Author: Daniel Barabander, Deputy General Counsel of Variant Fund; Translation: Jinse Finance xiaozou

On June 28, 2024, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Consensys, the developer of the non-custodial wallet application MetaMask. The accusation involves two different products: MetaMask Swaps and MetaMask Staking. For MetaMask Swaps, the core accusation of the SEC is that Consensys, as an unregistered securities broker, "exchanged one crypto asset for another on behalf of investors." For MetaMask Staking, the SEC accused Consensys of acting as an unregistered securities broker, "conducting Lido and Rocket Pool investment contract transactions on behalf of others," and participating in the unregistered "offering and sale of Lido and Rocket Pool pledge plan investment contracts."

These allegations echo those in the SEC v. Coinbase case, in which the SEC accused Coinbase of acting as a broker through its non-custodial wallet product, Coinbase Wallet, and engaging in unregistered securities offerings and sales through its staking program. At the time, I was a private practice attorney and lead counsel working with the prominent DeFi Education Fund (DEF) team to write their legal opinion for Coinbase, which went into technical details about why the SEC’s allegations against Coinbase Wallet and the Coinbase staking program did not hold water. The court granted Coinbase’s motion for judgment on the Coinbase Wallet complaint, but allowed the staking program to proceed.

Here’s a simple chart summarizing the wallet and stake litigation in both cases, and you’ll notice there’s significant overlap:

In this article, I will contrast the wallet/swaps allegations of Coinbase and Consensys, and delve into some of the specific allegations made by the SEC. My overall impression is that the SEC has better tied its allegations to the actual meaning of a securities broker in the Consensys case than in the Coinbase case, but in some cases the SEC has overstated key elements of the technology's misoperation in its attempts to exaggerate Consensys' role in user transactions.

1. Definition of Securities Broker

First, let’s define a broker-dealer. Like many things in securities law, the definition of a broker-dealer is fuzzy. Under the Exchange Act, a broker-dealer is defined as “any person who engages in the business of dealing in securities on behalf of another person.” The next question, of course, is what does that mean? There are many factors that the court considers, but I’ll cite the nine factors that Coinbase cited in its motion for judgment in the lawsuit:

Courts consider several factors to determine whether an entity is engaging in broker-dealer behavior, including whether it “1) actively solicits investors; 2) receives compensation based on transactions; 3) handles the securities or funds of others in connection with securities transactions; 4) handles documents related to securities sales; 5) participates in the order-taking process; 6) sells or has sold securities of other issuers; 7) is employed by an issuer; 8) participates in negotiations between an issuer and investors; and/or 9) evaluates or provides advice on investment returns.”

There is no minimum number of these factors that must be met to constitute a broker-dealer, but the more of these factors that are met, the more likely a court will find an entity to be a broker-dealer. Therefore, the SEC’s primary responsibility in drafting these complaints is to make the allegations meet as many of the above factors as possible so that they will survive a motion to dismiss.

2、Coinbase Wallet

Looking at the lawsuit against Coinbase, the core reasons why the SEC lost the case alleging that Coinbase Wallet was an unregistered securities broker were: 1) the SEC did not initiate enough broker-factor charges, and 2) for the alleged factors, the SEC did not fully explain how Coinbase carried out these activities.

As the court explained:

First, the SEC's allegations do not involve several factors that courts use to identify "broker-dealers." Notably, the SEC did not claim that the Wallet app negotiated transaction terms, made investment recommendations, arranged financing, held customer funds, processed transaction documents, or performed independent asset valuations. The indictment accuses Coinbase of: charging a 1% commission for Wallet's brokerage services; actively soliciting investors (on its website, blog, and social media) to use Wallet; comparing prices on different third-party trading platforms; and sending "customer orders" for crypto asset securities to these platforms. Upon closer review, these allegations (alone or in combination) are not sufficient to make a "securities brokerage activity" determination.

According to the complaint, Coinbase’s involvement in the order routing process was minimal. While Wallet “provides access or links to third-party services, such as decentralized exchanges,” the SEC did not allege that Coinbase performed any key trading functions related to these activities on behalf of its users. As the complaint acknowledges, Coinbase has no control over users’ crypto assets or the trades conducted through Wallet, and the product only provides users with the technical infrastructure to arrange trades on other decentralized exchanges in the market. Only users have control over their own assets, and when it comes to trading, users are the sole decision makers.

More importantly, while Wallet helps users discover prices on decentralized exchanges, providing price comparisons does not rise to the level of sending orders or providing investment advice… Similarly, the fact that Coinbase sometimes charges commissions does not in itself make Coinbase a securities broker.

As discussed above, due to these deficiencies, the Court granted Coinbase’s motion for judgment on this alleged complaint.

3、MetaMask Wallet

How should the SEC handle the securities broker charges against Consensys’ MetaMask Swaps after their failed lawsuit against Coinbase for similar products? As expected, I think they will try to attack each of the core deficiencies the court outlined in the Coinbase case one by one, making more securities broker element charges and detailing the active role that Consensys and the software developed by Consensys play in the user’s trading process.

