SEC Commissioner Writes: How the SEC Views DeFi and How Regulation Will Address Two Major Obstacles in DeFi

Author: Caroline A. Crenshaw, Commissioner of the U.S. Securities and Exchange Commission
Compiled by: Perry Wang, Chain News

Whether in news, social media, popular entertainment, or people's investment portfolios, cryptocurrency has now become part of everyday language. However, the term encompasses a wide and imprecisely defined range of content, including everything from tokens to non-fungible tokens (NFTs), and covering decentralized exchanges (DEXs) to decentralized finance (DeFi). For readers who are not yet familiar with DeFi, it is not surprising that the definitions of these terms vary greatly in their eyes. However, overall, these functions replicate our traditional financial systems using blockchain-based, composable, interoperable, and open-source smart contracts. Many DeFi activities occur 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 multitude of opportunities. However, it also poses significant risks and challenges for regulators, investors, and financial markets. While its potential profits have attracted close attention, sometimes even intense scrutiny, there is also considerable confusion surrounding this emerging market, often quite severe. Social media is rife with various questions, such as "Who specifically regulates the DeFi market in the U.S.?" and "Why are regulators involved?" These are critical questions, and the answers are important for both lawyers and non-lawyers. This article aims to briefly introduce the current regulatory environment of DeFi, the role of the U.S. Securities and Exchange Commission (SEC) within it, and highlight two significant barriers that the crypto community should address.

Many investments share important common attributes

Many DeFi services and products are very similar to products and functions in traditional financial markets. Some decentralized applications (or dApps) running on the blockchain allow individuals to obtain assets or loans after providing collateral, much like traditional mortgages. There are also services and products that enable users to deposit digital assets and earn returns. Both types of products offer returns, some directly and others indirectly through the use of borrowed assets for other DeFi investment opportunities.

Additionally, there are various online tools that help users identify or invest in the highest-yielding DeFi tools and venues. Some applications allow users to earn fees by providing liquidity or market-making. There are also coded tokens used to track the prices of securities transactions approved by the SEC, which can then be traded and utilized in various other DeFi applications. Thus, while the specific underlying technologies may not always be familiar to the general public, these digital products and activities share similarities with products and activities within the SEC's jurisdiction.

Given that they are all called "finance," these similarities should not surprise anyone. It is also not surprising that investment is often at the core of DeFi activities. The DeFi movement involves not just the development of new digital asset tokens. Developers have also built smart contracts that enable individuals to invest, leverage those investments, take various derivative positions, and quickly and easily transfer assets across various platforms and protocols. Some projects have demonstrated the potential to scale efficiencies in terms of trading speed, cost, and customization.

These projects have achieved incredible development speeds and possess new, exciting potential. Considering that the blockchain required to support complex smart contracts is still in its infancy, the progress made in the DeFi space to date is particularly remarkable.

But these products are not just products; their users are not merely consumers. DeFi is fundamentally about investment. This investment includes taking speculative risks in pursuit of passive profits from expected token price appreciation, putting capital at risk in search of returns, or locking up assets for the benefit of others.

Regulatory gaps are structurally constrained

Market participants who raise funds from investors or provide regulated services or functions to investors typically have legal obligations. To relieve themselves of these legal obligations, many DeFi project initiators extensively disclose the risks associated with DeFi, stating that investments may lead to losses, but they do not provide the detailed information necessary for investors to assess the likelihood and severity of those risks. Others have taken an approach that can accurately be described as simply claiming "buyer beware"; investors bear any and all risks that may result in losses from participating in DeFi. In light of this, many current DeFi market participants advise new investors to proceed with caution, and many experts and scholars believe that significant risks exist in DeFi.

While DeFi has created impressive alternative methods for writing, recording, and processing transactions, it has not rewritten all the characteristics of economics or human nature. Certain truths apply in DeFi just as they do in traditional finance:

• Unless required, some projects will invest without compliance or adequate internal controls;
• When potential economic returns are sufficiently large, some individuals will harm others, and as the likelihood of wrongdoers being caught and facing harsh penalties decreases, the chances of this occurring increase; and
• The absence of mandatory disclosure requirements and information asymmetry may benefit wealthy investors and insiders while leaving the smallest investors and those least informed as victims.

Therefore, the current "buyer beware" approach of DeFi participants is not a sufficient foundation for rebuilding financial markets. Without a set of common behavioral expectations and a functional system to enforce those principles, the market will tend toward corruption, rife with fraud, "front-running" trades, cartel-like monopolistic activities, and information asymmetry. Over time, investor confidence and participation will decline.

