How Decentralized Exchanges Are Regulated — Part I (Securities)
Though the idea of decentralized exchange (DEX) is nothing new, we’ve seen a wave of DEXs based on Ethereum crashing over the crypto shores in 2018. And as tons of DEXs are being launched with increasing ease and frequency, the regulator has a growing concern about the cryptocurrency Wild West and the semantics used to bolster it.
How are DEXs regulated? There are some major regulatory schemes that the U.S. regulator scrutinizes in — securities transaction, money transmission, and commodities and derivative trading. I’ll discuss these issues in two separate articles, and this article will focus on the securities regulations that DEXs are required to comply with.
Can DEX Be Exempted from Regulations?
Generally speaking, crypto exchanges are required to register as a national securities exchange in the SEC. Needless to say, the process takes so much time and money that registration may not be an option for many startups.
However, unlike a traditional exchange, DEX has no possession of order books and custody. Instead, users transact directly with their peers without the need for a central server. The funds are held in a smart contract in such a way that only the users can deposit /withdraw/ trade. For DEXs built with 0x, the order books are operated off-chain and orders are settled on-chain.
A question I’ve been asked frequently is that if such a DEX is decentralized enough, would it be exempted from the regulation of exchange?
The answer is that if a DEX satisfies the definition of “exchange” under the securities law, it’s subject to regulatory compliance, despite the “decentralized” nature.
Here’s what Rober Cohen, the Chief of Cyber Unit said:
Using any blockchain to create an exchange without central operations doesn’t remove the original creator’s responsibility.
The focus is not on the label you put on something or the technology you’re using. The focus is on the function, and what the platform is doing. Whether it’s decentralized or not, whether it’s on a smart contract or not, what matters is it’s an exchange.
Definition of “Exchange”
Here’s your formula:
Offer trading of “securities” + operate as an exchange = national securities exchange
Such a platform must register with the SEC as a national securities exchange or be exempt from registration.
But first, what are securities? Find in my former article here. Most of the tokens out there in the market are very likely securities.
And what does it mean to operate as an exchange? Rule 3b-16(a) of Exchange Act provided a functional guide:
(1) Brings together the orders for securities of multiple buyers and sellers, and
(2) Uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and seller entering such orders agree to the terms of the trade.
Be careful of the platform’s UI and underlying functions. If a DEX looks and runs like an exchange (provides trading of securities, brings together orders and used established, non-discretionary methods for orders interaction), it would be deemed as an exchange, no matter the orders are put in a blockchain or not.
The reason is that when a platform refers to itself as “exchange”, it gives the misimpression to investors that they are regulated or meet the regulatory standards of a national securities exchange. In fact, there’s no guarantee that the order books or other info provided by the platform have the same integrity as that provided by national securities exchanges, because the SEC did not review the standard to pick assets to trade, the digital assets, or the trading protocols. Investors’ interests are at risk. Even though a platform may be built upon distributed ledgers, if the UI, the name, the functions provided by the platform are alike those of a securities exchange, it would lead investors to reasonably believe that it’s regulated or meet the legal standard, and thus should be regulated.
Learn from EtherDelta
The first DEX involved in charges by the SEC is EtherDelta. The SEC has charged Zachary Coburn, the co-founder of EtherDelta on November 8, 2018, for operating an unregistered national securities exchange.
The SEC concluded that EtherDelta is an exchange, stating that 1) EtherDelta brought together orders by receiving and storing orders in tokens in the EtherDelta order book and displayed the top 500 orders as bids and offers on the EtherDelta website; 2) EtherDelta provided the means for these orders to interact and execute through the combined use of the EtherDelta website, order book, and pre-programmed trading protocols defined in the EtherDelta smart contract.
It’s notable that the SEC’s charges were not against the exchange but the individual — Zachary Coburn. EtherDelta was not a named Respondent in the Order and the platform appears to continue operations today. The SEC alleges that Coburn “caused” EtherDelta to violate Section 5 of the Exchange Act, on the basis that he 1) founded EtherDelta; 2) wrote and deployed the EtherDelta smart contract to the Ethereum Blockchain; and 3) exercised complete and sole control over EtherDelta’s operations. The liability can extend to “any other person that is, was, or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation.” Among other things, this enforcement action highlighted the potential liability for the person who develops, operates and promotes the trading system.
EtherDelta was run by a single entity led by Coburn, and if there exists a single point of failure, then the exchange may not be considered a decentralized platform. Rather, a more accurate description of EtherDelta is a non-custodial platform on which users have complete control over their private keys and funds. — CNN
How about the completely decentralized and peer-to-peer exchanges?Like Bisq, it can be run similarly to a Bitcoin node in that users download the Bisq software from GitHub and simply run it to use the exchange, will it be taken down by the authorities?
We may see it in two ways:
- A DEX will be deemed as an exchange as long as it satisfies the foregoing conditions, despite the decentralized nature.
- More importantly, if the DAO running the DEX is so decentralized that there’s no significant control over the DEX’s operations, it might be hard to find the individuals who “cause” the violation of Section 5.
Exemption
In the case that a platform satisfies the criteria of national securities exchange, one should file a form 1 for registration as a national securities exchange or exemption from registration.
The SEC explicitly excluded certain systems from the “exchange” definition, which includes systems that merely route orders to other execution facilities, and those allow a person to enter orders for execution against the bids and offers of a single dealer system
Alternative trading system (ATS) is a frequently used exemption. ATS is a system that provides or maintains a marketplace for bringing together purchasers and sellers of securities, but does not set rules for subscribers (other than rules for their trading on the system). Every ATS must (i) register as a broker-dealer, (ii) become a member of a self-regulatory organization, such as FINRA, (iii) file a Form ATS and (iv) have an ongoing compliance program to maintain the ATS and broker-dealer operations. ATS is also required to provide multiple disclosures, implement security measures and comply with the federal reporting requirements, as well as state laws in each state where the ATS operates.
ATS registration process includes voluminous submissions to the SEC, including information about the traded securities, subscribers, operating procedures, etc. The registration process may usually take 6 months. After registration, the ATS will have to comply with ongoing reporting requirements and other obligations, such as file quarterly transaction summaries and permit examination and inspection of the site, systems, and records by the SEC and FINRA in case of inspection or investigation. Also, as broker-dealers and FINRA members, ATSs are subject to strict standards of due diligence.
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