The SEC "Killed" ICOs, Will DeFi Be the Next Target?

Yesterday, the United States Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) announced that they had fined Abra, a California-based crypto company that allows users to trade tokenized stocks and foreign exchange.

Legal experts believe that DeFi could be hit hard by regulators, and operators of DeFi protocols are already feeling the pressure.

What happened to Abra?

The SEC said that while tokenized shares aren’t actually backed by the shares themselves — they’re just tokens representing the shares — they’re very similar to the physical things that constitute securities. Therefore, this means Abra broke the law by offering these services to U.S. customers without taking steps to ensure that customers were eligible participants.

The CFTC further supported the SEC’s view, saying that it was not important that Abra executed trades through its Philippine subsidiary and emphasized that U.S. customers could not participate; what was important was that the California team designed the app and promoted it to websites frequented by U.S. users without confirming whether its users were Americans.

As a result, the two government agencies fined Abra $150,000 each, and the company agreed to stop selling tokenized shares. As is customary in these types of settlements, Abra neither admitted nor denied the charges.

The coming blow

Legal experts and cryptocurrency industry insiders believe regulators may crack down on decentralized finance, or DeFi, a multibillion-dollar industry that is offering noncustodial financial services such as low-interest loans, tokenized stocks or stablecoins controlled by algorithms to anyone willing to invest in smart contracts.

Abra’s fine is proof that regulators are beginning to take notice of this fast-growing industry. (Recently, the total amount of Ethereum and Bitcoin locked in DeFi smart contracts doubled from $1 billion to $2 billion in less than a month.)

Josh Garcia, a partner at Ketsal Law Firm, which specializes in cryptocurrency regulation, expressed his views on this.

“As market forces push DeFi out of relative obscurity, it will draw the attention of (regulators) and lead to action against companies that break the rules. That’s what they do.”

We’ve been here before: The SEC sounded the alarm when the ICO industry raised billions of dollars, though it didn’t take immediate action. Over the past two and a half years, it has forced companies to return hundreds of millions of dollars to investors and caused many to fail.

Garcia said regulators are quickly catching up to DeFi. He said:

“They can look at DeFi applications, understand them, and then make a persuasive argument that could consume the time and energy of an entire development team.”

“I think there will be more inquiries, investigations and regulatory actions in the future.”

Risks of DeFi

Stani Kulechov is the CEO and founder of Aave, a DeFi protocol whose products include flash loans, which allow people to obtain large amounts of cryptocurrency with no collateral and at very low interest rates, provided that the borrower can repay it in the same transaction.

Kulechov said he was feeling the pressure and had started looking for a lawyer.

Abra was hit because it was too centralized, he said — it was built, operated, and designed by one company, with an office and full-time employees. But regulators can’t sue decentralized protocols — they can’t take the code to court.

Therefore, he is decentralizing the protocol. “Depending on our situation, we have to increase our legal resources and make sure our protocol is decentralized enough,” he said.

He’s not alone in thinking this. Talk to enough DeFi professionals and you’ll eventually hit a wall that says, “Decentralization is a spectrum.” DeFi companies tend to build their own networks with the goal of decentralizing their companies when “the network has legs.”

Kulechov said:

“Most DeFi protocols operate under the philosophy of progressive decentralization. This means that as the protocol successfully moves toward full decentralization, regulatory risk decreases.”

But until then, people like Kulechov will remain at the forefront.

Kulechov hopes the SEC will implement a proposal by Hester Peirce, a cryptocurrency-loving SEC commissioner affectionately known as "Crypto Mom." In February, Peirce suggested that the SEC give DeFi companies and other crypto startups a three-year "safe harbor" period to decentralize their services.

But for now, the proposal remains just that: a proposal. “Until there are any concrete measures, the risk remains,” Kulechov said.

Despite the legal anxiety that regulators have caused him, Kulechov is more than happy to accept their scrutiny. He said:

“The SEC and CFTC are primarily concerned with weeding out market practices that are clearly fraudulent or malicious.”

That’s not a bad thing for a market that’s interested in attracting institutional investors.

“We don’t invest in DeFi”

For now, Nic Carter, a partner at crypto venture capital fund Castle Island Ventures, remains away from DeFi.

“We don’t invest in anything that’s potentially questionable – we’ve always been more risk-averse from a regulatory perspective.”

“We are not investing in DeFi.”

(Other venture capital funds, such as Framework Ventures, which has invested heavily in DeFi, declined to comment for this article.)

Carter said the easiest targets for regulators are DeFi networks that are "purportedly decentralized but not very decentralized," such as those involved in money transmission and lending, "which are fundamentally regulated activities."

“Most of the top DeFi projects have this problem. There is usually a coordinator/administrator/central entity that manages the system,” he said, declining to name specific projects.

What DeFi really needs, Garcia said, is “lawyers who can appreciate the subtleties of crypto applications while also being optimistic about the industry.”