SEC's New Definition of Dealer Is 'Amorphous,' Disregards Digital Asset Industry: Suit

The new rule “scraps the longstanding, well-settled approach that market participants relied on — which identified dealers solely based on the types of services that they provided to customers — in favor of a far broader, amorphous standard,” the complaint said. The broader standard considers whether a person’s trading activity “regularly has the effect of providing liquidity,” it said.

The rule says market participants will meet the new standard when they “(i) 'regularly express[] trading interest' 'at or near the best available prices’ for a security ‘on both sides of the market’ or (ii) ‘earn[] revenue primarily from capturing’ the spread on securities prices or ‘incentives offered by trading venues’ for providing liquidity,” said the complaint. That means that whether someone is a dealer “no longer turns on ex ante considerations of the services a person offers to customers, but instead on an after-the-fact assessment of the effects of a market participant’s trading activity,” it said.

The new “amorphous standard,” which “has already sown confusion" in traditional financial markets, is “entirely detached from the concept of 'dealer’” as used in the Exchange Act and understood by the SEC since 1934, the complaint said. The rule is “even worse” applied to the digital assets industry, it said. Because of the rule’s “exclusive focus on post hoc effects of trading, the new definition of 'dealer’ will potentially sweep in all manner of digital asset markets participants, including users who merely participate in digital asset liquidity pools,” it said.

Imposing the existing dealer regulatory framework on the digital assets industry “makes little sense,” said the complaint. The existing framework doesn’t address or mitigate the potential risks of trading using digital asset technology, instead focusing on “matters such as customer sales practices and asset custody that have no relevance in that context,” it said. The rule, which focused on participants in traditional financial markets, “created many other questions about how it could practically apply in the digital asset markets,” the complaint said.

Digital assets industry stakeholders raised issues about the expanded definition of dealer in a 39-day comment period, asserting that it made no sense as applied to the digital side when the “market maker” that sets prices “is an automated software protocol running on a distributed ledger, rather than a person or firm acting as a market intermediary,” the complaint said. Stakeholders also questioned whether the new definition would include passive contributors to liquidity pools, “leading to the absurd result that traders simply contributing their idle assets to these decentralized pools would be forced to register as securities dealers,” it said.

Commenters noted that the uncertainty was compounded by questions around which digital asset transactions constitute securities transactions; they also identified broader costs the rule could impose if applied to the digital assets industry, the complaint said. The rule could harm competition, for one, or could impose a “a significant impediment to other digital asset applications that connect to those protocols to enable internet commerce without intermediation by large, centralized technology companies,” it said.

The focus of the SEC’s economic analysis of the effects of the proposed rule “was almost entirely on the need for further regulation of the U.S. Treasuries markets and the conduct of proprietary trading firms and hedge funds,” alleged the complaint. Digital asset industry commenters urged the commission to, “at a minimum, exempt digital assets from the rule’s new criteria,” it said.

In the final dealer rule, the SEC responded to the digital asset industry’s concerns “with a shrug,” the complaint said. The commission “simply speculated” that the rule’s impact on the industry – “an industry built on entirely novel technologies enabling decentralized trading and market liquidity solutions that have no equivalent in traditional finance -- would be similar to its effect on traditional financial markets,” it said. The SEC “refused to exempt the digital assets industry or to coherently explain how and when the rule would apply to those novel markets,” it said.

The dealer rule is the latest example of the SEC’s attempts “to thoughtlessly apply rules geared toward traditional financial markets to the digital assets industry, despite its entirely different market structure built on innovative new technology,” alleged the complaint. If the rule goes into effect, digital asset market participants that only trade digital assets “will potentially be subject to onerous regulations and compliance costs as ‘dealers,’” depending on the SEC’s “piecemeal, arbitrary approach to classifying transactions in certain digital assets as securities transactions,” it said.

The plaintiffs allege six violations of the Administrative Procedure Act and seek judgment that the expanded dealer definition is "arbitrary, capricious, or otherwise contrary to law within the meaning of the APA.” They also request orders vacating and setting aside the dealer rule pursuant to the APA, enjoining the SEC from enforcing the rule against digital asset industry participants, and issuing all processes necessary to delay the effective date of the rule’s implementation pending the conclusion of this case, it said.