November 10, 2021
by Jonah R. Hecht

 

On November 9, SEC Commissioner Crenshaw issued a Statement on DeFi Risks, Regulations, and Opportunities.  Commissioner Crenshaw noted that DeFi presents a panoply of opportunities.  But she noted that “investing is often at the core of DeFi activity,” and many digital products and activities have “close analogs within the SEC’s jurisdiction.”  She stated that some DeFi promoters' attempts to disclaim legal obligations by disclosing broadly that DeFi is risky and investments may result in losses, without providing the details investors need to assess risk likelihood and severity, may not be an adequate foundation on which to build reimagined financial markets.  According to Commissioner Crenshaw, “without a common set of conduct expectations, and a functional system to enforce those principles, markets tend toward corruption, marked by fraud, self-dealing, cartel-like activity, and information asymmetries.  Over time that reduces investor confidence and investor participation.”  Commissioner Crenshaw added that multiple federal authorities “likely have jurisdiction over aspects of DeFi, including the Department of Justice, the Financial Criminal Enforcement Network, the Internal Revenue Service, the Commodity Futures Trading Commission, and the SEC,” as well as certain state authorities.  Commissioner Crenshaw encouraged DeFi development teams to reach out to the SEC’s Strategic Hub for Innovation and Financial Technology if they are unsure if their project is within the SEC’s jurisdiction.  She said that “the more the project team can lead that discussion with possible solutions, the better outcomes they can expect.”

Commissioner Crenshaw also highlighted what she perceived to be two structural hurdles in DeFi:

  1. Lack of Transparency.  Commissioner Crenshaw said she was concerned that a lack of transparency contributes to a "two-tier market in which professional investors and insiders reap outsized returns while retail investors take more risks, get worse pricing, and are less likely to succeed over time."  She said that DeFi funding deals often grant professional investors equity, options, advisory roles, access to project team management, formal or informal say on governance and operations, anti-dilution rights, and the ability to distribute controlling interests to allies, among other benefits.  Rarely are these arrangements disclosed, but, according to Commissioner Crenshaw, “they can have a significant impact on investment values and outcomes.”  She also noted that although some say DeFi is transparent because it is based on publicly-available code, only a relatively small group of people can read and understand the code.  Commissioner Crenshaw said the quality of that code can vary drastically and has a significant impact on investment outcomes and security, but retail investors cannot afford to hire an expert to audit the code before investing.
  2. Pseudonimity.  According to Commissioner Crenshaw, "without an efficient method for determining the actual identity of traders, or owners of smart contracts, it is very difficult to know if asset prices and trading volumes reflect organic interest or are the product of manipulative trading by, for example, one person using bots to operate multiple wallets, or a group of people trading collusively."  She said that DeFi projects that solve for pseudonymity are “more likely to be able to comply with SEC regulations and other legal obligations, including requirements around anti-money laundering and countering the financing of terrorism imposed by the Bank Secrecy Act.”

Calling DeFi a "shared opportunity and challenge," Commissioner Crenshaw hoped that DeFi developers commit resources to collaborating with the SEC staff to ensure compliance with SEC regulations.  Her full statement can be found at:  https://www.sec.gov/news/statement/crenshaw-defi-20211109?utm_medium=email&utm_source=govdelivery

About Blockchain Law Center

Blockchain technology utilizes a distributed digital ledger to record and track information, and can be leveraged to gain transparency and certainty in transactions ranging from cryptocurrency to supply chain tracking.  This blog provides information on the legal developments surrounding implementation of blockchain technology, with an initial focus on the financial services sector.