“Projects that reward participants with valuable digital tokens or similar incentives could cross a line into activity that should be regulated, no matter how decentralized they say they are.” – Gary Gensler, August 2021
The Securities and Exchange Commission (SEC) is one of the most frustrating bureaucracies in the United States. It is at once expansive in its mission creep but slow to react to clear and obvious frauds in real time, it possesses serious power to destroy people’s lives but is grotesquely selective in who it charges, and it is nakedly political while publicly claiming to be a humble servant of the retail investor class. The SEC is like the Internal Revenue Service (IRS), except people know the name of the head of the SEC because he is on television all the time.
Gary Gensler is coming for DeFi, and don’t blame the chicken for giving you fair warning.
DeFi stands for decentralized finance, and it is the crypto world’s attempt to radically transform the entire financial system. It is truly innovative, dynamic, and filled with promise for a better world. It is also a direct threat to the core power base of the global elite – the world is already great for them, remember – and we suspect they won’t go down without a real fight. If we’re correct, that fight begins in earnest soon.
The SEC is all the things in the opening paragraph and one more: it is also predictable. When targeting a sector, the SEC playbook calls for three simple steps. First, SEC officials jawbone in public. Second, important policy statements are released on its website. Finally, the SEC cracks its knuckles and sets about the task of punching people in the face – but it tends to target only those who can’t punch back (i.e., most crypto billionaires will be just fine). Last week, it passed from the first to the second step. The trip to the third is usually a short one.
On November 9, 2021, SEC Commissioner Caroline Crenshaw published what we believe will be seen as a historically important statement on DeFi. If you know how to read such statements, the clear message of this one is undeniable
In Part I of the statement, Crenshaw insists that when it comes to DeFi, the word “finance” is just as important as the word “decentralized.” She makes the case that virtually all DeFi programs in existence today fall under the SEC’s jurisdiction. Here are two key quotes (emphasis added throughout this piece):
“So while the underlying technology is sometimes unfamiliar, these digital products and activities have close analogs within the SEC’s jurisdiction.”
“But these offerings are not just products, and their users are not merely consumers. DeFi, again, is fundamentally about investing. This investing includes 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.”
In Part II, Crenshaw reminds the public that unregulated markets suffer from structural limitations including corruption, fraud, self-dealing, and substantial information asymmetries among investors. She opens this section with a zinger aimed directly at today’s DeFi participants:
“Market participants who raise capital from investors, or provide regulated services or functions to investors, generally take on legal obligations*. In what may be* an attempt to disclaim those legal obligations*, many DeFi promoters disclose broadly that DeFi is risky and investments may result in losses, without providing the details investors need to assess risk likelihood and severity.*”
In Part III, Crenshaw drops the hammer. Using language that could not be more clear, she effectively calls virtually all existing DeFi projects illegal. Here’s the key passage:
“For example, a variety of DeFi participants, activities, and assets fall within the SEC’s jurisdiction as they involve securities and securities-related conduct. But no DeFi participants within the SEC’s jurisdiction have registered with us*, though we continue to encourage participants in DeFi to engage with the staff.”*
Let’s summarize what’s being said here. If your DeFi project has characteristics of securities (almost all do) and it allows US investors to participate (almost all do), you need to register with the SEC (and none have). Failure to register with the SEC in this context is blatantly illegal conduct, and it has the power to stop it. People are still being charged for illegal initial coin offerings from the last crypto peak – here’s an example from early September:
“The Securities and Exchange Commission today charged Rivetz Corp., Rivetz International SEZC, and Steven K. Sprague, the President of Rivetz and CEO of Rivetz International, with conducting an illegal, unregistered offering of securities through an initial coin offering.
According to the SEC's complaint, between July and September 2017, the defendants offered and sold digital assets designated as "RvT tokens" to the general public, including U.S. investors*, for the purpose of capitalizing Rivetz's business.*”
In Part IV of her statement, Crenshaw cuts to the chase:
“That being said, for non-compliant projects within our jurisdiction, we do have an effective enforcement mechanism. For example, the SEC recently settled an enforcement action with a purported DeFi platform and its individual promoters. The SEC alleged they failed to register their offering, which raised $30 million, and misled their investors while improperly spending investor money on themselves. To the extent other offerings, projects, or platforms are operating in violation of securities laws, I expect we will continue to bring enforcement actions**.**”
She goes on to say that her preferred path is not through enforcement and that she does not consider enforcement inevitable. That’s a fine hedge to explain why only certain people will be charged by the SEC in the coming years.
How can existing DeFi projects get right with the law? In Part V, Crenshaw lays out two main concerns: transparency and pseudonymity. DeFi projects need to be far more transparent with investors about governance and operations, anti-dilution rights, and the distribution of benefits across various classes of investors – all the things a typical registration filing would cover. The SEC also objects to the pseudonymous nature of DeFi participants. Currently, transaction volumes can be faked, bots can collude to drive up values, insiders can leverage their information asymmetry without proper disclosure, and money launderers have free reign. According to SEC, all this needs to end. She goes on to say exactly that:
“I recognize that in some ways DeFi is synonymous with pseudonymous*. The use of alphanumeric strings that obscure real world identity was a core feature of Bitcoin and has been present in essentially all blockchains that have followed.* But in the U.S., investors have long been comfortable with a compromise in which they give up some limited degree of privacy by sharing their identity with the entity through which they trade securities. In return, they benefit from regulated markets that are more fair, orderly, and efficient, with less manipulation and fraud.”
But…doesn’t that effectively end DeFi as we know it?
Predicted signs of the coming rapture have taken many forms - stars falling from the sky, seven-headed beasts bursting with rage like Mount Vesuvius (and locusts, and blood rivers, and lightening storms, oh my!). The SEC has posted a sign that requires very little in the way of interpretation: it is time for DeFi to get its house in order. Those in the crypto world may want to finally take notice of the bell-ringing crazies in the sandwich board signs proclaiming the end is nigh.