Let’s look at how the SEC describes MetaMask Swaps at a high level in the Consensys complaint:

MetaMask Swaps functions as follows. Investors enter the name and amount of the crypto asset they wish to sell, and the name of the crypto asset they wish to buy. MetaMask Swaps then pulls the currently available exchange rate for the requested trade from execution venues curated by Consensys and other third-party liquidity providers, and displays it to the investor, highlighting what Consensys considers to be the “best” option. With just one more click, MetaMask Swaps performs the necessary functions on the investor’s behalf to effectuate the trade with the third-party liquidity provider. As described in further detail below, Consensys’ software routes investors’ orders by transferring their assets and trade instructions through Consensys’ own blockchain smart contracts, which interact with third-party liquidity providers on the investor’s behalf. As is typical in traditional securities markets, investors here never interact directly with third parties; all investors interact directly with Consensys’ platform. And Consensys charges a fee for most trades.

You’ll notice that the SEC uses many of the key words (or synonyms) from the definition of a stockbroker, such as “emphasize,” “plan,” “best,” “implement,” “route,” “trade orders,” “represent investors,” “fees,” etc. I’ve listed all of the active roles the SEC alleges ConsenSys played.

4. Examining the specific allegations

Below, I will delve into some of the specific allegations made by the SEC and compare them to the actual technical functionality. I found that the SEC repeatedly exaggerated ConsenSys’ role in user transactions, which was inconsistent with the functionality of ConsenSys’ technology.

(1) Smart Contracts

The lawsuit states:

MetaMask Swaps will…interact with third-party liquidity providers who execute investors’ orders, thereby selling crypto asset A and acquiring crypto asset B on behalf of the investor…

Therefore, the Consensys software transfers crypto asset A to the blockchain address of Consensys’ Spender.sol smart contract.

The Consensys Spender.sol smart contract address temporarily holds the investor’s crypto asset A… The Consensys Spender.sol smart contract will interact with the “Adapter” smart contract developed by Consensys.

Specifically, through the Adapter smart contract, the third-party liquidity provider will obtain crypto asset A from the Spender.sol smart contract address and deposit crypto asset B into the Spender.sol smart contract address.

Consensys…processes client crypto-asset securities through smart contract addresses operated by Consensys…facilitates the trading of crypto-asset securities…

As I explain in detail below, my best guess as to what the SEC was saying is that users were executing atomic trades through smart contracts written by Consensys, which, if true, would give Consensys far less control over the trading process than the SEC is alleging.

But before diving in, let me make a general comment: I’m struck by some of the vague language the SEC is using here that obscures the functionality of the blockchain, specifically “smart contracts operated by Consensys” and “Consensys software transfers…” It’s not clear what the SEC means by “smart contracts operated by Consensys.” While there are certain multi-signature management functions on the smart contract that Consensys has control over, there’s no evidence that the company actively operates the smart contract’s code. In fact, the whole point of smart contracts is that the code is run by a decentralized network that no one controls. It’s not “Consensys software” that “transferred cryptoasset A to Consensys’ Spender.sol smart contract” — it’s the user who signed the transaction to authorize the transfer, not Consensys, and an external blockchain protocol independent of Consensys that updates the state.

Ok, let's get back to the question of atomic transactions. To understand what's going on, let's look at the code of the MetaMask Swap Router smart contract. The key function is _swap() on MetaSwap.sol, which calls swap() on Spender.sol:

MetaMask Swap is not about performing trades “on behalf of investors”. Users must sign all transactions that control their tokens, something Consensys cannot do on behalf of users because it does not have access to private keys stored on users’ devices. Looking at the code, the swap() function is atomic — its job is to send tokens and return tokens to the user in a single transaction. Even the flow of the user granting approval to Spender.sol before the transaction and later calling swap() cannot change this fact because: 1) the only function that transfers tokens is _swap(), and 2) the implementation of that function ensures that the sender must be the owner of the token (tokenFrom.safeTransferFrom(msg.sender, address(spender), amount)). Assuming the adapters are not malicious (which is another question entirely), their job is to enable users to perform atomic transactions — taking token A and exchanging it for token B in a single transaction. This means that the transactions “either succeed or fail” — either the tokens are redeemed or not, and they cannot ultimately own the Spender.sol contract or Consensys, as the SEC implies using terms such as “the Spender.sol smart contract address temporarily holds the investor’s” tokens, tokens being “deposited into the Spender.sol smart contract address,” and “Consensys…processes the tokens through a smart contract address operated by Consensys.”

(2) Slippage

The lawsuit states:

Setting a slippage range effectively creates a “limit order,” an extremely common order type offered by traditional stock brokers.

Slippage is not “actually” the same thing as a traditional limit order, and conflating the two implies that ConsenSys is managing user orders more proactively than is actually the case.

