Why the SEC should clarify exchange rules for blockchain apps: A safe harbor for software II

The U.S. Securities and Exchange Commission continues to advance Project Crypto and its ambitious goal of moving U.S. capital markets onchain. In April, the SEC’s Division of Trading and Markets clarified when certain user interfaces may operate without registering as broker-dealers. In June, the SEC proposed rescinding Rule 611 of Regulation NMS, which would remove a significant obstacle to the development of onchain securities markets. And last week, the SEC released its “Innovation Exemption,” exempting certain trading venues — Tokenized Securities Venues (TSVs) — from the definition of “exchange” under the Exchange Act and certain liquidity providers from the definition of “dealer.” Together, these efforts reflect a recognition of the potential of blockchain technology to upgrade the financial system and that onchain markets should not be forced into ill-fitting regulatory models.

The SEC deserves tremendous credit for these actions. But broker clarity and the proposed rescission of Rule 611 address only part of the regulatory uncertainty facing onchain markets. The Innovation Exemption is likewise an important first step, but it only provides an intermediated pathway for bringing securities markets onchain. As Commissioner Peirce noted in her statement on the exemption: “This order is not about decentralized finance. Truly decentralized systems that are driven by automated software do not give rise to the foundational concerns underlying securities regulation.” We agree.

We recommend, as its next steps in advancing Project Crypto, that the SEC clarify the circumstances in which developers of decentralized exchange protocols (DEXs) and the apps that provide access to them (DEX Apps) fall outside the Exchange Act’s exchange registration requirements. That is why we, together with the DeFi Education Fund, are now proposing a safe harbor from exchange registration requirements of the Exchange Act. 

The safe harbor would give developers clear standards for determining when DEXs and DEX Apps fall outside those requirements because they neither function as traditional exchanges nor create the risks that exchange regulation addresses. In this respect, our proposal applies Commissioner Peirce’s broader point to exchange regulation: Where automated systems do not give rise to the foundational concerns underlying securities regulation, market participants need clarity, not an exemption. A safe harbor would thereby complement the Innovation Exemption and extend regulatory clarity to truly permissionless systems. 

In parallel, we at a16z submitted a complementary proposal for crypto asset trading platforms (CTPs) that do function as traditional intermediaries, recommending a tailored registration framework modeled on the regime for alternative trading systems (ATSs) that would permit CTPs to offer trading in crypto asset securities, as well as both non-security pairs and security/non-security pairs. 

Together, the submissions draw a clear regulatory line: DEXs and DEX Apps that qualify for the safe harbor should receive clarity that exchange registration does not apply, while other platforms should have an appropriately tailored registration pathway. We also look forward to participating in the comment process for the Innovation Exemption itself.

What’s the problem?

The background underlying our broker safe harbor proposal is relevant here. 

DEX Apps are software that is typically embedded in wallets or deployed via websites, which enables users to interact with decentralized blockchain systems without taking custody of assets or acting on behalf of users. They provide a user interface that helps people transact directly onchain. This opens an entire world of peer-to-peer transactions, where users can make stablecoin payments, purchase network tokens on decentralized exchanges, or engage in borrowing and lending transactions all without relying on any intermediaries.

DEXs are typically permissionless smart contract protocols that self-execute transactions under predetermined conditions. Automated market maker (AMM) DEXs, the most common type of DEX, allow users to transact against a liquidity pool without a centralized operator whose control could give rise to risks that exchange regulation is designed to address, including conflicts of interest in determining how orders interact, the potential for manipulation by a centralized operator, and the need for governance and fair access rules where a centralized operator holds market power. 

Right now, DEXs and DEX Apps face regulatory uncertainty with respect to exchange registration. The SEC has previously taken the position — through at least one Wells notice — that a DEX or DEX App could be deemed an exchange if it enables users to transact in securities. That approach is flawed and threatens to chill innovation in one of the most promising areas of the new digital financial system.

