Crypto-based ‘ghost financial market’ scares regulators

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Watchdogs warn that some DeFi activity is likely illegal under federal law and poses serious danger to consumers, who invest their money in inherently less guarded and accountable systems and are vulnerable to cyber attacks.

I am very concerned about the lack of ratios, normal prices and regulatory limits, CFTC commissioner Dan Berkovitz said in an interview. The bottom line is that there are no free meals anywhere in the economic system.

The small but rapidly growing industry activity, measured in tens of billions of dollars, poses a major challenge for regulators as they face an unprecedented task of cracking down on an open source financial network that has grown completely in outside of their jurisdiction. The basis of modern financial regulation is that centralized entities like lenders and clearing houses register with the government and submit to oversight.

For the first time, you’re starting to see DeFi protocols that begin to put in place large-scale borrowing and lending procedures, said Joseph Borg, director of the Alabama Securities Commission. It is between unknown participants without any intermediary. So now the question is, who do we put this to?

DeFi flouts the old model, and its advocates claim that a decentralized and automated marketplace will reduce costs, increase efficiency, and provide more transparency.

Celsius Network CEO Alex Mashinsky, whose crypto-finance company uses DeFi technology, said the services offer a way “to innovate and bypass all those centralized toll collectors.”

The chronic systemic problem we have in our financial world is the fact that our traditional system, traditional finance, is focused, leveraged, and too big to fail, he said.

Among the most popular DeFi options is MakerDAO, one of the oldest services, which allows users to borrow so-called stablecoins in exchange for depositing cryptocurrency-based collateral. Another service, Uniswap, is a decentralized cryptocurrency trading exchange that relies on an automated liquidity protocol rather than a central order book to facilitate transactions. Like other large DeFi projects, they run on the technology behind Ether, one of the largest cryptocurrencies.

Gary Gensler answers questions from senators during his testimony before the Senate Committee on Banking, Housing and Urban Affairs on May 22, 2012. | Chip Somodevilla / Getty Images

The creators of some services are starting to contact regulators. Marc Boiron, general counsel for decentralized exchange builder dYdX, said in an email that “we have proactively (and willingly) communicated with the CFTC prior to the deployment of any protocols” and “have always carefully reviewed them. laws applicable to dYdX. ” He said the first protocol developed by dYdX required US users to follow CFTC rules for commodity retail transactions.

DeFi services have grown rapidly over the past year amid the cryptocurrency boom, with more than $ 50 billion “stranded” in services based on Ethereum, the network for Ether. Major centralized cryptocurrency exchanges like Coinbase, which has been at the forefront of offering digital currency exchange to the masses, have started letting their customers deposit funds and earn returns on DeFi.

Square CEO Jack Dorsey announced earlier this month that the digital payments giant plans to build a new business around an open development platform with the sole purpose of making it easier to build non-financial services. custodians, without authorization and decentralized. Even established Wall Street banks have started to see technology as a way to revamp their systems.

But DeFi’s rapid rise is raising growing concerns for lawmakers and regulators, who are signaling a possible crackdown amid mounting evidence of risks to consumers.

Recent research has raised red flags about the lack of human oversight of DeFi services and technical vulnerabilities, including attacks that have drained millions of dollars from DeFI protocols.

In DeFi, intermediaries are largely excluded in favor of transparent code, subjecting regulators and policy makers to complicated decisions about how to assess (often bilateral) transactions for which no clearly identified party can be. regulated, ”said Linda Jeng and Castle, visiting scholar at Georgetown Law. Island Ventures partner Nic Carter said in an article published last month.

Senator Elizabeth Warren urges SEC Chairman Gary Gensler to curb DeFi’s activities. In a letter this month, the Massachusetts Democrat said “scams have increased” on DeFi platforms, citing an estimate from analytics firm CipherTrace that $ 83 million in DeFi fraud was committed. during the first four months of this year.

In a speech on July 21, Gensler warned that services offering security-backed crypto tokens and operating as derivatives “whether in the decentralized or centralized financial space” must follow agency rules.

Berkovitz, Democratic Commissioner at the CFTC, has been among the most vocal about the urgent need for officials to tackle what he says could become an “unregulated shadow financial market.” He argues that trading on DeFi platforms is likely taking place illegally, as it does not meet the requirements of the Commodity Exchange Act, which imposes guarantees on derivative transactions. He revealed this month that his agency, which regulates the trading of futures and swaps, is reviewing DeFi across its various divisions.

“If there are loopholes that they cross, it may need legislation to close them,” he said.

Officials representing the SEC, CFTC and the International Organization of Securities Commissions were briefed by DeFi players in June, a sign of growing scrutiny.

Other federal agencies that oversee the banking system are also starting to look into DeFi, including the Office of the Comptroller of the Currency and the Fed.

“Although DeFi, by definition, is decentralized and does not necessarily rely on the banking system, there are links, which are part of our examination through the prism of responsible innovation, aware of the potential benefits of new technologies while focusing on understanding the potential risks and use cases, ”said OCC spokesperson Bryan Hubbard.

State officials are urging their federal counterparts to act.

“You have all kinds of potential opportunities and potential risks that we need to look at,” said Borg, the Alabama securities regulator. “It will be a federal mandate from Congress, by the SEC, the CFTC, to come up with some of these things.”

The possibility of a crackdown is already seeing the retreat of some federal decision-makers who defend free markets. Republican-appointed SEC commissioner Hester Peirce said cutting intermediaries improves the resilience of the financial system. She wants to avoid “just putting DeFi in a big bucket and saying it’s the same.”

Crypto industry groups are also urging regulators to be cautious.

“I don’t think there is a way to fit decentralized finance into the existing framework that depends on the regulation of intermediaries and gatekeepers,” said Miller Whitehouse-Levine, director of policy at the Blockchain Association.

One of the biggest challenges for regulators will be deciding how much to control the software underlying DeFi protocols, in light of free speech concerns.

Jerry Brito, executive director of cryptocurrency advocacy group Coin Center, said the restrictions on the computer code would trigger opposition from his organization and others over the belief that it is constitutionally protected.

“Writing and publishing software is a freedom of expression protected by the First Amendment,” he said. “There is no compromise to be made on this.

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