The public has until Tuesday, June 13th to submit comments, and comment everyone should, because the fatal flaws of this proposal have only been exacerbated in this latest version, said Bill Hughes, senior counsel and director of global regulatory matters at ConsenSys. Making matters more complicated, so-called groups who participate in protocols will almost always involve persons based outside the United States. That matters because U.S. securities laws generally do not apply extraterritorially.
The U.S. Securities and Exchange Commission (SEC) has reopened the comment period for a proposed set of rules that would redefine various blockchain protocols as U.S. regulated securities exchanges, a second try at reining in decentralized finance (DeFi) from early 2022. The central problem with the SEC’s proposal is that trying to treat blockchain protocols as regulated exchanges simply cannot be squared with the Exchange Act of 1934, existing exchange regulations, or an accurate understanding of blockchain technology. The SEC’s latest rulemaking proposal treats exchanges as any system that merely sets up potential buyers and sellers, allowing them to find and negotiate transactions with each other.
The SEC’s 2023 draft, other than clarifying that, yes, the rules would apply to blockchain, cures almost none of long-standing problems. The agency does not explain the threshold of significant token ownership at which blockchain users suddenly obtain sufficient control over the system to assume regulatory responsibilities. Nor does it address the circumstances when a service provider or third-party vendor begins exercising enough control to become responsible – alongside its clients – for a protocol or application.
The SEC summarily ignored the requirement that for a group of persons to be considered an exchange, they must act in concert. Instead, in order to ensnare decentralized finance (DeFi), the agency waters down the notion of collective liability to include persons engaged in related activities. The 2023 proposal also compounds confusion by making highly contestable pronouncements about the scope of its current regulation.
The SEC must discuss the benefits and costs of their proposal and how they compare. It is puzzling, therefore, how little attention this is given. For its part, the SEC confidently declares the main benefit is its expanded regulatory purview – as if that was all the reason one needs. With respect to costs, the proposal meekly offers that the fines would not be impossible to pay.
The proposal appears to greatly underestimate the number of blockchain protocols that would be affected. Further, it does not recognize that these regulatory burdens are magnified for the ordinary individuals who participate in the blockchain ecosystem – such as validators, DAO members, and liquidity providers. There are constitutional issues with how the SEC’s proposed rules would regulate speech.