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Commissioner Hester M. Peirce of the Securities and Exchange Commission (SEC), head of the SEC’s newly created Crypto Task Force, recently issued a call for public input aimed at developing a clear and workable regulatory framework for digital assets. In her statement, "There Must Be Some Way Out of Here," Commissioner Peirce acknowledged that existing securities laws are often incompatible with the rapidly evolving world of digital assets. Signaling a shift from the past four years, Commissioner Peirce is seeking input from industry leaders, innovators, and the public by requesting information about how to best foster innovation while protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. The DeFi Education Fund (DEF) recently met with the Task Force to provide feedback and share recommendations for how to effectively provide regulatory clarity to decentralized finance (DeFi) market participants.
As part of the SEC’s information gathering initiative, Commissioner Peirce posed a series of questions that are particularly relevant to the DeFi ecosystem. These questions explore critical issues, such as how digital assets and platforms should be regulated, how digital assets used within DeFi protocols should be classified, and what role transparency and custody rules should play in a decentralized environment.
Commissioner Peirce’s insightful questions reflect a strong grasp of the issues related to disintermediation and decentralization in digital asset markets. DEF has identified several key questions from Perice’s request for information that we believe are particularly crucial to the future of DeFi. Over the coming weeks, DEF will provide our perspective on how to address some of the issues most significant to DeFi.
Security Status
As Commissioner Peirce pointed out in her statement: “Blockchain technology has given rise to novel assets that rely on cryptographic protocols for their existence (“crypto assets”). Market participants have expressed a reasonable desire to determine with ease whether such an asset is a security or is being offered or sold as part of an investment contract.”
“What type of regulatory taxonomy would provide a predictable, legally precise, and economically rational approach to determining the security status of crypto assets and transactions in such assets without undermining settled approaches for evaluating the security status of non-crypto assets and transactions?”
“Should the Commission address when crypto assets fall within any category of financial instruments, other than investment contracts, that are specifically listed in the definition of ‘security’ in the federal securities laws?”
“Certain crypto assets are used in a variety of functions inherent to the operation of a blockchain network, such as mining or staking as part of a consensus mechanism or securing the network, validating transactions or other related activities on the network, and paying transaction or other fees on the network. These technology functions may be conducted directly or indirectly, such as through third-party service providers. What types of technology functions are inherent to the operation of a blockchain network? Should the Commission address the status of technology functions under the federal securities laws and, if so, what issues should be addressed?”
“Users of liquid staking applications receive a so-called ‘liquid staking token.’ This token represents their staked crypto asset, and the token can be used in other activities, all while continuing to participate in the proof-of-stake protocol. Should the Commission address the status of liquid staking tokens under the federal securities laws, and, if so, what issues should it address?”
Scoping Out
As Commissioner Peirce pointed out: “the Commission may be able to provide greater clarity to investors and other market participants by identifying categories of crypto assets (and transactions) that do not fall within its authority. In some cases, these types of crypto assets may be within another regulator’s authority. In determining what falls outside the Commission’s authority, the Commission should look to the economic reality of what is being offered or sold. Simply saying something is not a security does not mean it is not a security.”
“Should the security status of certain categories of crypto assets be addressed, such as stablecoins, wrapped tokens, and NFTs?”
“How can the Commission establish a workable taxonomy while remaining merit- and technology-neutral?”
Safe Harbor from Registration
Commissioner Peirce has previously proposed that the Commission consider a non-exclusive safe harbor—provisionally called Rule 195—that would, among other things, provide a time-limited exemption from the registration requirements under the Securities Act for offers and sales of crypto assets during the development of a blockchain project. “The safe harbor would allow projects to facilitate broad participation in and the development of a functional or decentralized network.”
“At the end of the safe harbor’s term, token transactions may not be securities transactions if the network had matured into a decentralized or functioning network that is not dependent on a single person or group to carry out the essential managerial or entrepreneurial efforts.”
“Should the Commission consider a version of Rule 195, my proposed token safe harbor? Is the iteration on my proposed safe harbor known as ‘Safe Harbor X,’ or some other iteration, a better approach?”
“Should the safe harbor be available retroactively for projects that comply with the disclosure requirements?”
“If a safe harbor of some form is the right approach, what disclosure requirements would be feasible for early-stage projects to provide to token purchasers the material information regarding the blockchain project, crypto assets, and development team? What information should be required to be updated on an ongoing basis, and how should that information be provided?”
“At the expiration of the safe harbor as envisioned, if the network were sufficiently decentralized or functional, registration of the tokens would not be required. If decentralization is used as an indicator of network maturity, should the Commission define objective quantitative thresholds (such as percentage thresholds for ownership and control) to provide greater clarity for issuers, developers, or minters of tokens regarding whether their networks and protocols are sufficiently decentralized and to allow third parties to verify decentralization?”
“Is dispersion of control a better framework than decentralization? If so, how should ownership of governance tokens and voting rights be considered in assessing dispersion of control? How should the delegation of voting rights be taken into account?”
“If an exit marker is achieved, who should be responsible for notifying the Commission?”
