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9 January 2025

Federal Judge Slaps Down The SEC's Attempt To Regulate Crypto Liquidity Providers

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Cryptocurrency traders and decentralized finance (DeFi) participants have an additional thing to be thankful for this year after a district court in the Northern District of Texas...
United States Texas Technology

Cryptocurrency traders and decentralized finance (DeFi) participants have an additional thing to be thankful for this year after a district court in the Northern District of Texas struck down a Securities and Exchange Commission ("SEC") rule redefining who must register as a securities "dealer." The SEC had attempted to use its regulatory powers to reinterpret the term "dealer," as that term is used in the Securities and Exchange Act of 1934 (the "Exchange Act") to include market participants that engage in a regular pattern of buying and selling securities in a manner that provides liquidity to other market participants.

Because the SEC has deemed many cryptocurrency tokens to be securities, this redefinition placed a variety of cryptocurrency companies, including users of DeFi protocols known as automated market makers ("AMMs"), in the crosshairs of SEC enforcement attorneys. By invalidating the SEC's rule and holding that promulgating this rule was outside the SEC's rulemaking authority, the court delivered a decisive loss to the SEC in its ongoing campaign to sweep cryptocurrency companies into its regulatory ambit without first obtaining congressional authority.

The Importance of AMMs to Decentralized Finance

It has been widely reported that DeFi platforms operating on blockchains have the potential to transform how money is managed. For its decentralization, however, the DeFi ecosystem is highly dependent on AMMs. As the U.S. Department of the Treasury has explained, AMMs are automated protocols that use mathematical equations to determine the prices at which cryptocurrency tokens trade on decentralized exchanges that operate on blockchains.

The AMMs are themselves software protocols, not companies (although it sometimes is possible for a company to influence the operation of an AMM in certain ways by making changes to its underlying software code). Without AMMs to constantly and automatically adjust the prices at which tokens trade on decentralized exchanges, much of the DeFi ecosystem could not function.

The Impact on AMMs of the SEC's Revised Definition of a Securities "Dealer"

It was immediately evident both to the SEC and to cryptocurrency traders that the SEC's redefinition of "dealer" could impact AMMs. In her statement explaining her opposition to the rule, for example, SEC Commissioner Hester Peirce stated frankly that "the rule raises new questions about how the rule will apply in the context of automated market makers." Similarly, comments submitted by cryptocurrency companies and investors in cryptocurrency companies expressed concerns about the impact that the SEC's redefinition would have on AMMs.

To understand why the SEC's redefinition would potentially implicate AMMs, it is first necessary to understand the treatment of "dealers" under the Exchange Act. The Exchange Act requires a securities "dealer" to register as such with the SEC, join a self-regulatory organization such as FINRA, and comply with the SEC's extensive dealer regulations. The Exchange Act defines a "dealer" as "any person engaged in the business of buying and selling securities . . . for such person's own account," but excludes, pursuant to the so-called "trader" exception, "a person that buys or sells securities . . . for such person's own account . . . but not as a part of a regular business." 15 U.S.C. §78c(A)(5)(A) & (B).

SEC Rule 3a5-4 (the "Dealer Rule"), which the SEC adopted on Feb. 6, 2024, redefined the SEC's interpretation of "dealer" under the Exchange Act. See 89 FR 14938 (Feb. 29, 2024); 17 CFR 240.3a5-4. Under the Dealer Rule, a market participant is a "dealer" if it "[e]ngages in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants."

The SEC set forth two qualitative tests for when a market participant provides such liquidity: (i) by "[r]egularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants"; or (ii) by "[e]arning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest."

These two factors are nonexclusive, and a "person engaging in other activities that satisfy the definition of dealer under otherwise applicable interpretations and precedent, such as underwriting, will still be a dealer even though those activities are not addressed by the two qualitative factors." 89 FR 14938, 14945. The Dealer Rule went into effect on April 29, 2024, with a compliance date of April 29, 2025. Id. at 14964-65.

Treating the provision of liquidity as the dispositive activity for assessing whether a market participant is a "dealer" was a significant change from the SEC's historical approach, and threatened to implicate many AMMs, which have been described as providing liquidity to market participants by enabling them to trade on a blockchain with pools of tokens provided by other users, known as "liquidity pools." Given that the SEC views some tokens traded on AMMs to be securities, it appeared that the SEC would conclude that anyone (or anything) that provided liquidity to token traders could be deemed to be a dealer under the Exchange Act.

The District Court's Decisions

Following the adoption of the Dealer Rule, two sets of plaintiffs—in one suit, the Crypto Freedom of Alliance of Texas and the Blockchain Association, and in the other an association representing private fund managers—each sued the SEC in the Northern District of Texas, alleging that the Dealer Rule exceeded the SEC's statutory authority under the Exchange Act and was arbitrary and capricious under the Administrative Procedure Act.

