Crypto venture capital firm Paradigm has criticized the United States Securities and Exchange Commission’s (SEC) efforts to redefine the term “exchange” which, if accepted, would bring decentralized exchanges (DEXs) under its purview. The SEC intends to expand the definition of “exchange” in the 1934 Securities Exchange Act to include DEXs and decentralized finance (DeFi). However, Paradigm believes that the fundamental differences between DEXs and exchanges make treating them as “exchanges” under the Act both “invalid and incoherent.”
In a 14-page letter sent to the SEC secretary Vanessa Countryman on June 8th, Paradigm’s legal counsel Rodrigo Seira stated that through this “haphazard rulemaking, the SEC inappropriately attempts to bring crypto trading platforms, including DEXs, under its remit and regulate them as securities exchanges.” He further commented on how after suing Coinbase for failing to register as a securities exchange when it was not possible, the SEC now wants to force DEXs into the same situation.
In March 2022, the SEC proposed amendments to the Act to include systems that “offer the use of non-firm trading interest and communication protocols to bring together buyers and sellers of securities.” In other words, any platforms that facilitate digital asset exchange or swaps. Paradigm argues that DEXs neither function as intermediaries nor have an “organization, association, or group of persons” that maintains the exchange. Instead, DEXs use algorithms to balance pools of crypto assets that buyers and sellers can freely access. Additionally, DEXs run on self-executing code and smart contracts, not associations or groups of people, Paradigm said.
The SEC’s Efforts against Crypto
The SEC has sued two of the world’s largest crypto exchanges, Binance and Coinbase in twin lawsuits last week. The agency has been relentless in its efforts against crypto for years, deeming at least 67 digital assets as securities. However, Congress has yet to pass any official legislation for crypto markets classifying them as such. With no clear regulatory framework, it is up to the SEC to interpret and apply traditional securities laws to the digital asset market.
FTX collapse led to an increase of 183% in SEC enforcement action against crypto companies over six months, as reported by Cointelegraph. This demonstrates how the SEC’s crackdown on crypto can easily spill over even to relatively small companies.
Paradigm’s Critique of SEC’s Efforts against Decentralized Exchanges
Paradigm’s critique is not unfounded. Decentralized exchanges are unique compared to centralized exchanges and have their advantages. They function and operate differently, and the SEC’s attempts to treat them the same is invalid and incoherent, as noted by Paradigm’s legal counsel. It should be noted that the traditional exchange infrastructure is centralized, which means one entity owns the system and all the data on it centrally. This has made centralized exchanges vulnerable to cyber attacks.
Decentralized exchanges, on the other hand, operate based on a distributed ledger technology (DLT) like blockchain, which eliminates intermediaries. Traders interact directly with each other, and there is no central point of control, hence less susceptible to cyber threats. Intermediaries can be a source of central vulnerability and are often the target of cyber threats. Therefore, DEXs eliminate the need for intermediaries, reducing the risk of cyber-attacks on central points of control.
Additionally, DEXs have a higher level of privacy as compared to centralized exchanges. For instance, centralized exchanges require users to submit their personal information to comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) policies. This means that KYC/AML compliance can compromise user privacy. DEXs, on the other hand, don’t require traders to submit their personal information to participate in the exchange. This makes DEXs attractive to privacy-conscious users.
DEXs use smart contracts to execute trades automatically once certain conditions are met. Since the code is open-source, traders can audit the trading code and verify the outcome of trades. This is in contrast to centralized exchanges where traders have to trust the exchange to execute the trades accurately.
Conclusion
Decentralized exchanges are a necessary part of the evolving digital asset landscape. Thus, it’s important to adopt the right regulatory framework that enables innovation while also ensuring investor protection. The SEC’s attempts to bring DEXs under its remit might stifle innovation and have far-reaching implications for the digital asset space. Regulators need to create tailored regulations for DEXs that reflect the uniqueness of these exchanges and protect investors while also enabling innovation. Paradigm’s criticism is a step in the right direction, and regulators should consider the points highlighted by the fund, as they seek to create a sound regulatory framework.
