On March 28, 2022, buried within a 200-page proposed rule ostensibly meant to redefine “dealer” and “government securities dealer” under Sections 3(a)(5) and 3(a)(44) of the Securities Exchange Act of 1934, the Securities and Exchange Commission (“SEC”) published a seemingly innocuous footnote:

"Proposed Rule 3a5-4 would apply to securities as defined by Section 3(a)(10) of the Exchange Act, and proposed Rule 3a44-2 would apply to government    securities as defined by Section 3(a)(42) of the Exchange Act, including any digital asset that is a security or a government security within the meaning of the Exchange Act."

The security status of digital assets is currently evaluated on a case-by-case basis, typically by applying the Howey Test. This footnote clarifies the staff’s position: They are keeping an eye on digital assets, and building a regulatory framework around the possibility that some, if not all, digital assets will fall within their purview.

If a broad swath of digital assets, including any number of crypto and blockchain-based assets, are deemed to be securities, and, accordingly, those in the decentralized finance (DeFi) industry are deemed to be participating in activities that avail themselves to categorization as “dealers” for purposes of federal securities regulation, it could amount to a shadow ban on the industry as it currently exists.

Under the proposed rule, if a DeFi exchange satisfies the proposed rule’s proposed thresholds (i.e., large trading firms that employ automated, algorithmic trading strategies to execute trades, and have or control more than $50 million in total assets under management) and doesn’t register with the SEC, it would then be deemed an unregistered dealer, which is potentially a felony offense.

The question remains: Is the SEC opening the door to proactive registration by DeFi exchanges, or anyone else who might be touched by the expanding reach of the staff? Is this an invitation to “come in and register”? If not, the fear of a potential shadow ban will remain. Hopefully, this means that proactive market participants can avail themselves of regulatory infrastructure and that this expansion of definitions will lead to clarity.

The comment period for this proposed rule is expected to extend until at least May 27, 2022.

Dinsmore attorneys are closely monitoring these developments, and are available to assist any DeFi market participant or exchange looking to proactively position themselves to minimize long-term risk exposure, or to facilitate making an official comment on the proposed rule.