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

SEC’s big DeFi move

Gary Gensler has been talking about entering the crypto industry since it started last April. Now he is working on it. The SEC is working on the crypto industry in ways that can have a widespread impact, especially on DeFi, by expanding the regulatory authorities of the decentralized trading system. A potential mechanism is a rule quietly proposed in January that extends the definition of “exchange” to include “communication protocol systems”.

This could be a major move by the SEC regarding cryptography. The industry is paying attention.

• “This is the largest and most profound rulemaking the SEC has ever experienced,” said Nicholas Losurdo, a partner at Goodwin, a law firm that previously worked for the SEC. “It has the ability to wipe out a lot of DeFi and cryptography, but currently has no jurisdiction.”
• The comment period for this proposal is still open, but it is sufficient that some crypto industry officials have asked the SEC to extend the comment period to 90 days so that more industry participants can comment. I am concerned about.
• This proposal has the potential to “extend the SEC’s authority over the spot digital asset market and peer-to-peer decentralized networks in ways not publicly mentioned or discussed in the proposal.” Paxos and others wrote a letter to the SEC.

DeFi players need to be careful. According to Losurdo, this change in definition could mean regulating not only centralized cryptographic entities, but even decentralized financial protocols.

• For clarity, the proposal on page 654 does not mention cryptography or DeFi. However, in addition to the previous “order”, we have changed the definition of “exchange function” and made important changes such as gathering people to interact with.
• Since the SEC document states that it applies to “all kinds of security transactions”, the expansion of the exchange’s scope could attract a variety of cryptocurrency products, Losurdo said. And Gensler makes it clear that he believes that many digital assets are actually securities.
• Since projects are usually open source, people and groups working on the DeFi protocol may need to register with the SEC, which could mean a wide range of contributors, Losurdo said. He said that even someone who wasn’t part of the company but wrote the software might need to register.

It’s unclear how this actually works. The SEC has enough problems to chase after a centralized crypto company.

• Many decentralized finance protocols are not owned by the company. It is unclear how the SEC will regulate these entities, as they are run by DAOs and may work with automated software.
• It may chase after companies that create these protocols. The SEC reportedly investigated Uniswap Labs, the company that created the distributed crypto exchange Uniswap. However, it is unclear how such behavior will change with the protocol itself, which has its own lifetime.
• This is another challenge, as many DeFi protocols are managed abroad or have key individuals who are not US citizens or residents.

The SEC is already trying to get more cryptocurrency worlds within that range. So far, it’s a mixed bag.

• It went aggressively after lending cryptocurrencies and recently settled on BlockFi for $ 100 million. However, it included a centralized lending business. It is not clear how the SEC will pursue truly decentralized lending, or more complex tasks such as staking.
• Gensler said he believes that cryptocurrency exchanges need more protection for investors and should be regulated by the SEC. However, to do so, the SEC needs to prove that the assets of the exchange are securities. And it may remain muddy until Congress acts.

It’s not clear what will happen with this particular rule change. See Morus of the SEC’s Climate Regulations for how easy it is to get stuck in rulemaking with lobbying and technical details. But passing the rules is one thing. Once you understand how to force it against DeFi, it will be easy to see.

— Tomio Geron (Email | twitter).

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