SEC approves rule to protect bond investors — but critics say DeFi will pay the price

The Securities and Exchange Commission has voted to adopt a rule that would draw more hedge funds and market-makers under its regulatory umbrella.

The rule is mainly aimed at making the US Treasury market safer and more resilient.

In crypto circles, the rule was met with howls of protest.

That’s because the rule, if enforced, will compel some DeFi market participants to register with the SEC, sweeping traders who provide liquidity to automated market makers into the SEC’s regulatory remit.

“This rulemaking targets proprietary trading funds, private funds, and others who make money by buying low and selling high in the Treasury market, while creating additional regulatory confusion in other markets, including crypto asset securities,” Republican commissioner Mark Uyeda, who joined Hester Peirce in rejecting the rule, said during an SEC meeting on Tuesday.

“This action feels just like another salvo in the commission’s ongoing war on private funds.”

Uyeda and Peirce were outvoted by Chair Gary Gensler and Democratic commissioners Caroline Crenshaw and Jaime Lizarraga.

DEX LPs that control over $50mm in capital need to register as securities dealers, or so proposes the SEC.

Activity that would result in you being a dealer if controlling over $50mm:

• Regularly expressing trading interest that is at or near the best available prices on both…

— Bill Hughes : wchughes.eth 🦊 (@BillHughesDC) February 6, 2024

Dealer definition

As technology advances, large liquidity providers, such as hedge funds, are emerging in financial markets like US Treasuries.

Many of them are unregulated, and this rule — proposed in 2022 — is aimed at soothing the SEC’s worries about increasingly automating markets.

The rule expands the legal definition of “dealer” to include trading firms dealing in securities. It captures hedge funds, market-makers, and speed-trading firms that meet the new definitional standards and control over $50 million in assets.

What does that have to do with crypto?

The rule encompasses dealers trading in all securities, and Gensler has made it clear that he considers the vast majority of crypto tokens to be securities.

Many funds have expanded their portfolios to include crypto assets, and they would now have to register with the SEC — a registration that comes with a heavy compliance burden.

No clarity

Advocates like the DeFi Education Fund and the Blockchain Association have hit back at the rules.

They said the SEC hasn’t provided enough guidance on cryptocurrencies’ treatment under securities laws, and that the SEC is overstepping its authority in trying to regulate crypto.

“The breadth and ambiguity of the proposal’s qualitative standards would raise many questions about the status of investors who use AMMs, other DeFi protocols, and other all-to-all execution protocols,” DeFi Education Fund CEO Miller Whitehouse Levine wrote in a letter.

At Tuesday’s meeting, Peirce grilled SEC staff on how an AMM — which, she said, is just a software protocol — could even be expected to register as a dealer.

🚨Very important exchange from today’s SEC hearing where SEC staff assert that the new broker-dealer rule will make all LPs in AMMs into securities dealers with a registration requirement. Paraphrase of @HesterPeirce ‘s incisive questioning of staff below: 🚨

Staff:
“AMM is…

— _gabrielShapir0 (@lex_node) February 6, 2024

Haoxiang Zhu, director of the SEC’s division of trading and markets, responded that staff distinguish between the front-end software, and the people using the protocols to deal and make markets in digital assets.

“In that sense, there’s nothing special about crypto. It’s analogous to a regular broker-dealer making the market, posting a bid and offer using software. We’re not trying to capture technology, but rather the people who use the technology for dealing,” he said.

When Peirce asked Zhu how many firms would be affected by the rules, he responded — echoing statements Gensler has made — that it was difficult to say as DeFi is an opaque and non-compliant industry.

Peirce replied: “One of the reasons they’re not compliant is they can’t figure out what our rules are. They can’t even figure out when we think that something is a security.”

She said that unless the SEC could provide some clarity, implementing these rules for DeFi would be challenging for both the regulator and the industry.

Contact the author at joanna@dlnews.com.