In separate opinions, Judge Reed O'Connor granted summary judgment in favor of both sets of plaintiffs, vacating the Dealer Rule in its entirety. See Crypto Freedom All. of Texas v. Sec. & Exch. Comm'n, 2024 WL 4858590 (N.D. Tex. Nov. 21, 2024); Nat'l Ass'n of Priv. Fund Managers v. Sec. & Exch. Comm'n, 2024 WL 4858589 (N.D. Tex. Nov. 21, 2024). The court concluded that the SEC had exceeded its statutory authority in promulgating the Dealer Rule "by expanding [the] definition of dealer, untethered from the text, history, and structure of the [Exchange] Act." Because it ruled in favor of the plaintiffs on these grounds, it did not address the plaintiffs' APA claims.

In the first opinion, the court concluded that "[t]he Exchange Act's text does not regulate trading entities without customers as dealers," and that the Dealer Rule was outside the SEC's rulemaking authority because it encompassed market participants without customers. See 2024 WL 4858589, at *5. In particular, the court determined that making the core issue whether a market participant provides liquidity to the market was inconsistent with the statutory phrase "the business of buying and selling securities," which "reinforces the customer-order-facilitation context of the [Exchange] Act." Id.

Turning to the history of the term "dealer," the court found that when congress enacted the Exchange Act, that term "had accumulated a settled meaning . . . 'limited to one who . . . buys and sells securities to customers.'" Id. at *6. The court also noted that, prior to the Dealer Rule, the SEC had taken the position that what distinguished traders, who are statutorily excluded from regulation under the Exchange Act, from dealers "was not volume or frequency but client-facing action" like "attempts to attract a clientele, soliciting investors and handling client money and securities, and assisting clients to buy and sell securities." Id.

The court also found it very significant that the Dealer Rule apparently encompassed the Federal Reserve, requiring the SEC to include a carveout for it. The notion that the Federal Reserve had been operating as an unregistered dealer for nearly 90 years indicated to the court that the "late recognition of a latent authority is good evidence to question the [SEC]'s statutory interpretation." Id.

Finally, the court held that the Dealer Rule was inconsistent with the structure of the Exchange Act. Viewing "dealer" and "broker" as "sister" terms that must be read consistently, the court concluded that, because brokers effect trades on behalf of customers, "reading the customer nexus out of the dealer definition would improperly create inconsistencies" between the two terms. Id. at *7.

The court's opinion in the second case addressed an additional argument brought by the cryptocurrency plaintiffs that the "'business' of dealing has always included 'services offered' to investors, 'not merely engaging in trading activities for a person's own investing or trading objectives.'" 2024 WL 4858590, at *3. The court agreed, finding that by "defin[ing] anyone engaging in trading activities that affect market liquidity as a 'dealer,'" the Dealer Rule impermissibly "remove[d] the distinction between 'trader' and 'dealer' as they have commonly been defined for nearly 100 years" in the Exchange Act. Id. at *4-5.

What's Next for AMMs and Cyrpto Traders?

The Dealer Rule had an understandable chilling effect on creators and users of AMMs after it went into effect in April, as it appeared that many cryptocurrency firms and traders would potentially fall under the "dealer" definition of the Dealer Rule. Indeed, the SEC had expressly rejected arguments made by commenters "that crypto assets should not be covered by the final rules," noting that the SEC was "not excluding any particular type of securities, including crypto asset securities, from the application of the final rules." See 89 FR 14938, 14950; see also id. at 15000 (explaining its rejection of the request for a "Carve Out or Narrow Application to Crypto Asset Securities").

The SEC stated that "[t]here is nothing about the technology used, including distributed ledger technology-based protocols using smart contracts, that would preclude crypto asset securities activities from falling within the scope of dealer activity," id. at 14960, and declined to articulate in any detail "how to apply the [Dealer Rule] to certain types of products, structures, or activities in the so-called decentralized finance ('DeFi') market," id. at 14950. The SEC furthermore specifically noted "persons using so-called 'automated market makers'" as persons who "must consider whether they are dealers under the final rules, and thus subject to dealer registration requirements." Id. at 14950.

Moreover, this risk was potentially devastating to users of AMMs because not only would it be expensive to try to comply with the requirements that apply to dealers, but it was not even clear that it was possible to do so. As SEC Commissioner Peirce asked, "given that an AMM is a software protocol, who will have to register? In light of the difficulties that other would-be crypto registrants have encountered with the SEC and FINRA, will those persons even be able to register?" With regard to these questions, she opined, that the Commission did not "engage seriously with these questions."

Because the court's vacatur of the Dealer Rule in its entirety was effective immediately, it appears that creators and users of AMMs now can move forward without addressing the challenges that the Dealer Rule created. Moreover, there is good reason to think the SEC will not be able to resurrect the Dealer Rule. The SEC's notices of appeal of the district court's decisions are due Jan. 20, 2025—the same day current SEC Chair Gary Gensler has indicated he will step down, and the same day Donald Trump will be inaugurated. The incoming Trump administration may not be inclined to initiate or maintain any appeal of the rulings, or to try again at promulgating a revised definition of a securities "dealer."

In short, the vacatur of the Dealer Rule is good news for crypto traders that use DeFi protocols. While much ambiguity remains about the application of U.S. regulations to the DeFi ecosystem, the judicial opinions vacating the Dealer Rule both eliminated one such problematic regulation and made it more difficult for the SEC to impose similar regulatory burdens on DeFi market participants without first obtaining congressional authorization to do so.

Originally Published by New York Law Journal

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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