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Securities Regulation Daily Wrap Up, BROKER-DEALERS—N.D. Tex.: SEC sued over dealer rule’s impact on liquidity pools, (Apr 26, 2024)

Law Firms Mentioned:Duane Morris LLP
Organizations Mentioned:Blockchain Association | Crypto Freedom Alliance of Texas | Duane Morris, LLP | Financial Industry Regulatory Authority

By Anne Sherry, J.D.

The existing dealer regulatory framework can’t simply be mapped on to the digital asset industry, the plaintiffs argue.

Two crypto industry groups are suing the SEC over the agency’s Dealer Rule, which requires market participants who pe ...

By Anne Sherry, J.D.

The existing dealer regulatory framework can’t simply be mapped on to the digital asset industry, the plaintiffs argue.

Two crypto industry groups are suing the SEC over the agency’s Dealer Rule, which requires market participants who perform dealer functions to register with the Commission and join FINRA and the SIPC. Crypto Freedom Alliance of Texas and Blockchain Association cite six alleged violations of the Administrative Procedure Act in seeking an injunction blocking the rule. In the plaintiffs’ view, the new rule “represents simply the latest example of the Commission’s attempts to thoughtlessly apply rules geared toward traditional financial markets to the digital assets industry” (Crypto Freedom Alliance of Texas v. SEC, April 23, 2024).

Parties. Both plaintiffs are 501(c)(6) nonprofits devoted to promoting innovation in the digital assets industry. CFAT specifically advocates for the responsible development of crypto regulation in Texas, believing the state should play a leading role in fostering innovation and economic growth using blockchain technology. Blockchain Association’s members are software developers, infrastructure providers, exchanges, custodians, investors, and others supportive of the blockchain ecosystem. CFAT is a co-plaintiff in a pending lawsuit, also in the Northern District of Texas, that challenges SEC’s regulatory claim over crypto assets.

Dealer Rule. The Dealer Rule, adopted by a 3-2 vote in February, requires market participants who perform dealer functions—in particular those who take on significant market liquidity-providing roles—to register with the SEC, join FINRA and the SIPC, and comply with reporting and recordkeeping requirements.

SEC Chair Gary Gensler called the rule “common sense.” But the plaintiffs say it departs from decades-long practice by replacing an ex-ante look at services provided with an after-the-fact review of the effects of trading activity.

Applicability. The rule has already created confusion in the traditional financial markets, but the picture is even worse in the digital assets industry, the plaintiffs argue: the new focus on the effects of trading mean the rule may pull in users who merely contribute to digital asset liquidity pools. Just as the SEC has failed to definitively state which digital asset transactions are securities, it failed to give the industry clear notice of which digital assets might subject market participants to the Dealer Rule, the plaintiffs assert.

Furthermore, simply applying the existing dealer regulatory framework to the digital assets industry makes little sense, the complaint asserts. The liquidity pool is a DeFi innovation that has no exact analogue in traditional finance. A formula built into the pool’s smart contract adjusts the prices of assets remaining in the pool after each transaction, effectively acting as automatic price discovery in contrast to relying on market makers as in traditional financial markets.

But the existing regulatory framework focuses on things like customer sales practices and asset custody that are irrelevant to the digital assets industry. The statutory regime underpinning dealer regulation was meant to address informational and financial disparities that leave customers vulnerable to dishonest dealers, but decentralized finance inherently avoids the risks the law was meant to address by removing the intermediary—relying on software, not dealers, to facilitate trades.

Violations. The complaint asserts that the Dealer Rule violates the APA in several ways. First, the SEC exceeded its statutory authority by promulgating a new interpretation of “dealer” that departs from the statutory definition. Second, the Commission ignored the questions and concerns that commenters raised about how the rule would apply to—and affect innovation in—the digital assets industry. Finally, the Commission failed to analyze the economic effects of the rule on the digital assets industry specifically, seeking only to justify the rule by reference to the costs and benefits for traditional financial markets.

The case is No. 24-cv-00361.

Attorneys: Randy D. Gordon (Duane Morris LLP) for Crypto Freedom Alliance of Texas.

Companies: Crypto Freedom Alliance of Texas; Blockchain Association

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