a16z Crypto: The SEC should clarify when blockchain applications do not need to register as exchanges

Author: a16z Crypto

Compiled by: Jiahua, ChainCatcher

The U.S. Securities and Exchange Commission (SEC) is advancing Project Crypto, aiming to bring U.S. capital markets on-chain.

In April, the SEC's Division of Trading and Markets clarified under what circumstances user interfaces can operate without registering as broker-dealers. In June, the SEC proposed to repeal Regulation NMS Rule 611 to eliminate a significant barrier to the development of on-chain securities markets. Last week, the SEC issued an "innovation exemption," excluding certain tokenized securities trading venues (TSVs) from the definition of "exchanges" under the Securities Exchange Act and excluding certain liquidity providers from the definition of "dealers."

These measures indicate that the SEC recognizes the potential of blockchain to improve the financial system and acknowledges that on-chain markets should not be forcibly subjected to regulatory frameworks that are unsuitable for them.

The SEC's actions are commendable. However, the clarification of broker-dealer registration requirements and the proposed repeal of Rule 611 only address some of the regulatory uncertainties faced by on-chain markets. The "innovation exemption" is also an important first step, but it still provides a pathway for conducting on-chain securities trading through intermediaries.

As SEC Commissioner Hester Peirce stated in her remarks regarding the exemption: "This order does not pertain to decentralized finance. Truly decentralized systems driven by automated software do not raise the fundamental issues that securities regulation seeks to address." We agree with this viewpoint.

We recommend that the SEC, while continuing to advance Project Crypto, clarify under what circumstances developers of decentralized exchange protocols (DEX) and their front-end applications (DEX App) are not required to comply with the exchange registration requirements of the Securities Exchange Act.

To this end, we have jointly proposed a "safe harbor" proposal with the DeFi Education Fund, which clearly outlines the boundaries for protocols and applications that qualify for exemption from registration.

This safe harbor aims to provide clear criteria: if a DEX and DEX App do not perform the functions of traditional exchanges and do not pose the risks that exchange regulation seeks to address, then the corresponding registration requirements should not apply.

This also applies Commissioner Peirce's viewpoint to exchange regulation: when automated systems do not raise the fundamental issues that securities regulation targets, market participants need clear determinations that the relevant rules do not apply, rather than having to apply for exemptions. The safe harbor can thus complement the "innovation exemption," providing regulatory certainty for truly permissionless systems.

Meanwhile, a16z has also submitted a supplementary proposal for crypto asset trading platforms (CTPs) that do perform traditional intermediary functions. We recommend establishing a registration framework for such platforms based on the regulatory regime for alternative trading systems (ATS).

Platforms can thus offer trading of crypto assets with securities characteristics and support trading between non-securities assets, as well as between securities and non-securities assets.

The two proposals together delineate a clear regulatory boundary: DEX and DEX Apps that meet the safe harbor criteria should be explicitly exempt from registration as exchanges; other platforms should have a registration pathway suitable for their business. We also look forward to participating in the comment solicitation for the "innovation exemption" itself.

Where is the problem?

The issues we previously identified in the broker-dealer safe harbor proposal are also present here.

A DEX App is a software application, typically embedded in wallets or provided through websites, that allows users to interact with decentralized blockchain systems. Such applications do not hold user assets or operate on behalf of users but provide an interface to facilitate direct on-chain trading. Users can thus conduct peer-to-peer stablecoin payments, purchase network tokens on decentralized exchanges, or engage in lending without relying on intermediaries.

DEXs are typically permissionless smart contract protocols, allowing users to operate without prior approval from operators, with trades executed automatically based on preset conditions. The most common type is the automated market maker (AMM) DEX, where users trade directly with liquidity pools without centralized operators controlling the trading process.

Control by centralized operators can introduce risks that exchange regulation seeks to address, such as conflicts of interest when arranging order executions or market manipulation through control. When operators have significant influence over the market, appropriate governance and fair access rules are also needed to constrain their behavior.

Currently, there remains regulatory uncertainty regarding whether DEXs and DEX Apps need to register as exchanges.

The SEC has previously expressed such a position through at least one Wells notice (a document informing parties that they may face enforcement action): if a DEX or DEX App enables users to trade securities, it may be deemed an exchange. We believe this approach is flawed and could stifle innovation in a promising area of the emerging digital financial system.

