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DeFi is creating a two-tiered market where insiders reap rewards and retail investors get burned, warns SEC’s Crenshaw

November 9, 2021, 3:18 PM UTC

A top official at the Securities and Exchange Commission is raising new concerns about the gatekeeper-less version of Wall Street that is decentralized finance, or DeFi.

In an op-ed published Tuesday, SEC Commissioner Caroline Crenshaw questioned the very nature of DeFi, calling its lack of transparency and pseudonymity “structural hurdles” that are bound to hold the market’s development back until appropriate investor safeguards are put into place. 

“DeFi participants’ current ‘buyer beware’ approach is not an adequate foundation on which to build reimagined financial markets,” Crenshaw wrote in the first edition of the International Journal of Blockchain Law. “Without a common set of conduct expectations, and a functional system to enforce those principles, markets tend toward corruption, marked by fraud, self-dealing, cartel-like activity, and information asymmetries.”

Over the course of 2021, DeFi has seen a flood of both money and interest. Built on blockchain technology, DeFi protocols are effectively designed to replicate many of the same offerings that traditional banks, exchanges, and investment firms have for decades—whether it be lending, trading, or otherwise. And all of it can be done without the middlemen that have acted as the anchors of traditional finance for decades. 

Its promise of a less risky and more accessible financial system has attracted billions of dollars’ worth of cryptocurrencies recently, as North Americans piled some $276 billion of crypto into DeFi platforms in the year leading up to June, according to Chainalysis. However, the DeFi market’s growth has also been subject to a massive uptick in hacks, fraud, and thievery. An August report from CipherTrace found that DeFi-related crimes are continuing to grow, having led to losses of $329 million in the second quarter of 2021, compared with $106 million in the first quarter. 

For Crenshaw, DeFi may represent “a panoply of opportunities,” but it is “fundamentally about investing.” And, in this case, the SEC commissioner wrote that those investments are in “speculative risks taken in pursuit of passive profits from hoped-for token price appreciation, or investments seeking a return in exchange for placing capital at risk or locking it up for another’s benefit.” 

While DeFi protocols are built on blockchain technology that allows nonstop public access to the ledgers of transactions, the market’s relative opacity to the assets overseen by the SEC may be putting the individual investors placing those bets at risk, the SEC commissioner wrote. For example, the DeFi market today carries little in terms of details on the roles or holdings of the venture capitalists and professional investors backing the projects, which may be creating a “two tier market” where those insiders “reap outsized returns while retail investors take more risks, get worse pricing, and are less likely to succeed over time,” Crenshaw wrote. And without the ability to pin down who is actually behind a trade or smart contract, Crenshaw says that “it is very difficult to know if asset prices and trading volumes reflect organic interest or are the product of manipulative trading.”

Of course, this is not the first time an official from Washington, D.C., has criticized DeFi.

Lawmakers and regulators have been ramping up their dialogue around the burgeoning crypto market for months. Sen. Elizabeth Warren of Massachusetts, for one, told Fortune’s Robert Hackett earlier this year that DeFi allows anonymous developers to “scam investors with rug pulls, pump and dumps, and other schemes without transparency or accountability.” Dan Berkovitz, a former commissioner at the Commodity Futures Trading Commission who has since joined the SEC as general counsel, has said “it is untenable to allow an unregulated, unlicensed derivatives market to compete, side by side, with a fully regulated and licensed derivatives market.” And SEC Chair Gary Gensler has said multiple times that if a DeFi protocol’s offerings can be classified as securities, then they should be regulated as such. 

So far, the SEC’s direct actions around DeFi have been minimal. In August, the agency filed its first case involving a purported DeFi company, in which the company had issued tokens that were in fact, in the SEC’s eyes, securities. And while many in the crypto sphere—and not just in DeFi—have expressed concern that the agency is heading toward a regulation-by-enforcement approach, Crenshaw does not think enforcement is inevitable. Instead, the SEC commissioner pushed DeFi protocol creators, some of whom have indicated an interest in working with regulators before, to take up the SEC’s offer to talk about what they plan to build and how.  That’s not to say that the regulator will allow an unregistered securities offering to go to market in the name of DeFi. But Crenshaw says the SEC is open to new ideas about how to integrate DeFi technologies and protocols into its regulatory regime. 

“Reimagining our markets without appropriate investor protections and mechanisms to support market integrity would be a missed opportunity, at best, and could result in significant harm, at worst,” Crenshaw wrote. “In conceiving a new financial system, I believe developers have an obligation to optimize for more than profitability, speed of deployment, and innovation. Whatever comes next, it should be a system in which all investors have access to actionable, material data, and it should be a system that reduces the potential for manipulative conduct.”

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