SEC: Statement on Decentralized Finance Risks, Regulations, and Opportunities

In recent years, Decentralized Finance (DeFi) has provided many opportunities to the market, but it has also brought serious risks and challenges to regulators, investors and financial markets. The U.S. Securities and Exchange Commission (SEC) issued a “Statement on Decentralized Finance Risks, Regulations, and Opportunities” for the regulation of DeFi, which was compiled by the Institute of Fintech, Renmin University of China. This article presents the current regulatory background of DeFi and the role of the U.S. Securities and Exchange Commission (“SEC”) in regulation, illuminating the risks DeFi faces.

introduction

Whether it’s in news, social media or mass entertainment, or in people’s investment portfolios, crypto is very popular. However, what this term actually encompasses is broad and amorphous, including everything from tokens to non-fungible tokens, including Dexes, decentralized finance, all of which fall into the category of DeFi. For those readers who are not yet familiar with DeFi, it is not surprising that the definitions will also be different. In general, DeFi is an attempt to replicate the functionality of traditional financial systems by applying blockchain-based smart contracts that are composable, interoperable, and open source. The majority of DeFi activity takes place on the Ethereum blockchain, but any blockchain that supports a specific type of scripting or coding can be used to develop DeFi applications and platforms.

DeFi offers many opportunities, but it also poses serious risks and challenges for regulators, investors and financial markets. While the potential gains have attracted market attention, doubts remain in the emerging market of DeFi. Questions such as “Who is regulating the DeFi market in the US?” and “Why are regulators getting involved?” abound on social media. These questions are crucial, and the answers to them matter, both for lawyers and non-legal practitioners.

This article will briefly describe the current regulatory background of DeFi and the role of the U.S. Securities and Exchange Commission (“SEC”), highlighting what are the important barriers that all sectors of society should address.

Common Attributes of Investments

Many DeFi product functions are similar to those in traditional financial markets. Through decentralized applications or dApps running on the blockchain, users are able to obtain assets or loans after posting collateral, just like traditional mortgage loans. Other products provide a mechanism for depositing digital assets and then getting returns. Both types of products offer returns, some directly and some indirectly by allowing borrowed assets to be used for other DeFi investment opportunities.

Additionally, web-based tools can help users identify or invest in DeFi with the highest yields. Other applications may allow users to earn fees by providing liquidity or making market transactions. There are also some tokens, which are used to encode and track the price of securities traded on a registered National Stock Exchange, which can then be traded and used in other DeFi applications. Therefore, although we are not necessarily familiar with all the underlying technologies of DeFi, these digital products and activities are related to the jurisdictional activities and responsibilities of the US Securities and Exchange Commission.

Finance is often conceptually defined, and it goes without saying that investing tends to be at the heart of DeFi projects. All kinds of DeFi projects are not only the development of new digital asset tokens. Developers have also built smart contracts that provide investment services for individuals, allow various types of derivatives to hold positions, and provide a mechanism to quickly and easily transfer assets between various platforms and protocols. There are also projects that show the potential for DeFi to scale up efficiency in terms of transaction speed, cost, and customization.

Various DeFi projects are developing at an astonishing speed and have certain potential. DeFi development is particularly impressive, considering that blockchains supporting the scripts required for complex smart contracts are still in their infancy. DeFi is fundamentally about investing. Such investments include speculative risks taken in pursuit of passive profits from the expectation of token price appreciation, or investments that seek returns in order to put capital at risk or lock up capital for the benefit of others.

Unregulated markets subject to structural constraints

Participants who raise funds from investors, or provide them with service functions that require regulation, often have legal obligations. In a bid to deny these legal obligations, many DeFi promoters have widely promoted that DeFi is risky and that investments can result in losses, without providing the details needed to assess the likelihood and severity of risks. Briefly described as advocating “buyers need to beware”, investment participants bear all the risk of possible losses. In view of this, many DeFi participants advise new investors to invest cautiously, and many experts and academics also believe that there are significant risks. 

While DeFi has alternative methods of composing, recording and processing transactions, DeFi has not changed the economics and human nature. Certain laws and facts are equally applicable in DeFi as in traditional finance. If there are no hard and fast rules, there will be projects that are not compliant and have no internal controls.

