DeFi in Deep Waters: SEC Asserts Securities Rules Apply, Reveals Its Hand

"SEC's Warning on Decentralized Finance Sparks Debate on Crypto Regulation"

The U.S. Securities and Exchange Commission (SEC) has sent a warning shot to decentralized finance (DeFi), stating that it could be included in the agency’s expanding definition of securities exchanges. This move aligns with Chairman Gary Gensler’s stance that cryptocurrency belongs in the securities world and will be regulated accordingly. The crypto industry has long requested specific rules or guidance from the SEC to provide digital asset businesses with clarity on how to comply with regulations or avoid the agency’s jurisdiction. However, the SEC’s decision to include DeFi in its proposal for a new exchange definition indicates that the crypto financial movement will not receive tailored regulations. Instead, the agency is making targeted adjustments to its rules to ensure that crypto will be subject to existing securities regulations.

The agency voted 3-2 to reopen an existing proposal to expand its definition of operations that need to be regulated as securities exchanges. This move aims to incorporate new technologies, including DeFi. To comply with this and other SEC initiatives, crypto operations will have to decide whether to make fundamental changes, such as increased centralization. Some of these changes could threaten what is unique about their approach to money and investing. SEC Commissioner Hester Peirce opposed the move, stating that the agency is substituting its own opinions for Congress’ prerogative on a significant question central to the future of the American economy. Peirce believes that the SEC’s actions could lead to the banning of DeFi protocols in America. She further added that the SEC is willing to kill off or drive offshore any company that does not look like incumbent firms or force them to turn into a centralized entity.

Jason Gottlieb, a lawyer with crypto clients at Morrison Cohen in New York, stated that the SEC’s change would sweep decentralized software protocols into a regulatory framework that was not built for them and with which they cannot comply technologically. Gensler reiterated his message that investors in the crypto markets must receive the same protections as those provided by the securities laws in all other markets. The SEC has already targeted trading platforms as unregistered exchanges and warned Coinbase that its turn for an enforcement action is coming. The agency has labeled several tokens, yield products, and staking services as securities.

Apart from last week’s vote to add DeFi to its exchange definition, the agency proposed a new way to define securities dealers last year, which could similarly include DeFi activity. Gensler believes that nothing about the crypto markets is incompatible with the securities laws. However, he intends to tell lawmakers that calling oneself a DeFi platform is not an excuse to defy securities laws. Gensler is expected to face the Republican-majority committee for the first time this year and be questioned on his crypto positions, which often run afoul of GOP preferences.

The SEC’s approach to crypto may only be changed by legislation from Congress or developments in court cases such as the outcome of its legal dispute with Ripple Labs over whether XRP is an unregistered security. The latest enforcement action against exchange Bittrex on Monday and a similar case last month against Beaxy are putting into action Gensler’s rhetoric that today’s crypto exchanges are improperly trying to fulfill multiple roles without registering. Gensler has often criticized crypto platforms for setting themselves up as exchanges, brokerages, custody operations, and clearinghouses, each of which should be properly registered for federal oversight.

DeFi proponents hoped that their decentralized approach would keep them out of such regulations by putting transactions on a peer-to-peer level without companies acting as intermediaries. However, if the SEC approves a final version of its proposed exchange definition, calling transactions “decentralized” will not be enough. Joshua Ashley Klayman, who heads the crypto practice at Linklaters in New York, believes that if pushed, there will be ways to innovate. She stated that the industry is filled with exceptionally smart people who will find ways to continue. Klayman added that the industry might not look the way it looks now, but it will continue to evolve.

Commissioner Peirce, who has been called “Crypto Mom” for her past support of the sector, believes that this latest move on DeFi marks a very consequential moment. Several of the questions she tried to ask the SEC’s legal team before the commission’s vote were met with uncertainty from the staff. The agency’s proposal did not define DeFi or say precisely how those transactions would fit into its rules, but SEC officials said that such operations would be measured case-by-case against its standards.

Martin Reid

Martin Reid

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