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Decentralized Finance or “DeFi” has been a hot topic in the crypto space for some time now. But in recent months, all that talk has turned into action.
In the last three months, the total amount of crypto “locked” in DeFi platforms has risen by an astounding 330% to over $11.5 billion today.
As the stock market suffers some of its biggest drops in history, the high and stable returns promised by many DeFi platforms are increasingly attractive to investors.
But are these offers too good to be true? In some cases, the answer is a resounding ‘yes’.
While there are a number of excellent, legitimate DeFi projects out there, every day I come across a frightening number of DeFi platforms that are just waiting to be targeted by regulators.
These projects are obviously securities or funds—some even outright call themselves “banks”—but they are not licensed or registered with any regulatory authority nor do they perform any KYC AML.
Financial services and investment offers, digital or otherwise, that cater to US investors are regulated by US authorities. Non-compliance can lead to huge fines, bankruptcy and potentially even criminal charges. So before you ‘lock’ your funds in with any of these projects, it pays to be aware of the regulatory risks you’re assuming.
Read on in today’s article to learn what kinds of DeFi platforms fall under US regulations and the questions to ask before you invest.
What is Decentralized Finance (DeFi)?
For those not yet familiar with DeFi, here is a brief introduction to the overall space.
When Bitcoin’s whitepaper was released, its creator, Satoshi Nakomoto made it clear that blockchain had the potential to completely disrupt the financial system.
The first use cases for this new technology was bitcoin, which opened up the possibility to make instant transactions across borders without having to go through traditional banks. No more ludicrous fees or waiting 3 business days to move money from one place to another.
That is incredible on its own, but the power of blockchain does not stop there. In fact, there are endless additional use cases for blockchain and finance. This is how DeFi was born.
Today, we’re seeing the rise of a number of decentralized apps built on blockchain that not only enable people to skip bank transaction fees and sending delays, but to skip traditional financial institutions altogether. This applies to everything from borrowing, lending, trading, investing and beyond.
For the most part, these apps use smart contracts and complex algorithms to establish systems that do not rely on a custodian or central manager. Users can make loans directly to others and interest payments can be distributed automatically based on market conditions or staked values. The use cases are endless.
Essentially, the main development in all of these cases is that there is no longer a middleman. Without a middleman, returns are much higher and fees much lower. This means higher interest rates for depositors and lenders, and more affordable lending rates for borrowers. It’s a win-win for everyone involved… except of course the traditional financial intermediaries.
This is an incredibly exciting new area of innovation and I’m very eager to see how it develops.
That said, while the technology is new, the activities of banking, finance, lending and investments are not. And an established regulatory framework already exists for all of these activities.
Ignoring these regulations could be very costly for projects down the line…
Are Decentralized Finance (DeFi) Platforms Regulated?
Similar to what we saw with ICOs, many projects in the DeFi space assume that because this is new turf the old rules for traditional financial institutions don’t apply.
Unfortunately, that’s not the case.
The same rules that apply to traditional financial platforms also apply to DeFi platforms. There are potentially some exceptions, but as FinCEN Director Kenneth Blanco put it,
“Just because you say you are a banana doesn’t make you a banana… FinCEN applies the same technology neutral regulatory framework to any activity that provides the same functionality at the same level or risk, regardless of its label. It is not what you label it, it’s the activity you actually do that counts.”
We saw how this played out with ICOs in recent years.
During the ICO boom of 2017/18, many projects believed that because they were decentralized or tokenized that they were not subject to traditional securities laws. These projects raised millions of dollars through token sales without registering their offerings with the SEC.
At first, this seemed like an ideal way to raise funds for a new project, but eventually, the SEC declared that nearly all ICOs are securities offerings that require registration and compliance with securities reporting requirements. Shortly thereafter, the SEC began going after one non-compliant project after another.
So in the wake of the ICO boom came a painful bust. Some projects were handed huge fines, some went into bankruptcy or walked away from their projects and some are still engaged in fierce legal battles with the SEC.
It is very likely that this will play out in the same way for DeFi projects. It is naive to think that a project in the finance and banking spaces can conduct business without any regulatory oversight.
Though the regulators have not yet set their sights fully on DeFi, it’s only a matter of time.
Types of DeFi projects that may need to be licensed by US regulators
The scope of the industry is very large and covers a wide variety of different types of financial instruments, all of which will likely require regulatory approval.
These include, but are not limited to, the following:
- Crypto Staking
- Yield Farming
- Digital “Banks”
- Liquidity Pools
- P2P Borrowing and Lending Platforms
- Prediction Markets
- Interest Rate Protocols and Swaps
Skipping past the jargon, the bottom line is that any project that offers yields to investors likely needs to acquire licensing or be registered with a regulatory body.
If you want to know which regulators a project should adhere to check out this report from the Congressional Research Service that breaks down which agencies regulate which types of financial service activities. On top of this, note that most borrowing and lending services also require licenses from the appropriate state or federal regulators.
How can a DeFi platform be regulated if it’s completely decentralized?