When the potential benefit is large enough, the stakeholder will allow others to be victimized, and the likelihood of this happening increases as the likelihood of being caught and potentially receiving sanctions is not necessarily severe. And, without mandatory disclosure requirements, information asymmetry would favor wealthy investors and insiders at the expense of ordinary investors and those with less access to information. Therefore, the current practice of “buyer at your own risk” by DeFi participants is not a suitable foundation for building a new era of financial markets. Without a common set of behavioral expectations, and a functional system for enforcing these principles, markets are prone to corruption, characterized by fraud, insider trading, capitalization activities, and severe information asymmetries. Over time, it reduces investor confidence and engagement. 

Conversely, well-regulated markets tend to thrive, and I think the U.S. capital markets are the best example. The market generally adheres to standards of conduct for reliability and minimum disclosure, and it is also the preferred location for investors seeking to raise funds. Securities laws are not only about mandatory obligations and burdens, but they also provide a key market benefit—helping to solve the above problems, and based on this, markets work better as a result. However, in the emerging DeFi world, the regulatory frameworks that provide important protections in other markets have not been widely adopted.    

Who is responsible for the regulation of DeFi?

Several federal agencies in the United States have regulatory authority over all aspects of DeFi, including the Department of Justice, the Financial Crimes Enforcement Network, the Internal Revenue Service, the Commodity Futures Trading Commission, and the SEC. Although many institutions have certain jurisdiction, investors participating in DeFi generally do not receive the same level of compliance and strong disclosure as other regulated markets in the United States. For example, various types of DeFi participants, activities, and assets involve securities and securities-related actions and therefore fall under the SEC’s jurisdiction. But DeFi participants within the SEC’s jurisdiction are not registered, and while regulators continue to encourage DeFi participants to interact with regulators, if investment opportunities are offered entirely outside of regulatory oversight, investors and participants must understand that these markets are more likely to follow the same Regular financial markets are more risky.

The role of the SEC

As SEC staff, we have a responsibility to ensure that market activity operates fairly and provides a level playing field for all investors. Hopefully this goal will be supported by DeFi market participants. There are many tools at the SEC’s disposal, from rulemaking powers, to various waivers or no-action remedies, to enforcement actions. Importantly, DeFi development teams should contact our Innovation and Financial Technology Strategy Center (“FinHub”) or other departments if they are unsure whether a project is within the SEC’s jurisdiction. These departments have excellent experts well-versed in issues related to digital assets, and their participation is meaningful.

If a Defi project does not conform to the existing framework, the project team should come to discuss with the SEC before entering the market. The DeFi project team proposes relevant solutions to guide the discussion, and it is possible to obtain better results. SEC staff cannot provide legal advice, but are always ready to listen to ideas and provide feedback. If a project is subject to SEC rules, it will be important for the SEC to have specific ideas on how to integrate these new technologies into our regulatory regime. This ensures that federal securities laws protect markets and investors, while innovation thrives.

structural disorder

It is not the role of the SEC to prevent all investment losses, nor is it our goal to limit investor access to equity and opportunity. Our job is to ensure that investors have equal access to key information so they can make decisions – invest or not? At what price to invest? We are equally committed to ensuring that markets are fair and free from manipulation. Given this, the DeFi community needs to address two specific structural issues.

lack of transparency

First, DeFi investments are not transparent, although transactions are usually recorded on public chains. We worry that a lack of transparency will create a polarized market in which professional investors and insiders earn outsized returns, while retail investors will take more risk, get worse pricing, and over time ultimately failed.

The bulk of DeFi funding comes from venture capital and other professional investors. I’m not sure how well-known this is in the DeFi retail investor community, but fundamental financing deals, usually granting professional investors equity, options, advisory roles, access to project team management, formal or informal speeches on governance and operations rights, anti-dilution rights, and the ability to distribute control to allies, among other benefits. These insider tips are rarely disclosed, but they can have a significant impact on investment value and results. In DeFi, retail investors are already operating at a distinct disadvantage, and this information imbalance exacerbates the problem.

Some argue that DeFi is more egalitarian and transparent because most trading activity is based on publicly available code. However, only a small group of people can actually read and understand the code, and even highly qualified experts can miss the flaws or dangers of the relevant project. The quality of code can vary widely between projects and can have a significant impact on investment outcomes and security. If DeFi is expected to gain popularity among a broad investment community, it should not assume that a significant portion of participating investors are capable or willing to run their own testnets to understand the risks associated with the code on which the project’s investment prospects depend. It is unreasonable to build a financial system that requires investors to also become interpreters of complex codes. 

