Many are concerned that a recently passed effort to expand the definition of a broker-dealer will severely hamper the decentralized finance (DeFi) industry — mostly due to a typical lack of clarity involved in the rule-making process. Is there something actually to worry about?
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In short, on Tuesday, the U.S. Securities and Exchange Commission (SEC) adopted a rule that will require more firms that "routinely work with securities" (like hedge funds and market makers) to register as dealers and submit to the stricter oversight that entails. The rule was originally suggested by the U.S. Treasury Department to fix liquidity problems in the Treasury bond market by addressing the regulatory gap that formed with the rise of electronic trading.
Traditionally, there has been a distinction between investors, who make directional trades (i.e. betting some stock will go up or down) and dealers, typically large institutions that buy both sides of the market to provide liquidity for those traders. The old definition of a broker included any company “engaged in buying and selling securities … as a part of a regular business,” with “regular business” essentially referring to the service of market making.
The new rule essentially expands that definition to include any institution that makes a lot of money (or tries to make a lot of money) capturing bid-ask spreads — like quant funds and high-frequency traders. According to Reuters, only about 48 firms are expected to have to come into compliance because they now trade enough, in both directions, largely through automated trading software, to be considered dealers.
The rule, scheduled to go into full effect April 2025, is causing alarm in crypto. Why?
First, there is the fact that the rule will apply to institutions that regularly trade crypto, because under its current leadership the SEC considers nearly all cryptocurrencies and tokens to be securities. But more importantly, decentralized protocols like Uniswap and other automated market makers (AMMs) might just fit the expanded definition of a broker, without an explicit carve out.
Crypto advocates including the Blockchain Association and DeFi Education Fund have raised jurisdictional concerns about the SEC’s ability to oversee crypto, in much the same way that Coinbase and Binance have raised the “major questions doctrine” — a mandate that restricts federal agencies from regulating economically important industries without explicit congressional approval — in their ongoing legal challenges with the agency.
The SEC specifically called out crypto in its announcement, making particular note of “so-called DeFi” organizations that asked for exemption when the expanded definition was first proposed. Two SEC Commissioners, the usual suspects of Hester Peirce and Mark Uyeda, rejected the decision, in part because of the regulatory spillover and confusion it causes for crypto, but mostly because it “obliterates this distinction” between regular investors and brokers in traditional markets.
On Tuesday, Peirce grilled her SEC colleagues specifically on AMMs, and how automated software could be expected to register with the agency. She also asked whether software coders or AMM users would have to regulate. The response from SEC Director of the Trading and Markets Division Haoxiang Zhu is telling: it depends on the “facts and circumstances.”
See also: U.S. SEC Clears 'Dealer' Rule Expansion
“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, as quoted by DL News.
To some extent, the fact that the SEC explicitly names crypto in its public communications is cause for genuine alarm. But the bill itself was not written in an attempt to blow up the industry, and there’s reason enough to think that by including crypto the SEC is only trying to be internally consistent. It said it considered a crypto carve-out but decided that would have "negative competitive effects" by giving crypto firms an unfair advantage over those who have to register.
It may not make sense to ask decentralized wallets, exchanges or lending protocols — all technologies coded to remove human overseers from the equation — to register, but to the extent that DEXs are used to facilitate market making, then they might meet the SEC’s broader definition for a broker. Others have argued that AMMs aren't a match, because they're just software that facilitates trading and its an algorithm that matches buyers and sellers.
But none of this should matter, theoretically. At the end of the day, if these applications are truly decentralized, then there really isn’t any way for them to comply with the rule or a way for the SEC to punish the protocols for noncompliance. Should the agency think through the implications and suggest a “discernible path to compliance for DeFi market participants," as the DeFi Education Fund wrote in its missive. Yes.
But you have to ask, is it really an imposition if the obligation cannot even be satisfied?