In her first public remarks since the U.S. Securities and Exchange Commission filed a lawsuit against open-source payment system developer Ripple Labs, SEC Commissioner Hester Peirce discussed with Forkast.News Editor-in-Chief Angie Lau the difficulties of regulating decentralized finance (DeFi). Peirce’s comments, along with an explosive year of growth in a sector that still has a “Wild West” reputation, made legal and crypto experts wonder whether DeFi could face SEC regulation and enforcement actions in 2021.
“People realize that we’re active in this space,” Peirce said, “both on the enforcement side, but we also took some important steps right at the end of the year on the regulatory clarity side by providing some clarity for brokers that want to engage in digital asset securities.”
Among the SEC’s end-of-year actions was its lawsuit alleging that Ripple Labs Inc., its CEO Brad Garlinghouse and Chairman Chris Larsen engaged in an unregistered securities offering when they raised US$1.3 billion through the sale of the company’s cryptocurrency XRP.
Yesterday, in a separate lawsuit, the SEC charged three people connected with the now-defunct crypto companies Start Options and Bitcoiin2Gen with defrauding hundreds of retail investors out of more than US$11 million through two unregistered security offerings. Bitcoiin2Gen had been illegally promoted by the actor Steven Seagal, who settled related SEC charges against him last year.
Peirce declined to discuss details of the Ripple lawsuit but said it has been difficult to regulate DeFi up to now because of its decentralized nature. But now that DeFi’s total value locked exceeds US$28 billion — a nearly 30-fold rise from just a year ago — the SEC and other regulators are indicating that they want to examine the industry more closely. But how?
“It’s going to be challenging to us because most of the way we regulate is through intermediaries and when you really build something that’s decentralized, there’s no intermediary,” Peirce said. “It’s great for resilience of a system. But it’s much harder for us when we’re trying to go in and regulate to figure out how to do that.”
Peirce, one of five commissioners at the SEC, is nicknamed “Crypto Mom” by the industry for her understanding of the technology and appreciation for its potential, putting her somewhat in a unique position among her fellow commissioners.
See related article: ‘Crypto Mom’ Hester Peirce calls for more regulatory coordination
Regulators’ uphill battle
Industry professionals also recognize the difficulty regulators face in the emerging field.
“The regulators are probably scratching their heads on how to deal with [DeFi],” said Binance CEO “CZ” Changpeng Zhao, in an interview. “Do they regulate the guys writing code or do they regulate the blockchain? What’s there to regulate?”
“That’s going to pose some really interesting challenges for regulators all around the world,” Zhao added.
In her experience as a financial regulatory lawyer at King & Wood Mallesons, an international law firm headquartered in Hong Kong, Partner Urszula McCormack sees how using a traditional financial services lens to regulate code is not enough.
“[Code] touches upon not just blockchain virtual assets, but also around automation and smart contracts more generally,” McCormack said, “and the more enlightened regulators are seeing how those things are linked and the need to look at those things together.
Because DeFi encompasses a broad range of applications and protocols, many of which may lie outside securities law, Peirce believes the SEC must be proactive to provide clarity for those working within the space.
“Let’s help people figure out when the securities laws might apply, so that we’re not faced with a situation a few years from now when we’re providing clarity through enforcement, which is never a good way to provide clarity” she said.
Without such clarity, it can be risky for new projects to determine whether they will run afoul of regulators throughout its development, increasing risk for developers and investors and limiting innovation and growth in the industry.
Should there be a ‘safe harbor’ rule?
As a solution, Peirce has suggested implementing a “safe harbor” policy with respect to DeFi and cryptocurrency projects, which would allow a three-year window for digital assets to reach a point in their life where it would become clearer whether these securities laws would apply to them.
This approach is essential to allow the industry to continue to grow according to Jason Gottlieb, a New York-based partner specializing in securities litigation at Morrison Cohen.
“The next 12 months will determine whether DeFi can survive as DeFi or whether it’s going to have to rethink the decentralization experiment to survive SEC scrutiny,” Gottlieb told Forkast.News.
Without this safe harbor policy in place, it is currently impossible for someone to develop a truly decentralized system without potentially being in breach of securities law throughout the development process.
Once complete, it may prove to be a decentralized system, but currently there is no clear path for a developer to go from the point of starting out to the completion of the project, when only then they will find out if they are in breach of securities law.