This proposal shares the same starting point as our previous broker-dealer safe harbor proposal: if all DEXs and DEX Apps are required to register as exchanges, software developers will be forced to assume roles and responsibilities that do not belong to them, acting as gatekeepers and trading intermediaries. This would undermine the advantages of blockchain systems and introduce new risks for users.

We have also proposed a supplementary plan for CTPs that perform traditional intermediary functions. In our view, the problem here is clear: there is currently no regulated market for trading tokenized securities with other tokenized securities or commodities. This is true whether these securities are investment contracts or NMS stocks (a category of stocks under U.S. securities rules).

Meanwhile, centralized crypto exchanges are also not permitted to offer these trading pairs. Our proposal aims to fill this gap with a registration framework more suited to the current early-stage crypto market.

What is the solution?

We propose establishing a safe harbor: for DEXs and DEX Apps that allow users to conduct peer-to-peer trading (including tokenized securities trading) and meet certain criteria, they should be presumed not to be engaging in exchange business. This is a "rebuttable presumption," meaning that the determination can still be overturned in the presence of contrary evidence. While our proposal primarily discusses AMM-based DEXs, it does not limit specific technical architectures. We also appreciate Commissioner Peirce's openness to other models and methods of tokenized securities trading.

To qualify for this safe harbor, DEXs must meet four objective standards:

1. No asset custody. DEXs must not control user funds; all signatures and transaction submissions must be initiated by users.

2. Automated operation. DEXs must automatically execute trades and other activities without human intermediaries involved, enforcing the corresponding rules. No individual or group controlled by the same entity may have unilateral authority or capability to change system functions, operation methods, or rules.

3. No permission required. DEXs must not restrict user access, nor grant anyone the power to restrict access.

4. Trustworthy neutrality. DEXs must not grant specific participants exclusive rights, code-based privileges, or other similar advantages that allow them to treat specific users or use cases differently.

DEX Apps must also meet four objective standards:

1. No asset custody. DEX Apps must not control user funds. As with the above requirement, all signatures and transaction submissions must be initiated by users.

2. Market data is objective and verifiable. Prices and market data provided by DEX Apps must be based on pre-disclosed, objective, and independently verifiable parameters, with data sources being public on-chain data or independent third parties.

3. No discretionary power exercised. No centralized entity, governance organization, or developer may intervene in the coordination, pricing, matching, or execution of transactions within the application, favoring specific users, counterparties, or trades.

4. Limited developer responsibilities. Developers' roles should be limited to maintaining the interface, implementing technical and security updates, and excluding digital assets according to objective, non-subjective screening rules. Screening criteria must be public and neutral, without subjective investment judgments or qualitative evaluations of asset quality. However, determining whether an asset exhibits characteristics of fraud, malice, or similar spam should not be regarded as an evaluation of asset quality.

For CTPs, our supplementary proposal suggests regulating them under the ATS framework, allowing such platforms to register with the SEC and the Financial Industry Regulatory Authority (FINRA). Once registered, platforms can offer trading of crypto assets with securities characteristics while supporting trading between non-securities assets and between securities and non-securities assets.

For crypto asset securities that fall under NMS stocks, the public disclosure requirements of the ATS-N form only apply when the platform's relevant trading volume exceeds a certain threshold. This form is used to disclose information about the operation of trading venues.

Below the threshold, CTPs still need to provide the SEC and platform clients with information about conflicts of interest, core operating methods, and fair access arrangements, but this disclosure is not open to the public, and the materials submitted by CTPs equivalent to ATS forms do not need to be made public. Additionally, CTPs should comply with record-keeping requirements similar to those of ATS and may use blockchain records.

Why now?

Blockchain technology can reduce costs, accelerate settlement, and expand market access, and DEXs and DEX Apps are key to realizing these advantages. Centralized tokenized securities markets also need regulatory frameworks suited to their business, and the SEC's recent "innovation exemption" has opened a pathway for this. The CTP registration framework can enable tokenized securities to trade in regulated markets.

Congress has missed the opportunity. Regulatory agencies should promote industry development by issuing guidelines, granting exemptions, and engaging in regular rule-making processes, and should not hesitate to use these tools. Our proposal provides a concrete pathway: delineating regulatory boundaries in the U.S. while supporting the responsible development of decentralized systems and crypto asset trading platforms.