• J McGlynn and M Bacina

SEC attempts to cast its net too wide to include Automatic Market Makers into exchange definitions

Updated: Feb 8

The SEC has published a proposal to amend alternative trading systems regulation, followed fast-behind by an exacting dissent from Commissioner Hester Pierce. The proposed change would expand the scope of what constitutes a securities exchange and aims to address misconduct and promote transparency in the securities based swap markets.

In the proposals position summary the SEC states:

The Commission is proposing to amend a rule which defines certain terms used in the statutory definition of “exchange”.. to include systems that offer the use of non-firm trading interest and communication protocols to bring together buyers and sellers of securities.

While the proposal totals 654 pages, it's ambition to expand the definitions of securities “exchange” has been criticised for lacking careful consideration of the impact it would cause on Blockchain and DeFi.

According to Commissioner Pierce:

The proposal is certainly not sloppy, but at the same time it is too wide-ranging and, given its length, too unwieldy to facilitate careful consideration.

The proposed rule does not expressly reference blockchain or DeFi but crypto experts suspect the SEC has proposed the broad definition to bolster it's currently weak argument that automated-market makers are securities exchanges under the ambit of its authority. An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol which removes the need for a counterparty (or other trader) to make a trade by relying on a mathematical formula to price assets instead. In other words, in contrast to a peer to peer trading platform where a seller is connected with an interested buyer to make a trade (and vice versa), an AMM algorithmically generates the market for a trader, allowing them to buy and sell from liquidity pools through smart contracts instead.

At the crux of major criticisms of the proposal is its absence of methods of registration and reporting which individuals who allegedly “make available” a AMM protocol or other DeFi systems, could follow if the definition is accepted to include AMMs.

As a result, crypto-expert Gabriel Shapiro describes the rule as:

at a minimum irresponsible and thoughtless as regulation, and...may also be unconstitutional as a restraint on free speech.

Describing the SEC's proposal as "rushed rule making", Commissioner Pierce agrees the SECs rule lacks sufficient foresight, explaining:

Any efforts to reform this market must take into account the potentially cataclysmic risks of inadvertently making things worse through sloppy or rushed rulemaking that introduces uncertainty for market participants or that deprives the public and the Commission of the opportunity to devote careful attention to thinking through the full implications of the proposed rules.

In sum, while the proposed rule is unlikely to be introduced on the basis of it's impractical and contested implications, the SEC's massively broad move contains lessons for regulators in being careful of unintended consequences when regulation is pushed through perhaps a little too quickly.