during the public comment period and failed to conduct the statutorily required economic analysis.
Crypto industry groups stated that the extended dealer rule exceeds the agency’s authority and amounts to arbitrary rulemaking since the SEC decided not to exempt the digital assets industry or thoroughly explain how the rule would apply to them.
They claimed that a single mention of digital assets in a footnote presents an insufficient notice of how and why the regulator intended to apply the novel rule to the digital asset markets, referring to it as an unlawful approach based on regulatory uncertainty.
This suit is one of many suits crypto industry groups filed against the SEC just in 2024, as opposed to waiting for even more incoming lawsuits from the agency.
For example, in February 2024, a group of crypto companies, including the crypto exchange Coinbase and venture capital company Andreessen Horowitz sued the agency and claimed that it doesn’t have jurisdiction over several areas of the crypto industry.
In March 2024, the DeFi Education Fund (DEF) sued the agency asserting that free airdrops don’t present a violation of securities law. The plaintiff wanted to proactively assert this notion to prevent the regulator from making similar claims in the future.
An interesting fact is that all of these 2024 lawsuits were filed in Texas, which is considered as a crypto-friendly state in the country.
The recent response triggered a mobilisation of advocacy groups and industry experts to seek a favourable regulatory framework or at least clarification and amendments to existing securities laws to highlight the unique nature of crypto assets.