It is frequently argued that decentralized platforms cannot be regulated because there is no individual or group that is wholly managing a platform and that can be held accountable for it.
That might have been a valid argument in 2018, but today that won’t stand in any court.
Over the past few years, the main financial regulatory agencies have made multiple statements specifically relating to decentralized networks making it clear that it does not matter what technology or terminology is being used by a platform. What the regulators look at is the actual activity that occurs between buyers and sellers to determine whether the platform requires regulation.
Here are some specific examples given by the SEC and FinCEN…
The SEC’s stance on decentralized networks
In November 2018, the SEC issued a public statement on Digital Asset Securities Issuance and Trading. This covered the SEC’s stance on ICOs, broker-dealer arrangements, crypto exchanges, and crypto investment vehicles.
The first victim of this ruling was decentralized exchange, EtherDelta, who the SEC fined $388,000. According to the SEC, the platform was a marketplace for bringing together buyers and sellers of crypto through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain.
The SEC found that these activities clearly fell within the definition of an exchange and that EtherDelta was obligated to either register with the SEC or file for an exemption.
Just as the SEC was able to hold a decentralized exchange accountable to securities laws, it will be able to do the same with DeFi apps.
FinCEN’s stance on decentralized apps
FinCEN has also provided some specific guidelines on decentralized applications (dapps). Its guidelines clearly state that if a dapp accepts and transmits value then it qualifies as a money transmitter and must be regulated accordingly.
Even if the application is decentralized, FinCEN guidance states that “the definition of money transmitter will apply to the dapp, the owners/operators of the dapp, or both.”
In fact, it even goes on to say that in some situations, the users of the dapp themselves may fall under FinCEN regulations if they use the dapp to transfer money as a business.
We have not yet seen FinCEN act on any cases against users of a dapp. However, this provides fair warning that when it comes to decentralized projects, FinCEN already has a contingency plan for who to hold accountable.
Make sure that doesn’t end up being you.
Do DeFi platforms need to abide by KYC AML laws?
Not only can the creators or developers behind a decentralized platform be held accountable for licensing requirements, but they could even be at risk for criminal charges if their platform is used for illicit activities.
Regulators have demonstrated in multiple instances that the creators of a platform are responsible for the activities on that platform. Even if they aren’t specifically involved.
A great example of this is the case of Backpage. This was a classified ads site similar to CraigsList that was known for being a place to advertise sexual services.
In 2018, US authorities seized and shut down the Backpage.com website. The site’s owner was arrested and indicted on 93 counts, including ‘facilitating’ prostitution and human trafficking.
The owner wasn’t involved with any human trafficking activity. But because he had enabled the advertisement of it, he was responsible for enabling these crimes.
In the same vein, the developers and founders of any dapp can equally be held accountable for activities that take place on their platforms.
So, while KYC AML may not be popular with users, there is good reason for a project to include some level of user verification.
Do non-US based DeFi platforms need to be regulated?
Do these same rules apply to companies that are not based in the US? In most cases, yes.
A project’s jurisdiction does not exempt it from being subject to US regulations. The domain of US regulation extends to any project that caters to US investors or users.
After losing its case against the SEC, Telegram appealed to the court and requested permission to issue Grams by excluding US investors and setting up safeguards to prevent Grams from being resold to US purchasers.
The judge denied the request stating that “the TON Blockchain was designed and is intended to grant anonymity to those who purchase or sell Grams,” and thus he didn’t believe that the proposed restrictions to block US purchasers would be enforceable in reality.
What questions should you ask before investing in a DeFi platform?
Overall, this article is not designed to discourage you from investing in DeFi. There are undoubtedly a great number of incredible opportunities in the space. The main goal here is to make sure that you are aware of the regulatory risks and give you the tools you need to take measures to safeguard your investments.
So as you consider investing in a project, be sure to ask these key questions:
- Is this project regulated or licensed? If so, by which authorities?
- Is the network thoroughly decentralized? Or is there a prominent team behind the network’s continual development and marketing?
- Does the platform take steps to restrict US citizens or residents?
Most traditional financial institutions very clearly display their licenses on their websites, but so far most DeFi apps do not. It may require you to search or send messages to customer support to find out the real status of a project. But this should be a part of your due diligence process.
What does this mean for Crypto Law Insiders?
For Insiders, the key here is to proceed with caution. Remember to do your due diligence and ask the important questions before you lock funds in a platform. Nearly all DeFi platforms must seek licenses and registration with the appropriate regulatory authorities. This applies regardless of what country the project is based in and regardless of whether or not it is ‘decentralized’.
Just because a platform is popular and growing fast does not necessarily mean it’s a safe bet. In fact, that just might make it a more attractive target for regulators.
If a project does not comply with the law, it may result in heavy penalties, bankruptcy and even criminal charges. According to FinCEN guidelines, with some decentralized apps the users themselves could even be held accountable for acting as money transmitters.
Overall, the question is not if regulators will go after DeFi, but when and with what level of force.
Hopefully, when the SEC and other regulators do turn their attention to DeFi, they take a measured approach that is genuinely designed to protect investors and not discourage innovation.