“It’s hard to see true DeFi taking root,” Gottlieb said, “there have been a lot of attempts to create something that’s very close to the line, but ultimately the biggest question I have for DeFi in 2021 is, ‘Will the SEC allow any of those attempts to survive?’”
New leadership will matter
The answer to that question will depend greatly on the incoming SEC chief. On January 19, President Joseph Biden nominated Gary Gensler to the position, which carries a five-year term.
Gensler, currently a professor at the Massachusetts Institute of Technology, had been chair of the Commodity Futures Trading Commission during the Obama administration. During that time, he took a strong position against the financial derivatives market and helped implement the Dodd-Frank banking reform bill, passed in response to the 2008 global financial crisis.
If confirmed by the Senate, he may be expected to take an aggressive approach to regulation in this new position.
“I would hope that the next administration is going to have a renewed focus on guidance and rulemaking, which seem to be completely absent over the last four years from the SEC,” Gottlieb said. “The SEC seemed content to rely on regulation by enforcement. And I think that a new leader might say, ‘We’ve got to give the marketplace some rules.’”
In yesterday’s lawsuit, the SEC accused Start Options, Bitcoiin2Gen and their digital asset token B2G coin of being a “sham,” and that the founder of both companies, Kristijan Krstic and promoter John DeMarr “misappropriated millions of dollars of investor funds for their own personal benefit.” The SEC also charged Robin Enos for drafting “fraudulent promotional materials that Enos knew would be disseminated to the investing public.”
According to Gottlieb, the securities lawyer, the SEC often tries to reach a settlement before resorting to pressing charges, and still has an extensive backlog to investigate.
“The SEC is extremely busy right now,” Gottlieb said. “They’re both trying to wind up the pile of investigations they have left over from the 2017/2018 ICO boom. At the same time that they are trying to run investigations on the newer wave, which is the DeFi. So they really got their hands full because they haven’t finished flushing out all the bad actors from the last big wave. And now they’ve got another big wave of activity going on.”
Gottlieb, who chairs Morrison Cohen’s white collar and regulatory enforcement group, also had a warning for people currently working in the DeFi space.
“People out there who are working on DeFi projects right now should know the SEC is looking very carefully at a number of DeFi projects,” he said. “And when I say carefully, I mean actively.”
DeFi’s future in developing economies
DeFi’s growth from just US$600 million at the start of 2020 to US$28 billion as of this publishing date was fueled in part by investors looking for increased transparency and control of their funds regarding its open network as an attractive alternative to traditional banking.
Decentralized exchanges (DEX) and lending platforms allow for trading without an intermediary, allowing for greater control of finances and independence from banking networks, or even from centralized crypto exchanges (CEX).
Currently CEXs remain more popular than DEXs due to the lower technical level of understanding required to operate them and establish brand loyalty.
Despite room for DeFi to grow, this technical issue may mean DeFi sees greater participation rates in developing economies first, such as Uganda or Tanzania, which have greater incentive to adopt new technologies, according to Charles Hoskinson, founder of cryptocurrency network Cardano.
“Does anybody really need peer-to-peer lending or peer-to-peer insurance if they live in New York or if they live in DC? Not really. Does anybody really need a payment service if they already have PayPal and all these other things? Not really,” Hoskinson told Forkast.News.
See related article: Cardano’s Hoskinson wants to win over Fortune 500 companies
As internet penetration continues to grow around the globe, there may be a willingness to try DeFi in a developing country where the people are deeply dissatisfied with existing currencies, banking infrastructure and capital controls.
“That market’s primed, it’s ready, and there’s a billion plus consumers in it. And there’s 5.6 trillion dollars in illiquid wealth,” Hoskinson said of the African continent.
Roughly 20% of the world remains “unbanked,” or lacks access to regular banking or financial services, in most cases because they lack the required know-your-customer documents such as state-issued identification required to gain access to these services.
As DeFi services only require a device with access to the internet, there is hope this technology could open the financial system to many unbanked people around the world.
To Hoskinson, the choice is clear. “People say, Well, where should I deploy my DeFi application? Should I deploy it where it’s just going to yield farmers and kids living in their mom’s basement … who don’t need this? Or people discovering a platform that has 30 million, 40 million customers on it who are primed and ready to go to create real demand growth for your application?”