SEC Proposal to Redefine 'Exchange' Is 'Unconstitutional', Says Coin Center

It's rulemaking season over at the U.S. Securities and Exchange Commission. Which means lobbying groups and think tanks focused on cryptocurrency are on high alert.

Washington, D.C.-based advocacy group Coin Center is directing attention to the SEC's proposed redefinition of the term "exchange" within the Securities Exchange Act to "include systems that offer the use of non-firm trading interest and communications protocols to bring together buyers and sellers of securities."

In a comment letter to the agency today, Coin Center calls the rule "unconstitutional."

A change to a definition within a law first drafted in 1934 may seem ho-hum, especially when placed in the most arcane language imaginable, but the consequences are real. Entities that fall under that definition would be required to register with the SEC. According to research director Peter Van Valkenburgh, that would include "anyone writing or distributing [decentralized exchange] software"—even though the agency never mentions DeFi or crypto.

Decentralized finance (DeFi) refers to a group of blockchain-based technologies that allow people to transact on a peer-to-peer basis, i.e., without an intermediary. Within DeFi, decentralized exchanges let people trade tokens without relying on a third party to ever take custody of the assets being traded.

In Van Valkenburgh's view, the redefinition amounts to switching from the regulation of conduct to the regulation of "speech as speech" because it affects software publishers who make "communications protocols" available.  

Coin Center writes that while the change is meant to bring other "financial services organizations" under the act's umbrella, "the way it does so, however, would create an inappropriately broad standard for registration that would impose an unconstitutional prior restraint on the protected speech activities of countless software developers and technologists."

According to Van Valkenburgh, attempts at prior restraint on speech as speech "are always unconstitutional." 

In a fact sheet about the proposed rule change, the SEC writes that "Communication Protocol Systems" need to be brought under the current exchange registration requirements because "market participants who use these systems are not availed to the same investor protection and fair and orderly market principles that apply to today’s registered exchanges and ATSs." It continues: "This proposal is designed to address this regulatory gap and the current disparities that affect competitive balances among like marketplaces for securities."

Van Valkenburgh told Decrypt, however, that since the SEC doesn't reference cryptocurrency, "it's not clear if they intended for their proposed language to cover those activities and simply didn’t discuss it, or if that would be an unintended consequence."

Others see the consequences for DeFi too. Spence Purnell, director of technology policy at the libertarian Reason Foundation, noted, "If technologies such as decentralized finance and smart-contracts were intended to be captured by the rule change, they should be explicitly considered. Since they are not, they should be explicitly excluded."

Coin Center thinks the case is cut and dry—so it's urging the SEC to rethink the draft to avoid wasting the Supreme Court's time (or setting back developers). The comment letter cites a 1985 Supreme Court case in which the SEC was sued over a ban on publishing newsletters with stock tips. The SEC statute was overturned, and then-Justice Byron White set forth a test for differentiating between the regulation of conduct and the censorship of speech. 

The bottom line: Speech isn't subject to registration.

The public comments period on the proposed rule closes on April 18, after which the SEC will determine whether to incorporate any changes as part of a final rule.