United States: SEC To Keep Watchful Eye On Digital Asset Trading Platforms

In July 2017, the SEC issued its landmark DAO Report, which clarified, among other things, its view that digital tokens with characteristics akin to those of an "investment contract" as established in SEC v. W.J. Howey Co.¹ are subject to federal securities laws. Although somewhat of an afterthought given the predominant digital-token-as-security focus of the DAO Report, the SEC also noted that certain digital asset trading platforms may satisfy the definition of a "national securities exchange" and therefore be subject to additional regulatory and compliance requirements.² Since 2017, the SEC's Division of Enforcement has targeted multiple digital asset trading platforms, charging several for violating, among other things, the exchange registration requirements under Section 5 of the Exchange Act.³ As the digital asset economy continues to grow by leaps and bounds, entities in the space need to be familiar with the pertinent regulations around exchanges.

When we analyze the pertinent regulations governing the space, however, it is the exception to the registration rule that necessitates a dominant focus. To date, there are only a few dozen registered national securities exchanges across the country. This is not a surprise, as registration is costly and subjects the entity to a litany of regulations. Instead, organizations operating platforms that allow buyers and sellers to trade securities – including digital asset securities – often look to Regulation ATS, the registration exemption for alternative trading systems, as their preferred method of regulatory compliance. Today, SECond Opinions Blog provides a basic background on Exchange Act rules and regulations around national securities exchanges, examine the exemption under Regulation ATS, and look ahead to how the SEC's recent rule proposal could impact the space going forward.

Exchange Laws and Regulation ATS

Section 5 of the Exchange Act makes it unlawful for any broker, dealer or exchange to effect any security transaction unless the exchange is registered as a national securities exchange under Section 6 of the Exchange Act or is otherwise exempted from registration. Section 6(a) empowers the SEC to prescribe rules for registration and accompanying requirements. Section 6(b) provides conditions an exchange must meet to be registered, such as requirements for member discipline and fraud prevention.

Section 3(a)(1) of the Exchange Act governs the definition of an exchange, and Exchange Act Rule 3b-16(a) provides a functional test to assess whether a trading system meets that definition.⁴ Under current rules, an "exchange" is generally defined as systems that 1) bring together the orders for securities of multiple buyers and sellers; and 2) use established, nondiscretionary 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 the trade.⁵ If an organization meets the criteria of Exchange Act Rule 3b-16(a) and is not otherwise excluded under Exchange Act Rule 3b-16(b), the organization must register pursuant to Section 5 of the Exchange Act as a national securities exchange under Section 6 of the Exchange Act or operate pursuant to an appropriate exemption.

Regulation ATS provides alternative trading systems – systems that match orders for buyers and sellers of securities – an exemption from exchange registration requirements.⁶ In effect, Regulation ATS allows these platforms "to choose to be regulated either as exchanges or broker-dealers."⁷ As such, an alternative trading system can avoid exchange-based regulatory requirements by, among other things, registering as a broker-dealer; complying with certain requirements concerning fees, order display, execution and security of automated systems; allowing examinations by the SEC or self-regulatory organization to which it is a member; filing appropriate information with the SEC; and establishing written procedures to ensure the confidential treatment of trading information.⁸

For digital asset trading platforms, the question of whether to utilize the exemption provided by Regulation ATS raises difficult gating issues. For example, a platform must consider whether the tokens trading on it constitute securities under the generalized Howey requirements. If so, the platform may need to comply with exchange-related registration or exemption requirements. A lack of clarity around which tokens are securities creates spillover ambiguity for these platforms and exposes them to significant risks that can handcuff startup entities before they even get off the ground.⁹

As the industry continues to introduce new products and platforms for exchanging such products, the SEC's recent rule proposal covering the definition of exchanges and scope of Regulation ATS could inject more uncertainty into an already uncertain regulatory regime.

The Road Ahead: Regulation ATS and Digital Asset Marketplaces

As demonstrated by several enforcement actions against digital asset trading platforms in recent years and the agency's hyper-focus on the digital asset industry at large, it's not a surprise that Regulation ATS has become an ancillary focus point for the SEC. But in its Jan. 26, 2022, 654-page rule proposal, the agency proposed rules that, if adopted, could result in a seismic shift for many platforms in the digital asset space.¹⁰

The headline for the rule proposal involved suggested changes to Regulation ATS and Regulation SCI with regard to alternative trading systems for government securities. However, the rule proposal includes multiple contemplated changes that could have significant impacts on all alternative trading systems, including digital asset trading platforms. Specifically, the proposal expands the definition of "exchange" in three key respects.

First, under the proposed rule, an "exchange" includes systems that bring together any "trading interest," as opposed to simply "orders" for securities. Under the proposal, systems that brings together "non-firm trading interest" – meaning both orders and non-firm indications of a willingness to buy or sell a security – could be considered an exchange. The definition of "trading interest" would include "any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price."¹¹ The SEC noted in the proposal that "[a]mending Exchange Act Rule 3b-16(a) to include non-firm trading interest would eliminate the possibility that systems may offer the use of non-firm trading interest that, in practice, functions as firm orders, so as to avoid exchange registration or complying with Regulation ATS."¹²

Second, the proposed rule expands what constitutes an "exchange" by adding "communication protocols" as an established method of bringing together buyers and sellers of securities. The SEC stated that these communication protocols systems "generally use non-firm trading interest as opposed to orders to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade."¹³ The SEC stopped short of providing a specific definition for the term. Instead, the agency highlighted several examples that could be considered a communication protocols system: "For example, if an entity makes available a chat feature, which requires certain information to be included in a chat message (e.g., price, quantity) and sets parameters and structure designed for participants to communicate about buying or selling securities, the system would have established communication protocols."¹⁴ The SEC also indicated its intention to take "an expansive view" of what would constitute "communication protocols."¹⁵