In contrast, well-regulated markets tend to thrive, and I believe the U.S. capital markets are the best example. Due to their reliability and the common adherence to minimum disclosure of information and behavioral standards, our markets have become the preferred destination for investors and entities seeking to raise capital. Our securities laws are not only used to impose obligations or burdens but also provide key market goods. They help address the issues mentioned above and others, allowing our markets to operate more effectively. However, in the brave new world of DeFi, a regulatory framework that provides essential protections seen in other markets has yet to be widely adopted.

Who regulates DeFi

In the U.S., multiple federal agencies may have jurisdiction over various 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). State governments may also have jurisdiction over certain aspects.

Despite many agencies having some jurisdiction, DeFi investors typically do not receive the same level of compliance and robust information disclosure as in other regulated markets in the U.S. For example, various DeFi participants, activities, and assets fall under the SEC's jurisdiction because they involve securities and securities-related activities. However, DeFi participants under the SEC's jurisdiction have not yet registered with us, although we continue to encourage DeFi participants to engage with SEC staff. If investment opportunities are offered entirely outside of regulation, investors and other market participants must understand that these markets are typically riskier than traditional markets where participants adhere to the same rules.

The role of the SEC

As an SEC Commissioner, I have a responsibility to help ensure that market activities operate fairly, whether in new markets or old ones, and to provide a fair competitive environment for all investors. I hope this goal is supported by DeFi market participants.

To this end, the SEC has various tools available for the DeFi space, from rule-making authority to various exemptions or no-action relief, to enforcement actions. Importantly, if DeFi development teams are unsure whether their projects fall under the SEC's jurisdiction, they should reach out to our Innovation and Financial Technology Strategic Hub, "FinHub," or our other offices and divisions, all of which have outstanding experts—well-versed in issues related to digital assets. To my knowledge, FinHub has never refused a meeting, and their involvement can be very meaningful. If a series of meetings is needed, they will invest the necessary time. If a project does not fit neatly within our existing framework, the project team should come and talk to us before entering the market. The more discussions project teams have with the SEC about possible solutions, the better their expected outcomes will be. Our staff cannot provide legal advice, but they are always ready to listen to ideas and provide feedback, as developers know their projects better than we do. If a project appears to be subject to our rules, it is crucial for us to have concrete ideas on how to integrate these new technologies into our regulatory framework to ensure that federal securities laws provide market and investor protections while allowing innovation to flourish.

That said, we do have an effective enforcement mechanism for non-compliant projects within our jurisdiction. For example, the SEC recently settled an enforcement action with an alleged DeFi platform and its individual founders. The SEC alleged that they raised $30 million without legally registering their token offerings and misled their investors while improperly spending investors' money on themselves. If the operations of other products, projects, or platforms violate securities laws, I expect the SEC to continue taking enforcement actions. However, my personal preferred path is not through enforcement, and I do not believe enforcement is inevitable. A broad range of violations requiring extensive enforcement actions is not an effective way to achieve the common goals of DeFi. The more projects voluntarily comply with regulations, the less frequently the SEC will need to investigate and litigate.

Structural barriers

I recognize that the SEC's responsibility is not to prevent all investment losses. Limiting investors' access to fair and appropriate opportunities is not my goal. But my job is to ensure that investors can equally access key information so they can make informed decisions about whether to invest and at what price. I am equally committed to ensuring that markets are fair and not manipulated. In light of this, the DeFi community seems to need to address two specific structural issues.

1. Lack of transparency

First, although transactions are often recorded on public blockchains, DeFi investments are not transparent to a considerable extent. I worry that this lack of transparency will lead to a two-tier market, where professional investors and insiders reap substantial rewards while retail investors take on more risk and receive worse pricing, making it less likely to succeed over time. Much of DeFi is funded by venture capital (VC) and other professional investors. I am unclear how much awareness this has within the DeFi retail investor community, but foundational financing transactions often grant professional investors equity, options, advisory roles, opportunities to engage with project team management, formal or informal say in governance and operations, anti-dilution rights, and the ability to allocate stakes to allies, among other benefits. These arrangements are rarely disclosed, yet they can significantly impact investment value and outcomes. Retail investors are already at a significant disadvantage in DeFi compared to professional investors, and this information imbalance exacerbates the issue.

Some argue that DeFi is actually more equitable and transparent because most activities are based on publicly available code. However, relatively few people can truly read and understand that code, and even highly qualified experts may miss flaws or dangers. Currently, the quality of this code can vary greatly and significantly impact investment outcomes and security. If DeFi aims to democratize investment pools, it should not assume that a large portion of that crowd can or wants to run their own test nets to understand the risks associated with the code on which their investment prospects rely. It is unreasonable to build a financial system that requires investors to understand complex code.