The key difference is this: whereas in a traditional limit order, one party first tells the other party the conditions for when the trade should be executed, slippage involves a smart contract that runs a check function when the trade is executed. This leads to a very different result from a control perspective, as traditional limit orders usually require trusting the other party's observation of the market and submitting the order only when the conditions are met. Slippage, on the other hand, does not involve any active management by a third party. Instead, the user sets the minimum amount of tokens they want to receive and then executes the trade, and the smart contract (running automatically) checks whether the minimum amount of tokens was actually received, otherwise the trade will fail.

In simple terms, slippage is an emergency brake that users put in place to protect themselves, whereas a traditional limit order is an instruction to another party when the order should be executed on the user’s behalf. The latter has a middleman associated with brokerage activities, while the former does not.

(3) Private key storage and recovery

The lawsuit states:

The Consensys software reads the investor’s private key from the MetaMask Wallet. The private key is a digital password that cryptographically unlocks the crypto asset A so that the crypto asset can be transferred from the investor’s MetaMask Wallet.

By placing orders through MetaMask Swaps, investors do not need to know or enter their private keys (the cryptographic “password” required to transfer crypto asset A out of their wallet).

First, it’s not clear what the SEC means by “Consensys software read investors’ private keys from MetaMask Wallet.” What is “Consensys software” here? I thought it was MetaMask Wallet, which the SEC defines as “a software application developed by Consensys to store investors’ crypto assets,” but that doesn’t make sense. If the SEC is trying to say that other Consensys software besides the wallet application had access to private keys, then this is clearly wrong. To clarify, “MetaMask generates passwords and keys on your device,” not on the software application itself, so it’s not accurate to say that private keys are read from “MetaMask Wallet.” Instead, MetaMask Wallet requests private keys from device storage.

But what I really want to focus on here is the implication here: recovering private keys through a wallet app somehow implies brokerage activity. But it doesn’t. We interact with the internet every day in one way or another, and we use software to abstract away the tedious technicalities. Think about it, it’s Chrome that does everything behind the scenes to make your experience usable. Chrome stores your passwords locally so you don’t have to enter them every time you visit a site, and it participates in the TLS protocol behind the scenes to ensure that data is transmitted privately. Does this mean that when a user utilizes these features to make a trade on Fidelity.com, Google, through Chrome, is acting as a broker? Of course not. The same considerations apply to wallet software developers.

The SEC cites software that abstracts the details of interactions on the internet as evidence of control, a scary implication that the crypto space cannot bear.

(4) RPC Node

The lawsuit states:

The Consensys software submits the blockchain transaction to a remote procedure call (RPC) node operated and controlled by Consensys. The RPC node stores the blockchain transaction in a memory pool (a collection of proposed transaction queues) until it is included in a block and executed, as follows. More specifically, the Consensys software creates, signs (using the investor's private key) a block transaction, and submits this blockchain transaction to Consensys's RPC node, which, after the transaction is executed, transfers the specified amount of crypto asset A from the investor's wallet address to the smart contract "Spsender .sol" developed by Consensys.

Consensys … facilitates order execution by submitting blockchain transactions to Consensys nodes …

Here, the SEC is describing what I would consider a pretty ordinary RPC Ethereum node, but by labeling it as “operated and controlled by Consensys,” it is interpreted as if Consensys is doing something special beyond just participating in the Ethereum blockchain protocol. It makes no difference that Consensys submits transactions to the node it runs — Consensys can submit them to any RPC node it wants and the result will be the same.

(5) Wallet account "Create"

The lawsuit states:

Consensys … facilitates the trading of crypto-asset securities by creating client wallets (i.e., “accounts”) …

This is an allegation that the SEC also made against Coinbase, but was dismissed, as it did not fit with how the wallet was created:

The blockchain has no concept of “open” and “closed” “accounts” or choosing which private keys to use. There is a simple way to understand why this is so: it is perfectly possible to transfer crypto assets on the blockchain to a public key, and no one is trying to get from the private key; unless someone randomly selects the private key associated with that public key, those assets cannot be accessed. All wallets on the blockchain already exist, and users choose which wallet is theirs by selecting a random number (private key). No one, including the developer of any wallet application, authorizes or manages this process; the process is entirely dependent on the fact that, for all practical purposes, no two users will select the same number. There is no checking or approval process, no “accounts” or “lists” of “approved” and “unapproved” that are checked to ensure that the user is registered. After a user selects a random number (private key), that user can immediately start transacting on the blockchain using a digital signature. Therefore, Coinbase or Wallet does not actively do anything to “open” an “account” because there is no “account” of the kind the SEC is alleging.

Given how out of touch with technological reality it is, I’m surprised the SEC would repeat this allegation without actually changing anything.

5 Conclusion

From a litigation perspective, the SEC's complaint against Consensys does a much better job of attempting to incorporate the elements of the definition of a securities broker, which I believe makes it a stronger case than the Coinbase case. However, the allegations still need to be carefully scrutinized to ensure that they accurately portray the role Consensys played in user transactions. Upon closer inspection, the SEC has either overstated key elements of the technology's operation or misunderstood them. This raises serious questions about the credibility of its allegations that Consensys acted as a securities broker through MetaMask.