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State of Crypto: The SEC Takes on DeFi

The SEC’s investigation into DeFi platforms is unsurprising. The question is whether the U.S. regulator will bring charges.

CoinDesk Insights
Sep 7, 2021 at 4:29 p.m. UTC
Updated Sep 7, 2021 at 4:29 p.m. UTC

Nikhilesh De is CoinDesk's managing editor for global policy and regulation. He owns marginal amounts of bitcoin and ether.

The SEC is reportedly investigating decentralized finance (DeFi) platforms and the parties behind them. While not unexpected, this is a new phase in the crypto-regulatory landscape. We may be able to predict how these investigations will proceed by looking at prominent historical examples.

You’re reading State of Crypto, a CoinDesk newsletter looking at the intersection of cryptocurrency and government. Click here to sign up for future editions.

DeFi investigation

The narrative

News broke Friday that the Securities and Exchange Commission (SEC) is conducting a probe into Uniswap Labs and other DeFi platforms. It’s unclear whether these investigations are still primarily for information-gathering purposes or whether there will be enforcement actions coming. Regardless, this is a pivotal, if expected, development in the regulator’s oversight of the crypto market.

Why it matters

How the SEC approaches DeFi might determine how well DeFi platforms survive in the coming years, particularly as the agency’s investigations mature. There are few details about the SEC’s investigations that are publicly available at this time, but we can look to the past to guesstimate how these investigations may proceed.

Breaking it down

The SEC has signaled for a few weeks now that it’s going to be taking a look at DeFi. I’ve written about this at least twice now, so news stories that the agency is actively looking into this segment of the crypto market are absolutely not a surprise.

To sum up what we do know: The SEC is reportedly investigating Uniswap Labs, the developer behind Uniswap, the leading decentralized exchange (DEX) on Ethereum. What’s a DEX, you may ask? Consider it a robot on the internet routing trades through various pools of funds, no middleman (beyond the software) needed. Other (unnamed) DeFi platforms may also be in the SEC’s crosshairs.

While we don’t yet know what the regulator is specifically looking for, we can find some clues in recent history that point to how the agency might approach DeFi and enforcement actions.

DeFi tea leaves

SEC Chair Gary Gensler has helpfully explained his views in detail a few times now. Most recently, he told the European Parliament that a lack of regulated brokers and clear-cut investor protection rules leaves “the investing public … vulnerable,” particularly to scams or other forms of abuse.

In the past he has also pointed to “promoters and sponsors” who write the software behind DeFi platforms and create their governance mechanisms. The theme that’s emerging so far is a focus on the centralized players that might help create or power DeFi projects (or even engage in what my colleague David Morris calls “decentralization theater”).

The SEC therefore doesn’t appear to be looking at the decentralized parts of DeFi, even if the projects themselves are adequately decentralized after launch. If a project isn’t fully decentralized in its earliest development stage, its backers may soon receive an inquiry.

This would explain why the SEC is investigating Uniswap Labs at any rate.

In a statement emailed to CoinDesk, an external spokesperson for Uniswap Labs said, “We are committed to complying with the laws and regulations governing our industry and to providing information to regulators that will assist them with any inquiry.”

Looking further back, the SEC may also look at how a DeFi platform actually operates – whether it provides a marketplace for tokens that the SEC considers securities and uses its own orderbook.

Past cases

The agency’s precedent here would be EtherDelta, the decentralized trading platform the SEC brought charges against in 2018 on allegations it acted as a securities trading platform.

At the time, the agency pointed to EtherDelta’s smart contract, order book, order display website and marketplace as evidence it was supporting illicit securities transactions.

The SEC also specifically brought charges against Zachary Coburn, who founded the platform but left over a year before the charges were filed.

So just because a platform is decentralized doesn’t mean the SEC won’t file charges against a centralized party with a significant role in setting it up.

It is worth noting here that there may be lines drawn between decentralized finance platforms generally and decentralized exchanges specifically, but the role of centralized developers or founders is salient to both types of entities.

In short, what the SEC is likely considering includes:

  • Investor protection concerns;
  • The role of centralized parties in these decentralized platforms;
  • Whether the tokens are securities in the SEC’s view.

Watch this space.

Bitcoin’s litmus test

Guest essay by Andrés Engler

Finally, the speculation on the use of bitcoin in El Salvador will end, and a real analysis can begin on whether the cryptocurrency is useful or not in a country in need of financial tools for its population.

Knowing like no other the power of social networks, President Nayib Bukele was extremely adept at joining an explosive tribe in search of state legitimacy. The Salvadoran case study was a win-win for both parties.

Still, Bukele had to back down in early battles against the financial establishment. The first stumbling block was the International Monetary Fund, which quickly issued a statement naming “a number of macroeconomic, financial and legal issues” that bitcoin would generate in that country, in the midst of negotiations for a $1 billion loan for the country.

Bukele, without much leeway in the international arena, made several concessions. The most striking was to desist from applying Article 7 of the law, which stipulated that all economic agents must accept bitcoin as a form of payment when offered by the person acquiring goods or services. In August, the president said the use of bitcoin as legal tender would not be mandatory, and the resulting question was obvious. If businesses are not forced to accept it, can bitcoin be considered legal tender?

