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US Securities and Exchange Commission Commissioner Caroline A. Crenshaw said, “DeFi is a shared opportunity and challenge. Some DeFi projects are fully within our jurisdiction, while others may have difficulty complying with currently applicable rules. Me and I Of employees have been actively engaged in useful discussions with DeFi experts and will sincerely consider and help promote responsible innovation.”
Written by: Caroline A. Crenshaw, member of the US Securities and Exchange Commission Compiler: Perry Wang
Whether in news, social media, popular entertainment, or in people’s investment portfolios, cryptocurrencies have now become part of everyday language. However, the term actually contains a wide range of content and is not precisely shaped, including tokens to non-fungible tokens (NFT), and covers everything from decentralized exchanges (DEX) to decentralized finance (DeFI). For those readers who are not yet familiar with DeFi, as expected, the definitions of these terms are also different in their eyes. However, in general, these functions use blockchain-based composable, interoperable and open source smart contracts to replicate our traditional financial system. Many DeFi activities take place on the Ethereum blockchain, but any blockchain that supports certain types of scripts or coding can be used to develop DeFi applications and platforms.
DeFi brings a lot of opportunities. However, it also brings great risks and challenges to regulators, investors and financial markets. Although its potential profits have attracted people’s close attention, and sometimes even very strong attention, people also have some confusion about this emerging market, which is usually very serious. Social media is flooded with various questions, such as “Who specifically regulates the DeFi market in the United States?” and “Why are regulators involved?” These are vital questions, and the answers are important to lawyers and people other than lawyers. This article aims to briefly introduce the current regulatory environment of DeFi, the role of the US Securities and Exchange Commission (SEC) in it, and emphasize two important obstacles that the crypto community should address.
Many investments share important attributes in common
Many DeFi services and products are very similar to those in traditional financial markets. Some decentralized applications (or dApps) running on the blockchain enable people to obtain assets or loans after putting in collateral, just like traditional mortgage loans. There are also some services and products that provide users with the ability to deposit digital assets and get rewards. Both types of products provide returns, some are direct, and some are provided indirectly by using borrowed assets for other DeFi investment opportunities. In addition, there are some network tools that can help users identify or invest in DeFi tools and venues with the highest return on investment. There are also applications that allow users to earn fees by providing liquidity or making markets. There are also coded tokens that are used to track the price of securities transactions approved by the SEC, which can then be traded and used in various other DeFi applications. Therefore, although the specific underlying technology is sometimes not familiar to the public, these digital products and activities are similar to those under the jurisdiction of the SEC.
Considering that they are all called finance, these similarities should not surprise anyone. Investment is usually at the core of DeFi activities, and this does not surprise anyone. The DeFi movement does not just involve the development of new digital asset tokens. Developers have also built smart contracts that enable individuals to invest in them, leverage these investments, take various derivative positions, and quickly and easily transfer assets between various platforms and protocols. There are also projects that show the potential to increase efficiency on a large scale in terms of transaction speed, cost, and customization.
These projects have achieved an incredible rate of development, with new and interesting potential. Considering that the blockchain supporting scripts required for complex smart contracts is still in its infancy, the developments in the DeFi field so far are particularly impressive. But these products are not just products, and their users are not just consumers. DeFi is fundamentally about investment. Such investments include speculative risks to seek passive profits from expected token price appreciation, or putting capital at risk to seek returns, or locking up assets for the benefit of others.
Regulatory blank market is subject to structural restrictions
Market participants raise funds from investors, or provide investors with regulated services or functions, usually requiring legal obligations. In order to avoid these legal obligations, many DeFi project sponsors widely disclosed the risks of DeFi, saying that investment may cause losses, but did not provide the detailed information required by investors to assess the likelihood and severity of risks. The approach taken by others for this can be accurately described as simply declaring that “buyer is liable to pay”; investors bear any and all risks that may cause losses in participating in DeFi. In view of this, many current DeFi market participants recommend that new investors proceed with caution, and many experts and scholars believe that there are significant risks in DeFi.
Although DeFi has created impressive alternative methods to write, record, and process transactions, it has not rewritten all the characteristics or human nature of economics. The applicability of certain truths in DeFi is no different from their role in traditional finance:
• Unless required, there will be some projects that will invest in non-compliance or lack of proper internal control;
• When the potential economic return is large enough, some people will hurt others, and as the possibility of criminals being caught and the possibility of severe sanctions reduced, the possibility of this happening Will increase; and • The absence of mandatory disclosure requirements, information asymmetry may benefit wealthy investors and insiders, while the smallest investors and the least informed investors will become victims.
Therefore, the current “Buyer Pays” method of DeFi participants is not a sufficient foundation for restructuring the financial market. Without a common set of behavioral expectations and a functional system to implement these principles, the market will tend to be corrupt, which is full of fraud, “rat warehouse” transactions, cartel-like monopolistic activities, and information asymmetry. Over time, investor confidence and investor participation will decrease.