Third, the SEC included a more subtle change to the definition of an "exchange" by replacing the phrase "uses established, nondiscretionary methods" with "makes available established, nondiscretionary methods." Although small on the surface, such a change could have a significant impact across the market. According to the proposed rule release:

The proposed change to use the word "makes available" rather than "uses" is designed to capture established, non-discretionary methods that an organization, association, or group of persons may provide, whether directly or indirectly, for buyers and sellers to interact and agree upon terms of a trade. In contrast to the term "uses," the Commission believes the term "makes available" would be applicable to Communication Protocol Systems because such systems take a more passive role in providing to their participants the means and protocols to interact, negotiate, and come to an agreement.¹⁶

Although the scope of the entities that the SEC hopes to bring under its regulatory jurisdiction with the proposed change remains to be seen, it seems clear that the agency is looking to bring third parties within the scope of exchange-related considerations. As the agency noted, "[t]he term 'makes available' is also intended to make clear that, in the event that a party other than the organization, association, or group of persons performs a function of the exchange, the function performed by that party would still be captured for purposes of determining the scope of the exchange under Exchange Act Rule 3b-16."¹⁷

If adopted, the expanded definition of an exchange would clearly require many platforms to comply with the exchange-related requirements or otherwise fit within an exemption such as Regulation ATS. Despite the lengthy rule proposal and its potentially far-reaching effects, the SEC has provided only a 30-day comment window from date of publication in the Federal Register to respond to the 224 questions in the proposal. Unsurprisingly, some within the digital-asset industry have submitted comments to the rule proposal requesting more time for public comment and raising concerns that the proposed rule has material implications for the industry.¹⁸

Footnotes

¹ 328 U.S. 293, 301 (1946).

² See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and The DAO, Exchange Act Release No. 81207 at 16–17 (July 25, 2017).

³ See, e.g., Press Release, U.S. Sec. & Exch. Comm'n, SEC Charges Poloniex for Operating Unregistered Digital Asset Exchange (Aug. 9, 2021); Press Release, U.S. Sec. & Exch. Comm'n, SEC Charges Dallas Company and Its Founders with Defrauding Investors in Unregistered Offering and Operating Unregistered Digital Asset Exchange (Aug. 29, 2019); Press Release, U.S. Sec. & Exch. Comm'n, SEC Charges EtherDelta Founder with Operating an Unregistered Exchange (Nov. 8, 2018).

⁴ 17 C.F.R. § 240.3b-16(a). Note that the Commission adopted Exchange Act Rule 3b-16(b) to explicitly exclude certain systems that the Commission believed did not meet the definition. 17 C.F.R. § 240.3b-16(b).

⁵ 17 C.F.R. § 240.3b-16(a).

⁶ 17 C.F.R. § 240.3a1-1(a)(2).

⁷ Regulation of Exchanges and Alternative Trading Systems, Exchange Act Release No. 34-40760 (Dec. 8, 1998).

⁸ See 17 C.F.R. § 242.301.

⁹ A fair assessment of the space requires an acknowledgement that some guideposts – albeit disparate and incomplete ones – do exist for participants. For example, concerning such gating issues, the SEC and its various divisions have provided resources over the years to highlight their positions on various issues in the digital asset space – such as its FinHub website, the 2019 investment contract framework and no-action letters (such as TurnKey Jet). As it relates to trading platforms and Reg ATS, the agency has highlighted the potential implication of exchange-related rules in this space dating to the DAO Report, and participants can garner guidance from settled orders like those in FN 3 above. Additionally, the SEC and FINRA in 2019 discussed ways for broker-dealers to operate digital-asset ATSs, proposing several models through which a broker-dealer could match buyers and sellers of digital assets. Similarly, FINRA offered guidance via FINRA Notice 18-25 to remind registered broker-dealers seeking to comply with Reg ATS of certain supervisory responsibilities.

¹⁰ This post does not touch on other aspects of the proposed rule, such as eliminating the exemption for systems that exclusively trade government securities or those that trade repurchase and reverse repurchase agreements on government securities.

¹¹ Proposed Amendments to Rule 3b-16 Regarding the Definition of "Exchange" and Regulation ATS for ATSs That Trade U.S. Government Securities, Exchange Act Release No. 94062 at 575 (Jan. 26, 2022) (to be codified at 17 C.F.R. § 242.300(q)).

¹² Id. at 29.

¹³ Id. at 43.

¹⁴ Id. The Commission noted that communication protocol system "may take many forms and could include: setting minimum criteria for what messages must contain; setting time periods under which buyers and sellers must respond to messages; restricting the number of persons a message can be sent to; limiting the types of securities about which buyers and sellers can communicate; setting minimums on the size of the trading interest to be negotiated; or organizing the presentation of trading interest, whether firm or non-firm, to participants." Id. at 43–44.

¹⁵ Id. at 44 ("[T]he determination of whether the system meets Rule 3b-16(a)(2) would depend on the particular facts and circumstances of each system. Nevertheless, as proposed, the Commission would take an expansive view of what would constitute "communication protocols" under this prong of Rule 3b-16(a).").

¹⁶ Id. at 40.

¹⁷ Id.

¹⁸ See Glob. Digit. Asset & Cryptocurrency Ass'n, Comment Letter on Proposed Rule to Change Definition of Exchange and Regulation ATS for Government Securities (Feb. 2, 2022), (requesting an extension of the public comment period to allow proper industry input); Ass'n for Digit. Asset Mkts., Comment Letter on Proposed Rule to Change Definition of Exchange and Regulation ATS for Government Securities (Feb. 2, 2022).

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