New SEC rule may sweep DeFi participants into the definition of “dealer”

On February 6, 2024, the Securities and Exchange Commission (SEC) announced a new rule to amend the definition of securities “dealer.” The rule has important and potentially concerning implications for DeFi and blockchain as the SEC has publicly suggested it may subject automated market maker (AMM) liquidity providers and other DeFi participants to registration requirements and other regulation.

New rules supplement the definition of “dealer”

The Exchange Act and SEC rules subject securities “dealers” to comprehensive registration and other regulatory requirements. Section 3(a)(5) of the Exchange Act defines “dealer” to mean “any person engaged in the business of buying and selling securities . . . for such person’s own account” but excludes “a person that buys or sells securities . . . for such person’s own account . . . but not as part of a regular business.” The SEC notes in this release that the purpose of registering and regulating dealers is to “support market stability and resiliency and protect investors by promoting the financial responsibility and operational integrity of market participants that are acting as dealers.”

The SEC has previously considered several factors in determining whether a person is a securities dealer. For example, a 2002 SEC release stated a person may be a dealer if engaged in the following activities: (1) underwriting; (2) market making on an organized exchange or trading system; (3) acting as a de facto market maker whereby market professionals or the public look to the firm for liquidity; or (4) buying and selling directly to securities customers together with conducting activities such as investment advice, extending credit and lending securities, and carrying a securities account.

In explaining the need for new rulemaking, the SEC claims that in recent years, market participants engaging in significant liquidity provisioning have not registered as dealers. The SEC notes this is particularly true for proprietary trading firms, which account for significant trading volume but may not engage in other types of dealer activities (such as those described above). The SEC claims a need to regulate such participants in certain circumstances to reduce the difficulty and complexity for regulators to investigate, understand, and address significant market events.

Accordingly, new SEC Rule 3a5-4 further defines what it means to be engaged in the business of buying and selling securities “as part of a regular business.” Under the new rule, a person is engaged in buying and selling securities for their own account “as part of a regular business” if that person “engages in a regular pattern of buying and selling securities that has the effect of providing liquidity” by either (i) “regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants” or (ii) “earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest.” The rule also excepts certain persons from the definition, most notably “a person that has or controls total assets of less than $50 million.”

The rule does not establish the exclusive means of determining whether a person is a securities dealer; existing SEC interpretations and precent will continue to apply.

All five commissioners issue statements

Each of the SEC’s five commissioners issued statements on the final rule. In particular, Commissioner Hester M. Pierce objected to the rule’s disregard for the “dealer-trader distinction.” According to Pierce, the SEC has long interpreted the definition of “dealer” to exclude “a person that buys or sells securities . . . for [its] own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” In Pierce’s view, the new rule sweeps in “any person whose ‘regular business’ involves trading activity for its own account that provides liquidity on a more than ‘incidental’ basis.”

The impact of dissolving this distinction would be subjecting market participants to a “regulatory regime that does not make sense for them” while stripping them of “protections now afforded them as customers.” Commissioner Pierce further criticized the rule for penalizing liquidity provision, which, in her words, “means there will be less of it” which, in turn, “harms the broader market.” Small and midsize liquidity providers that are unable to bear the cost of registration and compliance could be driven to consolidate or withdraw liquidity making “the market more fragile.”

Though these concerns were not directed to DeFi specifically, Commissioner Pierce’s logic applies to it equally. Pierce recognized that the rule’s application to DeFi would raise distinct concerns. Noting that, under the rule, “a crypto automated market maker might have to register as a dealer under the final rules,” Pierce asked, “How can a software protocol register as a dealer”? Commissioner Mark Uyeda’s remarks echoed Commissioner Pierce’s concern about the new definition of “dealer” and the accompanying risk to market liquidity.

Chair Gary Gensler and Commissioners Caroline Crenshaw and Jaime Lizárraga each expressed support for the rule. Gensler touted the rule’s greater protection for investors, and, through registration and compliance with high standards for statutory “dealers”, Gensler anticipated greater market integrity, resiliency, and transparency. Commissioner Gensler spoke about his anecdotal experience as a young Wall Street associate hearing about government securities firms that were not registered as dealers and failed catastrophically in the 1980s. Though issues with government securities dealers were largely solved by the Government Securities Act of 1986, Gensler believes that “potential regulatory gaps” exist and pointed to the “electronification” of markets as a source of risk. Under the new rules according to Gensler, anyone who “trades in a manner consistent with de facto market making … must register with us as a dealer.”

DeFi participants note its potential application

A number of commenters on proposed versions of the rule noted that it might be held to apply to certain participants in the DeFi market who provide crypto asset securities liquidity, including liquidity providers (LPs) in AMMs. LPs typically provide liquidity in trading pairs of tokens and receive fees from the AMM for doing so, potentially meeting one of the rule’s definitions of dealers. The SEC notice of final rulemaking declined to provide specific guidance to determine whether a particular activity in the DeFi market gives rise to dealer activity, stating such a determination would require an analysis of the totality of particular facts and circumstances.

This rule has added to the crypto industry’s growing concern over SEC attempts to regulate the crypto markets. The rule itself leaves unanswered questions about when LPs and similar DeFi participants might be considered dealers, subject to securities regulation. And it remains to be seen (if not doubtful) whether the SEC would approve any dealer registration applications for such DeFi market participants.

DLA Piper boasts award-winning and nationally recognized Blockchain and Cryptocurrency, White Collar Crime, and Global Investigations practices with former federal prosecutors and regulators. Please reach out to any of the authors or your DLA Piper contact with any questions.