On the contrary, well-regulated markets tend to develop prosperously. I think the US capital market is the best example. Due to their reliability and mutual compliance with minimum information disclosure and behavioral standards, our market has become the preferred destination for investors and entities seeking to raise funds. Our securities laws are not only used to impose obligations or burdens, but also provide key market commodities. They help solve the above and other problems, so our market works better. However, in the brave new world of DeFi, regulatory frameworks that provide important protections in other markets have not been widely adopted so far.
Who will supervise DeFi
In the United States, multiple federal agencies may have jurisdiction over all aspects of DeFi, including the Department of Justice, the Financial Crimes Enforcement Network, the Internal Revenue Service, the Commodity Futures Trading Commission (CFTC), and the U.S. Securities and Exchange Commission (SEC). The state government may also have jurisdiction over some of these aspects. Although there are many institutions with some jurisdiction, DeFi investors generally do not obtain the same level of compliance and robust disclosure of information as other regulated markets in the United States. For example, various DeFi participants, activities, and assets fall under the jurisdiction of the SEC because they involve securities and securities-related activities. However, DeFi participants within the jurisdiction of the SEC have not yet registered with us, but we continue to encourage DeFi participants and employees to interact with the SEC. If investment opportunities are provided entirely outside of supervision, investors and other market participants must understand that these markets are generally more risky than traditional markets where participants follow the same rules.
The role of the SEC
As a member of the SEC, I have a responsibility to help ensure fair operation of market activities, whether it is new or old, and to provide a level playing field for all investors. I hope this goal will be supported by DeFi market participants.
To this end, the SEC has a variety of tools that can be used in the DeFi field, from rule-making powers to various waivers or inaction remedies to law enforcement actions. It is important that if the DeFi development team is unsure whether their project is under the jurisdiction of the SEC, they should contact our innovation and financial technology strategy center “FinHub”, or our other offices and departments, all of which have Very good expert-proficient in issues related to digital assets. As far as I know, FinHub has never refused to meet, and their participation will be meaningful. If a series of meetings need to be held, they will invest the necessary time. If a project does not fully fit our existing framework, the project team should come and talk to us before entering the market. The more the project team discusses with the SEC about possible solutions, the better the results they expect will be. Our employees cannot provide legal advice, but they are always ready to listen to ideas and provide feedback because the developers know their projects better than we do. If the project seems to be restricted by our rules, it is important to us how to integrate these new technologies into our regulatory system to ensure that the federal securities laws provide market and investor protection while allowing innovation to flourish to obtain specific ideas. Said is crucial.
Having said that, we do have an effective enforcement mechanism for non-compliant items within our jurisdiction. For example, the SEC recently reached a settlement with a supposedly DeFi platform and its individual promoters during an enforcement operation. The SEC alleged that they raised $30 million without legally registering their token offering, misled their investors, and improperly spent their money on themselves. If the operation of other products, projects or platforms violate the securities laws, I expect the SEC will continue to take enforcement actions. But my personal preferred path is not through enforcement, and I don’t think enforcement is inevitable. Widespread violations and the need for a large number of enforcement actions are not an effective way to achieve the common goals of DeFi. The more projects that voluntarily comply with regulations, the less frequently the SEC conducts investigations and litigation.
I realize that the SEC’s role is not to prevent all investment losses. It is also not my goal to limit investors’ access to fair and appropriate opportunities. But my job is to require investors to have equal access to key information so that they can make wise decisions about whether to invest and at what price. I am also committed to ensuring that the market is fair and free from manipulation. In view of this, the DeFi community seems to need to solve two specific structural issues.
Lack of transparency
First, although transactions are usually recorded on public blockchains, to a considerable extent, DeFi investment is not transparent. I am worried that this lack of transparency will lead to a two-tier market, in which professional investors and insiders get huge returns, while retail investors take more risks and get worse pricing. It may succeed. Most DeFi is funded by venture capital (VC) and other professional investors. I don’t know how much this is known in the DeFi retail investor community, but basic financing transactions usually allow professional investors to obtain equity, options, consulting roles, access to project team management, and formal or informal speeches on governance and operations. Rights, anti-dilution rights, and the ability to allocate controlling rights to allies, and other benefits. These arrangements are rarely disclosed, but they can have a significant impact on investment value and results. Retail investors are already at a significant disadvantage compared to professional investors in DeFi, and this information imbalance has exacerbated this problem.
Some people believe that DeFi is actually more equal and transparent because most of the activities are based on publicly available code. However, only relatively few people can really read and understand the code, and even highly qualified experts will miss defects or dangers. At present, the quality of these codes may vary greatly, and have a significant impact on investment results and security. If DeFi has the ambition to democratize the investment pool, it should not assume that a large proportion of this population can or want to run its own testnet to understand the risks associated with the code on which its investment prospects depend. It is unreasonable to establish a financial system that requires investors to understand complex codes.