The same concern that animated our proposed broker safe harbor animates this submission: specifically, that requiring exchange registration for all DEXs and DEX Apps would force software developers to take on roles and responsibilities they never assumed, acting as gatekeepers and intermediating activity, undermining the benefits of blockchains systems and creating new risks for users.

Below, we also discuss our supplemental proposal for CTPs that do function as traditional intermediaries. The current problem here seems obvious to us. No regulated market currently exists for trading tokenized securities, whether those securities are investment contracts or NMS stock against other tokenized securities or commodities. Centralized crypto exchanges, meanwhile, are not permitted to trade these pairs. Our proposal closes this gap with a registration framework better suited to the crypto markets at their current, nascent stage.

What’s the solution?

We propose a safe harbor that provides a rebuttable presumption that a DEX and DEX App that enables users to engage in peer-to-peer transactions, including in transactions of tokenized securities, is not engaged in exchange activity. Although our submission primarily addresses AMM-based DEXs, it is not architecture specific, and we appreciate Commissioner Peirce’s openness to other models and ways of trading tokenized securities.

To qualify for this safe harbor, a DEX must meet four objective criteria:

• Non-custodial. The DEX must never take control of user funds. All signing and transaction submission must be user-initiated.

• Automated. The DEX must execute and enforce transactions and other activities without human intermediation and without any person or group under common control having unilateral authority or the ability to alter the functionality, operation, or rules of the system.

• Permissionless. The DEX must not restrict access or empower any person to restrict access. 

• Credibly neutral. The DEX must not grant anyone private permissions, hard-coded privileges, or similar rights over others that would enable them to discriminate against particular users or use-cases.

A DEX App must also meet four objective criteria:

• Non-custodial. The DEX App must never take control of user funds. As in the criteria above, all signing and transaction submission must be user-initiated.

• Objective and verifiable market data. The DEX App’s pricing and market data must be based on pre-disclosed, objective, and independently verifiable parameters, with such data sourced from public onchain data or independent third-party sources.

• No discretion. The DEX App must operate without any central authority, governance body, or developer exercising discretion over trade coordination, pricing, matching, or execution in a manner that advantages particular users, counterparties, or transactions.

• Limited developer role. A DEX App’s developer activities must be limited to maintaining the interface, implementing technical and security updates, and applying objective, non-discretionary filters to exclude digital assets, provided such filters are based on publicly disclosed, neutral criteria and do not involve subjective investment judgment or qualitative assessments of asset merit (though assessments of fraudulent, malicious, or spam-like characteristics should not constitute assessments of asset merit for this purpose).

Separately, our supplemental submission on CTPs proposes that the regulation of CTPs be modeled on the regime for ATSs and permit CTPs to register with the SEC and FINRA and offer trading in crypto asset securities, as well as both non-security pairs and security/non-security pairs. The public disclosure requirements of Form ATS-N would apply to a CTP’s trading of crypto asset securities that are NMS stocks only above a trading volume threshold. Below that threshold, a CTP would provide certain disclosures to the SEC and to its subscribers on a confidential basis (in which conflicts of interest, core operations, and fair access details are disclosed), and the equivalent of Form ATS for CTPs would not be made public. Lastly, CTPs would be subject to similar recordkeeping requirements as ATSs, with blockchain-based records permitted.

Why now?

Blockchain technologies offer enormous benefits, including lower costs, faster settlement, and expanded access — and DEXs and DEX Apps are critical to realizing those benefits. Centralized markets for tokenized securities should also benefit from a fit-for-purpose regulatory infrastructure similar to that which the SEC has just made possible through the Innovation Exemption, and the CTP registration would allow the trading of tokenized securities through a regulated market. 

Congress has missed its opportunity. Regulators should move the industry forward through guidance, exemptive relief, and traditional rulemaking, and they should not hesitate to use those tools. Our proposals offer a concrete path to establish clear boundaries and support the responsible development of both decentralized systems and crypto asset trading platforms in the United States.

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Read our full proposals here and here.

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