SEC’s ‘communication protocol systems’ rule could hit DeFi

The SEC’s big DeFi move

Gary Gensler has been talking about taking on the crypto industry since he started last April. Now he’s getting down to business. The SEC is taking on the crypto industry in a way that could have far-reaching implications, particularly for DeFi, by expanding the agency’s regulatory authority over decentralized trading systems. The potential mechanism is a rule quietly proposed in January that would expand the definition of an “exchange” to include “communication protocol systems.”

This could be the SEC’s big move on crypto. The industry is taking notice.

• “It’s the biggest, most profound rule-making the SEC has ever had,” said Nicholas Losurdo, a partner at law firm Goodwin who previously worked at the SEC. “It has the ability to sweep in a lot of DeFi and crypto, whereas now they don’t have jurisdiction.”
• The comment period on this proposal is still open, but some crypto industry officials are concerned enough that they’ve called on the SEC to extend its comment period to 90 days so that more industry participants can give comments.
• The proposal could “expand SEC authority over spot digital asset markets and peer-to-peer decentralized networks in ways not publicly mentioned or discussed in the Proposal,” Michelle Bond, CEO of the Association for Digital Asset Markets, which represents Galaxy, FTX, Paxos and others, wrote to the SEC.

DeFi players should take note. This change in definition could mean regulating not just centralized crypto entities but even decentralized finance protocols, according to Losurdo.

• To be clear, the 654-page proposal does not mention crypto or DeFi. But it makes key changes, such as changing the definition of an “exchange function” to bringing together people who interact, instead of just “orders” as it was before.
• This broadening of the scope of what an exchange is could pull in a range of crypto products, Losurdo said, since the SEC document says that it applies to “trading any type of security.” And Gensler has been clear that he believes that many digital assets are in fact securities.
• Any person or group working on a DeFi protocol — which could mean a wide range of contributors, since the projects are typically open source — might need to register with the SEC, Losurdo said. Even someone who wasn’t part of a company but wrote software would potentially need to register, he said.

It’s unclear how this would practically work. The SEC has enough trouble going after centralized crypto companies.

• Many decentralized finance protocols aren’t owned by a company. They may be run by a DAO and operate on automated software, so it’s unclear how the SEC would regulate these entities.
• It could go after the companies that create these protocols. The SEC has reportedly investigated Uniswap Labs, the company that created decentralized crypto exchange Uniswap. But it’s unclear how such action would change anything with the protocols themselves, which have a life of their own.
• Many DeFi protocols are managed overseas, or have key individuals who are not U.S. citizens or residents, so that’s another challenge.

The SEC is already trying to get more of the crypto world under its purview. So far it’s a mixed bag.

• It has gone aggressively after crypto lending, recently settling with BlockFi for $100 million. But that involved a centralized lending operation. It’s not clear how the SEC would pursue truly decentralized lending, or more complex operations like staking.
• Gensler has said he believes crypto exchanges need more protections for investors, and thus should be regulated by the SEC. But to do that, the SEC would need to demonstrate that assets on exchanges are securities. And that may remain muddy until Congress acts.

It’s not clear what will happen with this particular rule change: Look at the SEC’s climate rule morass for how easy it is for rule-making to get bogged down in lobbying and technical detail. But getting a rule passed is one thing. Figuring out how to enforce it against DeFi will make that look easy.

— Tomio Geron (email | twitter)

A MESSAGE FROM NOVOPAYMENT

The future of the digital economy is in our hands. That’s why NovoPayment partners with fintechs to turn their visions into reality. Unlock the power of NovoPayment’s suite of complementary BaaS solutions from digital banking to card solutions, payment infrastructure, and more – all on our easy-to-use platform. Let’s innovate.

Learn more

On the money

On Protocol: Europe’s holdout governments gave way on banning some — not all — Russian banks from SWIFT. The U.S. and its Western allies will also work to freeze the assets of Russia’s central bank, the White House, the European Commission and others jointly announced Saturday.