In short, if a retail investor has $2,000 to invest in risky programmable assets, it is not cost-effective for the investor to hire experts to review the code to ensure that its behavior is consistent with its advertising. Instead, retail investors must rely on marketing, advertising, word of mouth, and social media to obtain information. On the other hand, professional investors can hire technical experts, engineers, economists, and others before making investment decisions. Although this professional advantage has historically existed in our financial markets, DeFi has exacerbated this advantage. DeFi removes intermediaries that perform important gatekeeping functions and operates outside of the existing investor and market protection systems. This may prevent retail investors from obtaining professional financial advisors or other intermediaries to help them screen the quality and legitimacy of potential investments. The above-mentioned third-party institutions have provided practical assistance in reducing fraud and risk assessment in traditional finance, but in the DeFi field, their alternatives are very limited.
The second fundamental challenge of DeFi is that these markets are susceptible to manipulation that is difficult to detect. DeFi transactions occur on the blockchain, and every transaction is recorded, immutable, and available for everyone to view. But this visibility only extends to a certain identifier. Due to the anonymity of users, the blockchain displays the blockchain address that sends or receives the asset, but does not display the identity of the owner who controls it.
Without an effective method to determine the actual identity of the trader or smart contract owner, it is difficult to know whether the asset price and transaction volume reflect organic interests or the product of manipulated transactions, for example, whether a person uses a robot to operate multiple wallets , Or whether a group of people colluded in a transaction. There are real securities regulations in the United States that prohibit transactions for the purpose of pretending to be market activity or manipulating the price of securities, because successful investment depends on reliable information and market integrity. Anonymity makes it easier to hide manipulation activities, and it is almost impossible for investors to distinguish individuals engaged in manipulation transactions from normal organic trading activities. In DeFi, since the market usually affects asset prices, transaction volume, and momentum, investors can easily suffer losses due to others’ manipulation of transactions, making these signals unreliable. If the transaction occurs outside the public chain, it is more difficult to assess whether the transaction is legal.
I realize that, to some extent, DeFi is synonymous with anonymity. The use of alphanumeric strings to conceal real-world identities is a core feature of Bitcoin, and it basically appears in all subsequent blockchains. But in the United States, investors have long been satisfied with compromises, giving up a certain degree of privacy by sharing their identities with entities that trade securities. In return, they benefit from a regulated market that is fairer, orderly, efficient, with less manipulation and fraud.
I suspect that when turning to DeFi, most retail investors did not do this because they seek a higher degree of privacy; they are seeking what they think is better returns that can surpass the returns of other investments. Although some people in DeFi believe in absolute financial privacy, I expect that projects that solve the problem of anonymity are more likely to succeed, because investors can rest assured that asset prices reflect the actual interests of real investors, rather than hidden manipulators Manipulated prices. Projects that solve this problem are also more likely to comply with SEC regulations and other legal obligations, including the requirements of the Bank Secrecy Act on anti-money laundering and combating the financing of terrorism.
I respect innovation, but I will not reduce my commitment to help ensure that all our financial markets are sustainable and to provide ordinary investors with a fair chance of success. DeFi is a shared opportunity and challenge. Some DeFi projects are fully within our jurisdiction, while other projects may have difficulty complying with currently applicable rules. Just saying that supervision is too difficult or compliance with regulations is too difficult is lazy behavior.
Many projects have stated that they want to operate in DeFi in a compliant manner, which is a positive sign. I believe in their sincerity on this point and hope that they will devote resources to cooperating with SEC staff in the same spirit. For DeFi problems, finding a compliant solution will be the best result of the two parties’ joint efforts. If there is no proper investor protection and mechanism to support market integrity, trying to reimagine our market under such circumstances will miss good opportunities on the good side, and cause major harm on the bad side. When conceiving a new financial system, I believe that developers have an obligation to optimize, not just consider profitability, deployment speed, and innovation. No matter what happens next, DeFi should be a system that all investors can access and manipulate important data, and it should be a system that reduces the possibility of manipulation. Such a system should guide funds to flow effectively to the most promising projects, rather than just being blinded by hype or false claims. It should also promote the development of interconnected markets, but with adequate safeguards to withstand major shocks, including the potential for rapid deleveraging. In a decentralized network with decentralized control and diverse interests, regulations help create common incentives to benefit the entire system and ensure that the participants with the least power get fair opportunities.
My employees and I have been actively engaged in useful discussions with DeFi experts, and my door is still open. Unfortunately, I cannot guarantee that this is a simple or fast process, but I can assure you that we will sincerely consider and help promote responsible innovation.
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