Simply put, if a retail investor invests $2,000 in a risky programmable asset, it doesn’t make sense for him to hire an expert to audit the code to make sure it behaves as advertised. Instead, retail investors must rely on information obtained through marketing, advertising, word of mouth and social media. Professional investors, on the other hand, have the ability to hire technologists, engineers, economists, and others before making an investment decision. While this professional edge has historically existed in our financial markets, DeFi exacerbates it.

DeFi eliminates intermediaries that perform critical gatekeeping functions and operate outside of existing investor and market protection regimes. This would deprive retail investors of access to professional financial advisors or other intermediaries to help screen potential investments for quality and legitimacy, a presence that provides meaningful fraud reduction and risk assessment assistance in traditional finance but rarely in DeFi There is a similar existence.

pseudonym

The second challenge of DeFi is that the market is vulnerable to manipulation that is difficult to detect. DeFi transactions take place on the blockchain, and every transaction is recorded, cannot be tampered with, and can be seen by everyone. But this visibility only extends to a certain identifier. Due to anonymity, the blockchain shows the blockchain address from which the asset is sent or received, not the identity of the person in control.

Without an efficient way to determine the actual identity of a trader, or the owner of a smart contract, it can be difficult to know whether asset prices and trading volumes reflect some interest, or are the product of manipulative trading, for example, whether a person is Use a bot to operate multiple wallets, or a group of people colluding to trade. There are specific securities laws that prohibit transactions such as false market activity or manipulation of securities prices, and successful investing depends on reliable information and market integrity. Anonymity makes activities such as market manipulation easier to conceal, making it nearly impossible for investors to distinguish individuals engaged in manipulative trading from normal organic trading activity. In DeFi, the market is often dependent on asset prices, trading volume and momentum, and investors are vulnerable to losses due to manipulative trading. If the transaction occurs outside the public chain, it is more difficult to assess whether the transaction is legitimate.

I admit that in some ways DeFi is synonymous with pseudonym. The use of characters that mask real-world identities is a core feature of the Bitcoin world, and has appeared in basically all blockchain worlds since. But investors have long been comfortable with relative compromises, as they give up a degree of privacy through real-name registration with entities that trade securities. In return, investors benefit from a more fair, orderly, efficient, regulated market with less manipulation and fraud.

And in DeFi, I think most retail investors are not doing this because they are looking for greater privacy, they are looking for so-called better returns. While some users in DeFi espouse absolute financial privacy, I expect projects that address the issue of anonymity are more likely to succeed and investors can rest assured that asset prices reflect real investor interest and are not manipulated by hidden manipulators price. Projects that address this issue are also more likely to comply with SEC regulations and other legal obligations, including requirements under the Bank Secrecy Act around anti-money laundering and combating the financing of terrorism.

Epilogue

We support innovation, but this does not diminish our commitment to fairness. We need to ensure that all financial markets are sustainable and provide fair investment opportunities for ordinary investors. DeFi is an opportunity and a challenge we face together. Some DeFi projects fit within the SEC’s jurisdiction, while others have difficulty complying with applicable rules.

Many DeFi projects have expressed a desire to operate in a compliant manner, which is a positive sign. Trust in their sincerity and hope that they will devote their resources to working with SEC staff in the same spirit. For DeFi problems, finding a compliant solution is best done by all parties. Re-planning the market without proper investor protection mechanisms to support the integrity of the market is a missed opportunity and, in the most extreme cases, could result in significant losses. When conceiving a new financial system, I believe that developers have an obligation to optimize profitability, speed of deployment, and innovation, and should be a system that reduces possible manipulation.  

Such a system should channel funds efficiently to the most promising projects, rather than just being infected with hype or false claims. It should also aim to drive the interconnectedness of markets, but with adequate safeguards against major shocks, including the potential for rapid deleveraging. In a decentralized network with decentralized control and competing interests, the role of regulation is to create common incentives that benefit the entire system and ensure fair opportunities for its most vulnerable participants.

The SEC staff has been actively engaged in relevant discussions with DeFi experts, and our attitude is open. This process is difficult to do overnight, but what is guaranteed is that our real desire is to deliberate and promote responsible innovation.

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SEC: Statement on Decentralized Finance Risks, Regulations, and Opportunities

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