“How should the decentralization of a deployed protocol best be evaluated? How should permissioned aspects of crypto-adjacent software or participant roles, such as validators, relayers, and sequencers, be considered? Are there tech-neutral thresholds that can be agreed upon for determining thresholds for decentralization?”
Trading
On the subject of trading of digital assets, Commissioner Peirce mentioned that, “secondary market trading of crypto assets raises a variety of issues, some of which may fall within the Commission’s authority. The Commission’s authority in secondary markets generally is limited to assets that themselves are securities based on their intrinsic economic properties or rights, so we have to grapple with how to regulate platforms and market participants that trade securities alongside non-securities.”
“Should the Commission create a new entity registration status with tailored registration requirements for any platform that trades crypto assets that are securities? Should the Commission use or adapt the existing requirements for national securities exchange registration or the alternative trading system exemption from such registration, and if so, how?”
“What updates to the Commission rulebook are needed for side-by-side pairs trading of securities and non-security crypto assets to allow for enhanced interoperability and composability in finance?”
“The crypto markets are inherently transparent because they use open-source data, from public blockchains to open application programming interfaces (“APIs”). Are there programmatic/technological ways that crypto market participants, intermediaries, potential self-regulatory organizations, or regulators can monitor crypto markets using open-source data? How would this take into consideration nested accounts on centralized exchanges, given that this activity may not appear in public ledgers? Is open-source data sufficient for the market to monitor trading and therefore what non-public information might warrant mandatory disclosure? What sort of open-source tools can be used for enhanced transparency, such as proof of reserves, or proof of holdings? What are the limitations of such tools and such data?”
“With the understanding that both APIs and public ledgers can provide order books, what would be a good strategy for regulators to efficiently ingest and analyze order book data? How can the regulators leverage publicly available data to become more efficient and alleviate regulatory burdens?”
“How should Commission registrants assess Maximal Extractable Value (“MEV”) when they consider building or transacting in these environments? How best should Commission registrants delineate between the different types of MEV occurring onchain? In what ways is the market addressing the MEV in which MEV extractors order or re-order transactions to engage in front running, back running, or so-called ‘sandwich attacks’?”
Custody
On the subject of custody, Commissioner Peirce stated: “market participants have broad and specific questions regarding custody requirements for Commission regulated entities—broker-dealers, investment advisers, and investment companies—including whether existing requirements suffice for custodying crypto assets. The Task Force is seeking input on answers to these questions so that individuals and organizations can safely, legally, and practicably custody client crypto assets themselves or with a third party.”
“Should the Commission amend existing rules, propose new rules, or provide guidance to facilitate custody arrangements for crypto assets? If so, what rule amendments or new rules would be appropriate, and to which types of activities should they apply? Should the Commission propose any specific changes to its rules to accommodate the self-custody of crypto assets by entities registered with the Commission? If so, what conditions should apply to self-custody arrangements to mitigate any related risks? Should the requirements for crypto assets that are securities and those that are not differ?”
“Public, permissionless blockchains are being used to tokenize permissioned assets. To the extent the custody rules for broker-dealers, investment advisers, and investment companies are implicated, how should the Commission differentiate between native crypto assets of permissionless blockchains and tokenized permissioned assets? Does either type of crypto asset present greater risks of theft or loss?”
Crypto Lending
Commissioner Peirce also posed questions on the subject of “crypto lending.” She stated that “crypto platforms may offer custodial and noncustodial services through which people can lend their crypto assets in return for interest. Crypto lending concepts vary widely, challenging many traditional notions of financial products.”
“How should the Commission approach various crypto lending concepts in a way that doesn’t stifle the potential opportunities they provide?”
“Participation in traditional securities lending programs, such as fully paid securities lending programs offered by broker-dealers, generally does not represent a new securities transaction or implicate Investment Company Act registration requirements. How are crypto lending programs similar to or different from traditional securities lending programs?”
Sandbox and Related International Issues
Last year, Commissioner Peirce proposed the creation of a micro-innovation sandbox, which could be used for small-scale projects, including tokenization and blockchain projects.
“Would the Sandbox help foster tokenization and blockchain innovation? What types of products and services across the fintech landscape would firms like to test in the Sandbox? What regulatory, technical, and operational barriers pose the biggest challenges to innovation in this space? Could the Sandbox mitigate those challenges?”
“Could a cross-border Sandbox address challenges that U.S. and non-U.S. firms face when attempting to innovate in multiple jurisdictions? If so, how should the Commission structure it to operate globally? Do sandboxes in other jurisdictions serve as a good model?”
Looking Ahead – Future of Crypto Asset Regulation
Commissioner Peirce’s call for input marks an important step toward building a regulatory environment that supports the growth of digital assets and DeFi. By sharing our perspectives and recommendations on these key questions, DEF and the crypto community have the opportunity to help shape regulations that allow DeFi to thrive, while ensuring that the SEC upholds its mandate to ensure American markets remain fair, transparent, and secure.
Stay tuned—over the coming weeks, the DEF team will share insights on how the SEC can foster a future with a harmonious balance between innovation and compliance.
The following with authored by Israel Lopez-Morillo, a legal intern with the DeFi Education Fund.