The second concession, more symbolic but no less important, was saying the measure of the economy would be in dollars, and that salaries would be paid in that currency. It is worth remembering that although El Salvado has a central bank, the country does not issue its own currency but uses the U.S. dollar.

Despite the changes, bitcoin could have concrete benefits for El Salvador. It could save them $400 million that Salvadorans abroad send as remittances to their country, boost tourism and even create a mining industry if Bukele effectively makes available volcanic energy as promised.

On a continent-wide scale, the success of bitcoin in El Salvador – demonstrated in massive adoption and savings in remittances – could mean a domino effect of adoption in Latin America and developing countries in other continents.

So far, Bukele’s strategy has led different politicians in the region – from the North in Mexico to the far South in Argentina – to present bills to regulate the sector and, in some cases, promote it. Either way, bitcoin bills have been a gold mine for officials in search of votes and fame, and an important step in putting cryptocurrencies on the discussion table.

The bitcoin experiment will not only be a litmus test for Bukele but also for bitcoin itself and the discourse that proposes this cryptocurrency as a financial solution for underbanked territories.

The adoption of bitcoin in El Salvador will mean something unprecedented: the first state educational policy on crypto assets, with different offices where locals will learn to use the official digital wallet Chivo and gain knowledge about how bitcoin works and its usages, such as remittances.

Bitcoin is political

The adoption of bitcoin in El Salvador comes at a tumultuous political moment for the country. On Friday, the country’s Supreme Court – which has a pro-government tilt – declared it constitutional for the president to be reelected after his five-year term, generating pushback from the entire political opposition.

It is not the only issue. At least three opinion polls published last week showed the majority of Salvadorans do not agree with the use of bitcoin as legal tender in the country, with an average of between 65% and 70% of El Salvador’s population against it. Such a level of rejection was crystallized in some small marches that took place with only hundreds of people and unions opposed to Bukele, which could have political interests beyond bitcoin itself.

Thus, Bukele expressed days ago his frustration against those who criticized the use of bitcoin in the country for remittances.

“If you don’t want to, you can always go to Western Union and pay a commission. No problem at all,” he wrote on his Twitter account.

El Salvador’s political spectrum is on the lookout for any Bukele misstep, and has criticized the Bitcoin Law in different ways. Both the FMLN party (left) and Arena (right) are unforgiving of a president who wears a backwards cap, has broken with the status quo, entered Congress with the military to try and force the legislature to approve more military and police funding, and won the last legislative elections with a supermajority that gave him a majority in parliament.

“Some will prefer to believe the thieving opponents who have done nothing but loot our country, destroy it and pay for them to murder our people. Others will choose to believe the government. But in the end, everyone will realize the reality on Sept. 7,” Bukele wrote last week.

Tether’s reserves

In May, I filed a Freedom of Information Law (FOIL) request with the New York Attorney General’s Office asking for the documents detailing Tether’s reserve composition breakdown. My goal was to verify that Tether submitted similar documents to the NYAG that the company published when revealing its breakdown to the public (the pie charts, as Twitter has taken to calling them).

The NYAG FOIL officer who saw the request initially denied it, tying the request to a similar FOIL request made by another individual. CoinDesk appealed, and a different FOIL officer agreed with our appeal.

Procedurally, Tether had an opportunity to push back against the second officer’s decision, which it did in the form of a petition filed last week. I imagine we’re still close to the beginning of this process, so obviously more to come on this front.

Here’s more context on how we got here, including Tether’s full statement after filing.

You can follow the court filings here.

Biden’s rule

Changing of the guard

Key: (nom.) = nominee, (rum.) = rumored, (act.) = acting, (inc.) = incumbent (no replacement anticipated)

Emory University School of Law Professor Kristin Johnson might become President Joe Biden’s next nominee to the Commodity Futures Trading Commission, Bloomberg reported last week.

Elsewhere:

Outside CoinDesk:

  • (The Atlantic) Australia seems to be pioneering some new grounds in lockdown enforcement. Some of these measures include apps that require quarantined individuals to verify their location within 15 minutes of receiving a notification, for example. What could go wrong?
  • (Human Rights Watch) El Salvador’s legislature passed new laws that would allow local officials to fire any judges or prosecutors over the age of 60 or extend the term of judges and prosecutors at the government’s discretion, actions which could threaten judicial independence, according to the Human Rights Watch.
  • (The New York Times) The Times published an interesting interactive graphic explainer on crypto energy use. It’s worth taking a look at this.

If you’ve got thoughts or questions on what I should discuss next week or any other feedback you’d like to share, feel free to email me at nik@coindesk.com or find me on Twitter @nikhileshde.

You can also join the group conversation on Telegram.

See ya’ll next week!

DISCLOSURE

The leader in news and information on cryptocurrency, digital assets and the future of money, CoinDesk is a media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. CoinDesk is an independent operating subsidiary of Digital Currency Group, which invests in cryptocurrencies and blockchain startups.

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