The SEC Adopts Controversial New Rule: Potentially Problematic for DeFi

The Securities and Exchange Commission (SEC) has introduced a controversial new rule requiring market participants engaged in significant liquidity-providing roles, including those in the cryptocurrency sector, to comply with federal securities laws.

According to a statement by SEC Chair Gary Gensler, the rationale behind this rule is to enhance investor protection, market integrity, and transparency.

The rule applies to transactions involving crypto assets meeting the definition of securities or government securities, with exceptions for entities with assets less than $50 million. It requires registration for entities involved in regular market-making activities, aiming to address concerns in areas such as decentralized finance (DeFi).

Pushback and Criticism

However, the rule has faced significant pushback from the crypto industry, particularly regarding its applicability to DeFi. Critics of the new rule, including SEC Commissioner Hester Peirce and the DeFi Education Fund, argue that it is impractical for DeFi products due to their decentralized nature and lack of central control.

The DeFi Education Fund noted that imposing registration obligations on DeFi entities could stifle innovation and hinder the ecosystem’s growth. In May 2022, when the rule was first proposed, the Fund sent a detailed letter to the SEC setting out why the new definition could not practically be applied to DeFi.

It recommended that “the Commission should be clear to exempt from its requirements activities implicating digital assets, as there is no support for this rulemaking to apply to them. To the extent the Commission intends to address digital assets, it should instead do so as part of the coordinated, deliberate, multi-agency approach President Biden ordered on March 9, 2022 and in consultation with Congress“.

Additionally, Commissioner Peirce raised concerns about the ambiguity surrounding the registration process for entities like automated market makers (AMMs), which operate as software protocols.

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She also pointed out the challenge of compliance for DeFi participants, who may struggle to navigate the registration requirements and may be unable to meet them due to the decentralized nature of their operations. This could lead to a chilling effect on DeFi innovation and investment, as participants may opt to avoid regulatory scrutiny altogether.

Additionally, the lack of clarity on how entities like AMMs can register as dealers raises questions about the practical implementation of the rule. Peirce noted that SEC regulations and expectations have been particularly difficult for cryptocurrency firms to comply with. She said: “I think one of the reasons they’re not compliant is because they can’t figure out what our rules are and they can’t even figure out when we think that something is a security”.

Regardless of the opposition, the rule is due to come into effect 60 days after publication in the official register. Firms will be expected to comply one year from the effective date.