Are Cryptoexchanges the Exchange Act’s Trojan Horse?

In Spring 2023, Bittrex, Coinbase and Binance – among the largest cryptoexchanges in the world – found themselves in the crosshairs of the U.S. Securities and Exchange Commission (SEC) for operating as unregistered securities exchanges, broker-dealers, and clearing agencies. Contemporaneously, the commission clarified its intention to regulate a range of cryptoasset platforms under the Securities Exchange Act of 1934 (Exchange Act). To some extent, this was a surprise. The SEC made no mention of cryptoassets in its 2022 rulemaking proposal to expand its reach over exchange-like alternative trading systems (ATSs), and it did not object to Coinbase’s 2021 initial public offering. The SEC staff, moreover, had already begun to offer compliance guidance to broker-dealers carrying cryptoassets and ATSs trading cryptoassets that might be deemed securities.

Public outcry following the failure of FTX, Celsius, and other cryptoasset platforms no doubt forced the commission’s hand to a certain degree.[1] Nevertheless, Commissioner Hester Peirce presciently characterized the 2022 rulemaking proposal as “expansive” enough to regulate cryptoasset platforms – a “Trojan Horse,” in the view of some commentators. Chair Gary Gensler has since warned crypto industry participants that they “should do their work within the bounds of the law, or they shouldn’t do it at all.” Cryptoexchanges have naturally pushed back. Much of the debate – whether in Congress, the courts, or academia – meanwhile focuses on plausible alternatives to federal securities law for regulating the offer and sale of cryptoassets.

Policy proposals seem to be converging on the idea that a cryptoasset ought to be regulated as a “commodity” rather than a “security” in the aftermarket once certain benchmarks are met. For example, under the draft Financial Innovation and Technology for the 21st Century Act, cryptoassets would not be deemed “securities” once their associated networks or entities are “decentralized” (like Bitcoin and possibly Ether). If there is no “issuer” chargeable with ongoing disclosure obligations, arguably there is no need for securities regulation. Disclosure rules comparable to the Securities Act of 1933 might still apply to promoters raising capital in initial coin offerings. But under these proposals, secondary market trading in cryptoassets could be regulated by the Commodity Futures Trading Commission, by an industry self-regulatory body, by cryptoexchanges acting as self-regulators, or by a combination thereof.

And yet, as I argue in a recent article, it is hard to think of a framework as comprehensive as the Exchange Act to bestow legitimacy on cryptoasset trading, and more generally, the gamut of cryptoasset transactions comprised in decentralized finance (DeFi). The Exchange Act – designed to oversee spot markets in quintessential financial assets such as stocks and bonds – has long grappled with a range of concerns that cryptoasset markets must eventually tackle to win institutional and retail confidence. Exchange Act rules coordinate trading across fragmented market centers and over-the-counter markets, generate consolidated market information for pricing collateral and derivative transactions, self-finance market surveillance, and facilitate responsible lending, borrowing and hypothecation of customer securities.

I don’t mean to suggest that these rules should be applied uncritically to cryptoasset transactions. But if DeFi is at heart a system for creating liquidity, the bones of the Exchange Act are as well, if not better, suited for the evolution of cryptoasset markets as any other existing or novel regime.

There is nevertheless an argument for excluding cryptoasset transactions from the Exchange Act’s remit: the risk of undermining the Exchange Act itself. Today’s rules and regulations are the result of decades of experimentation – collaboration and compromise with major market centers, incremental steps and occasional missteps – that shaped market structures in unpredictable ways. It is not clear how the Exchange Act’s allocation of authority among broker-dealers, ATSs, exchanges, and clearing agencies would or should map onto cryptoasset markets. Forcing  cryptoasset transactions to fit into the Exchange Act could not only upend cryptoasset markets, but might also frustrate the SEC’s ability to rein in disruptive innovation in traditional equity and debt markets.

For starters, allowing cryptoexchanges the option, however remote, to register as “national securities exchanges” could upset the balance of power with dominant exchange groups like ICE/NYSE, Nasdaq, and Cboe. These groups wield statutory authority to manage the Exchange Act’s market mechanisms and the funding they generate to surveil markets. Meanwhile, allowing cryptoasset platforms the possibility of acceding to such mechanisms could gut the integrity of traditional exchange listings in the face of competition from unlisted tokens. Furthermore, allowing cryptoassets to trade under the banner of federal securities law could tempt policymakers to bully industry backstops like the SIPC fund to make investors whole for inevitable product and platform failures in an emerging asset class.

In this sense, cryptoexchanges and cryptoasset platforms may well turn out to be the Exchange Act’s Trojan Horse, insofar as their integration into the Exchange Act ecosystem risks might strain the ties that bind traditional securities markets together. Instead of hurriedly wheeling them into its gates, the commission might better preserve its jurisdictional claims by offering concessions to Congress and the cryptoasset industry: for example, clear exemptions for decentralized exchanges and firmer guidance for integrating centralized exchanges into the broker-dealer/ATS regime. The SEC might also use its authority to carve out from regulation stablecoins, non-fungible tokens, and other cryptoasset classes that probably benefit least from Exchange Act oversight.

At the same time, the SEC could work with leading cryptoexchanges and cryptoasset platforms to establish rules for aggregating and accessing transactional interest. Dominant cryptoasset platforms may have an incentive to collaborate with data aggregators today, but as competition intensifies, mutual advantage may not suffice to assure fair pricing, let alone surveillance for manipulative and deceptive devices. The SEC might eventually adapt “best execution” and “fair access” principles to empower institutional investors and protect retail customers against unfair or anticompetitive practices. As an inducement, the SEC could find a path to integrate some cryptoassets and cryptoasset transactions into traditional Exchange Act market mechanisms, much as it has begrudgingly admitted Bitcoin ETFs into the fold.

Tendering such an olive branch to the cryptoasset community might advance several strategic goals. It could reinforce DeFi’s promise of networked liquidity by planting it within an established regulatory framework. It would offer traditional financial services providers greater encouragement to invest in and collaborate on DeFi services. It would demonstrate that congressional intervention is not necessary to build an effective regulatory regime for cryptoassets. And it would give the SEC an opportunity to peek into the Trojan Horse before closing the doors behind it.


[1] See, e.g., Hal Scott & John Gulliver, A Question for Congress: Why Didn’t the SEC Stop FTX?, Wall St. J., Jan. 18, 2023 (accusing the SEC and FINRA of being “more interested in protecting their turf than protecting investors”); David Gura, Wringing its hands over FTX’s collapse, Washington hopes to prevent more crypto pain, NPR, November 22, 2022.

This post comes to us from Onnig H. Dombalagian, the John B. Breaux Chair in Law and Business and George Denègre Professor of Law at Tulane University School of Law. It is based on his recent article, “Are Cryptoexchanges the Exchange Act’s Trojan Horse?” available here.

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