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SEC Expands ‘Dealer’ Definition That Could Ensnare DeFi

Regulation | Feb 8, 2024

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SEC Expands 'Dealer' Definition, Impacting DeFi and Markets

The U.S. Securities and Exchange Commission (SEC) has adopted new rules broadening the definition of a 'dealer,' which could now encompass significant participants in the decentralized finance (DeFi) sector. This regulatory shift mandates entities engaging in liquidity-providing roles to register as dealers, aligning with efforts to bolster market transparency, integrity, and investor safety. The move has sparked a mix of support and criticism, highlighting its potential wide-reaching implications.

  • The SEC's rules, Exchange Act Rules 3a5-4 and 3a44-2, clarify activities that constitute as 'dealer' functions, requiring registration and compliance with federal securities laws.
  • The rule as adopted states:  "Any market participant that engages in activities as described in the rules would be a “dealer” or “government securities dealer” and, absent an exception or exemption, required to:
    • Register with the Commission under Section 15(a) or Section 15C, as applicable;
    • Become a member of an SRO; and
    • Comply with federal securities laws and regulatory obligations, including as applicable, SEC, SRO, and Treasury rules and requirements."
  • Affected market participants must register with the SEC, become members of a self-regulatory organization (SRO), and adhere to a comprehensive set of regulatory obligations.

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  • The expanded definition raises concerns within the DeFi community about the feasibility of compliance, potentially stifling innovation and growth in the sector.
  • Ongoing legal battles over the classification of cryptocurrencies as securities could further influence the regulatory landscape for DeFi and crypto-related activities.

Commissioner Peirce Criticizes Final Rule

Commissioner Peirce expresses her inability to support the final rule, criticizing it for perpetuating the proposal's fundamental flaw and for being inconsistent with the statutory framework. She believes the rule will distort market behavior and degrade market quality.

The rule is seen as turning traders, many of whom are customers, into dealers, which runs counter to the statute as interpreted by the Commission and market participants for decades. Peirce argues that this obliterates the long-standing dealer-trader distinction.

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Peirce warns that the rule penalizes liquidity provision, potentially leading to reduced market liquidity and driving competitors out of the markets. She highlights the rule's costly and ill-fitting regulatory regime for liquidity-providing market participants, which could deter them from activities that contribute positively to market liquidity.  She suggests that the rule could lead to a more concentrated and homogenous group of liquidity providers, making both these firms and the market more fragile.

The rule's broad application could force entities that do not have characteristics of dealers under the current understanding to register as dealers. This includes entities executing common trading, investing, and risk management strategies that incidentally provide significant liquidity to the market.

Commissioner Mark Uyeda Disagrees Too

After the new rules were adopted, Commissioner Uyeda expressed a dissenting view, criticizing them for being unclear and problematic. He pointed out that the rules fail to clearly define dealer status, leading to potential broader interpretations beyond the Treasury market.

Commissioner Mark Uyeda disagrees with the decision:

“The lack of any limiting principle creates the potential for arbitrary and capricious government action.  Further, today’s action may reduce liquidity in the Treasury markets, make them more volatile, reduce the number of liquidity providers, and increase debt costs to taxpayers.”

Why It's Important

By bringing more market participants under its regulatory umbrella, the SEC aims to enhance market integrity and protect investors. However, this move raises important questions about the balance between regulation and innovation, the practicality of compliance for decentralized entities, and the future of liquidity provision in the markets.

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