In short, if a retail investor has $2,000 to invest in risky programmable assets, it is not cost-effective for that investor to hire an expert to audit the code to ensure it behaves as advertised. Instead, retail investors must rely on information obtained through marketing, advertising, word of mouth, and social media. On the other hand, professional investors can hire technical experts, engineers, economists, and others before making investment decisions. While this professional advantage has historically existed in our financial markets, DeFi exacerbates this advantage. DeFi removes intermediaries that perform critical gatekeeping functions and operates outside existing investor and market protection systems. This may prevent retail investors from accessing professional financial advisors or other intermediaries to help them screen the quality and legitimacy of potential investments. The aforementioned third-party institutions provide tangible assistance in reducing fraud and risk assessment in traditional finance, but their alternatives in the DeFi space are very limited.

2. Anonymity

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, where each transaction is recorded, immutable, and visible to all. However, this visibility extends only to a certain identifier. Because users are anonymous, the blockchain shows the blockchain addresses that send or receive assets but does not reveal the identities of their owners.

Without an effective way to determine the actual identities of traders or smart contract owners, it is difficult to know whether asset prices and trading volumes reflect organic interest or are the product of manipulated trades, such as whether one person is using bots to operate multiple wallets or whether a group of people is colluding to trade. There are securities regulations in the U.S. that prohibit trading for the purpose of pretending to engage in market activities or manipulating securities prices, as successful investing depends on reliable information and market integrity. Anonymity makes it easier to hide manipulative activities, and investors can hardly distinguish individuals engaging in manipulative trading from normal organic trading activities. In DeFi, as markets often affect asset prices, trading volumes, and momentum, investors can easily suffer losses due to others' manipulative trading, rendering these signals unreliable. If trades occur outside of public chains, assessing the legality of those trades becomes even more difficult.

I recognize that to some extent, DeFi is synonymous with anonymity. Using alphanumeric strings to obscure real-world identities is a core feature of Bitcoin and essentially appears in all subsequently developed blockchains. However, in the U.S., investors have long been satisfied with a compromise, sharing their identities with entities trading securities to relinquish a degree of privacy. In return, they benefit from a more fair, orderly, efficient market with less manipulation and fraud.

I suspect that when turning to DeFi, most retail investors are not doing so because they seek a higher degree of privacy; they are seeking what they perceive to be better returns that can outperform other investments. While some in DeFi believe in absolute financial privacy, I expect that projects addressing the anonymity issue are more likely to succeed, as investors can be reassured that asset prices reflect the genuine interests of real investors rather than prices manipulated by hidden manipulators. Projects that address this issue are also more likely to comply with SEC regulations and other legal obligations, including the Bank Secrecy Act's requirements for anti-money laundering and combating the financing of terrorism.

Conclusion

I respect innovation, but I will not diminish my commitment to helping ensure that all our financial markets are sustainable and provide ordinary investors with a fair chance of success. DeFi is a shared opportunity and challenge. Some DeFi projects fall entirely within our jurisdiction, while others may struggle to comply with currently applicable rules. Simply stating that regulation is too difficult or compliance is too challenging is a lazy approach.

Many projects express a desire to operate in DeFi in a compliant manner, which is a positive sign. I believe in their sincerity on this point and hope they will invest resources to work with SEC staff in the same spirit. Finding compliant solutions to DeFi issues will be the best outcome achieved through collaboration. Attempting to reimagine our markets without appropriate investor protections and mechanisms to support market integrity would, at best, miss a significant opportunity and, at worst, cause substantial harm. When envisioning a new financial system, I believe developers have an obligation to optimize, not just consider profitability, speed of deployment, and innovation. Whatever happens next, DeFi should be a system accessible to all investors, capable of operating important data, and should be a system that reduces the potential for manipulative behavior. Such a system should guide funds effectively to the most promising projects rather than being blinded by hype or false claims. It should also promote the development of interconnected markets, but with sufficient safeguards to withstand significant shocks, including the potential for rapid deleveraging. In decentralized networks with decentralized control and differing interests, regulations help create common incentives that benefit the entire system and ensure that its least powerful participants have a fair chance.

My staff and I have been actively engaging in fruitful discussions with DeFi experts, and my door remains open. Unfortunately, I cannot guarantee that this will be a simple or quick process, but I can assure you that we will sincerely consider and help drive responsible innovation.