Rethinking SEC rulemaking: Why crypto needs its own rules
Editor’s note: This op-ed is part of a bigger package of crypto policy views. Find the rest here: “Making the U.S. the crypto capital: What it would take.”
Rulemaking by the U.S. Securities and Exchange Commission (SEC) has always been a slow process, involving proposed rules, public comments, economic analysis, and careful redrafting before final adoption. It’s not a flashy process, but it’s designed to ensure fairness and thoroughness. By administrative design, rulemaking is a relatively measured and deliberative process. (There’s even a section in most rule releases un-ironically entitled “The Paperwork Reduction Act.”) So it’s curious that a number of recent rules proposed under former SEC Chair Gary Gensler have sought extension to crypto assets and crypto markets, seemingly without any discussion or deliberation on how they would apply.
The SEC has frequently been criticized for its crypto-related “regulation by enforcement” over the years, but what’s less appreciated is how its “rulemaking by extension” — taking rules developed for other markets or products and applying them wholesale to new areas of technology — has been equally counterproductive. Rules for traditional securities markets often don’t align with crypto; the uniqueness of blockchain technologies warrants its own considerations. Now, there’s an opportunity for the Commission to adopt a bespoke approach to rulemaking that will help the technology thrive while protecting investors and consumers. (Except where Congress has expressed an intent to legislate — including on some matters relating to decentralized finance, or, DeFi — the agency should postpone relevant rulemaking.)
The new administration at the SEC can address existing shortcomings by reexamining proposed rules. These include the Best Execution Rule for broker-dealers, the Safeguarding Rule for registered investment advisers, and the proposal to amend the definition of an “exchange.” These rules are primarily concerned with the regulation of traditional securities markets and market intermediaries. Yet, as proposed, all of these rules note that they would also apply to “crypto asset securities” and entities that transact in “crypto asset securities.”
This approach fails in three aspects. First, it is based on the premise that “crypto asset securities” is a clear and well understood term. Although a tokenized version of a traditional security, such as a stock or bond, would fall within the SEC’s regulatory jurisdiction, it is much less clear when other forms of crypto assets represent securities within the SEC sphere. Proposing rules without providing clarity as to their reach or limit is a terrible practice. The proposed rules also are lacking in that they have not taken into account how crypto assets that are securities, such as tokenized equities or bonds, differ from non-crypto based securities. These differences need to be reflected in any new rulemaking if they are to be effective. In other words, on the surface these rules, designed to provide investor protections in familiar contexts, like broker-dealer order routing or asset custody — need to be carefully tailored to work with respect to this new asset class with unique features. The best way to approach this tailoring reveals the third problem in the rules as proposed — they have not been based on market data and industry input, both of which are essential to ensuring the rules work operationally.
Otherwise? Confusion. Uncertainty. And the stifling of business practices and technological innovation.
Let’s examine the proposed Safeguarding Rule for starters. At its core, the proposal aims to ensure registered investment advisers (RIAs) properly safeguard client assets, including crypto. Sounds fair, right? But the way it’s written makes one thing clear: It’s about making custody in the crypto space commercially impracticable. Instead of being principals-based and allowing knowledgeable fiduciaries to design appropriate procedures (as is the case under much of the Investment Advisers Act), the proposed rule all but ensures that RIAs won’t even bother trying. (For example, under the proposal an RIA could not legally purchase a crypto asset if custodians do not offer safeguarding services for that particular asset. Should there exist a qualified custodian that can hold the asset for the RIA, then the RIA [really, its clients] must forgo making productive use of the asset [voting or staking] while it sits idle in the portfolio.) It does the same for banks too, preventing them from doing what they do best: determining how best to safeguard assets.
The SEC would be better served by taking a different approach. Rather than suffocating custody solutions for crypto, why not offer clear guidance on how to establish safeguarding controls tailored for this unique asset class? Crypto isn’t traditional — it comes with challenges like the management of private keys, decentralized platforms, and constantly evolving technologies. But these challenges are surmountable, and regulators could work with industry leaders to craft a framework that protects investors without squelching an asset class.
Let’s consider another example. The SEC’s proposed Best Execution Rule primarily seeks to establish a best execution standard for broker-dealers. The proposed rule focuses on the regulation of order routing practices in traditional securities markets and on payment-for-order-flow arrangements, but it also observes that it “would apply to all securities, including any digital asset that is a security or a government security under the Federal securities laws.” Despite this, the SEC provides no evidence to suggest that payment-for-order-flow is as prevalent in crypto markets as it is in traditional securities markets. Nor does the SEC even consider that direct retail participation in the crypto markets is far more significant than in traditional securities markets — meaning that brokers play a very different role in crypto markets.
Most puzzling of all is that the SEC does not even consider what “best execution” might mean in the context of crypto markets, making compliance with the proposed rule nearly impossible. Should a broker-dealer seek execution on the best regulated crypto asset market? Or should it seek execution on the deepest crypto asset markets, irrespective of that market’s regulatory status? Should a broker-dealer consider only the universe of U.S. domiciled crypto asset markets when seeking to identify the best market? Or should it consider all crypto asset markets, irrespective of location? The proposal provides no answer, just the blanket application of rules that were designed for an entirely different system and do not have an obvious application to transactions in crypto assets.
Finally, let’s consider the SEC’s proposal to redefine the term “exchange” under Securities Exchange Act Rule 3b-16. The proposal has been so controversial that it was opened for comment three times over two years. For context, ordinary proposals will be opened only once by the SEC prior to rule adoption. The initial proposal ignored crypto asset markets altogether. Then over a year later, the SEC re-proposed the rule with a supplement noting that the proposed revisions would apply to all crypto exchanges, centralized and decentralized. Amazingly, the SEC noted in that proposal that it lacked data on both crypto asset securities as well as crypto asset trading platforms, yet it went ahead with some crypto-focused revisions anyway.
Rather than forcing ill-fitting rules onto crypto, the SEC should reconsider its misguided approach. It should start with the assumption that rules for traditional securities markets don’t apply to crypto, unless explicitly stated otherwise. It should gather data and collaborate with industry experts to understand the unique features of the assets and the technologies so that it can craft a regulatory framework specifically suited to them. And while not giving the crypto industry a free pass, it should recognize that it already has powerful tools, like Exchange Act Rule 10b-5, to address fraud and manipulation.
A bespoke approach to rulemaking is superior. After the financial crisis, the SEC adopted a tailored approach to regulating security-based swaps under the Dodd-Frank Act. Specifically, SEC rules exempted swaps and swap market participants from some registration requirements as the regulator learned how these markets work and adapted its approach to more appropriately handle the unique risks of these instruments. This allowed the SEC to tailor specific rules to the contours of swap trading while still retaining the power to address fraud and manipulation.
While the SEC’s campaign of “regulation by enforcement” has attracted the most attention in recent years, its “rulemaking by extension” has also been damaging. Hopefully, the new leadership at the SEC will adopt an approach where new instruments, technologies, and new business models are regulated with clarity and on terms that accommodate innovation.
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Scott Walker is Chief Compliance Officer at Andreessen Horowitz. Previously, he was the Senior Specialist for Digital Assets and Blockchain Technology in the Division of Examinations at the U.S. Securities and Exchange Commission and, before that, Vice President & Counsel at BlackRock with a focus on derivatives, prime brokerage, and securities finance transactions.
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