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OFF THE CHAIN

The SEC successfully put DeFI on notice

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A new kind of computer.
  • John Detrixhe
By John Detrixhe

Future of finance reporter

Published Last updated on

The US securities watchdog aimed a warning shot at the burgeoning world of decentralized finance. And crypto whales are taking notice.

Crypto exchange Coinbase went public this month about a tiff with the US Securities and Exchange Commission (SEC), which threatened to sue the company if it went live with a product that would let users earn 4% for lending out their digital tokens. Lend, which Coinbase ultimately canceled over the lack of regulatory clarity, would have offered customers an interest rate well in excess of a savings account in exchange for letting Coinbase use their crypto funds to make loans.

As Coinbase CEO Brian Armstrong pointed out on Twitter, the $50 billion exchange’s proposal wasn’t entirely groundbreaking: These types of lending products have grown quickly in the decentralized finance (DeFi) arena. But the SEC said Coinbase’s crypto-borrowing service was a security, which would put the product within its remit. Some legal experts say the agency is targeting high-profile players first and will ultimately make its way down the food chain. The SEC is also reportedly investigating Uniswap Labs, which is behind the largest decentralized exchange. A spokesperson for Uniswap said it is “committed to complying with the laws and regulations governing our industry and to providing information to regulators that will assist them with any inquiry.”

While Coinbase’s centralized venue doesn’t fall strictly under the DeFi umbrella, the SEC’s warning is a sign that the agency plans to bring many more crypto-based financial services out of the shadows.

The DeFi connection

Unlike Coinbase, a centralized public company listed on the Nasdaq exchange, DeFi upstarts purport to be autonomous software programs running on a blockchain—a network of computer databases made airtight from tampering with cryptography. By connecting users without a middleman, many of these systems aim to reinvent banking, trading, and borrowing.

Business is booming. Crypto worth around $85 billion has been put up for collateral on DeFi platforms, according to DeFi Pulse, a crypto-data and analytics website. But the assets deposited on those platforms dipped after news of the SEC’s scrape with Coinbase. While that figure has since rebounded, it’s still below pre-scrape levels.

Hunter Horsley, CEO of index fund manager Bitwise Asset Management, acknowledged the hit, but he thinks the sector still has room to grow, particularly when the regulatory questions are sorted out. “I don’t think the DeFi train is stopping here,” he says. “We see continued enthusiasm.”

Rockstar stock-picker and CEO of ARK Invest Cathie Wood has also reiterated her bullishness on crypto, telling a conference in New York that the traditional financial industry doesn’t yet appreciate DeFi’s ingenuity for stripping out costs. Mike Novogratz, CEO of crypto-financial-services firm Galaxy Digital, acknowledged on CNBC that SEC chair Gary Gensler had rattled many in the industry, but said his firm is getting more inquiries from clients than ever. “I see nothing but engagement and activity from our investing clients and our corporate clients,” he said.

DeFi is big business

DeFi has ballooned in size and diversity in recent years. In the second quarter, around $2.5 trillion of transactions settled on the Ethereum blockchain, which undergirds many DeFi applications.

DeFi enthusiasts access their digital tokens with a wallet like MetaMask, which says it has more than 10 million active users, a 19-fold increase from a year ago. From there, users can deposit crypto coins to, for example, earn interest from a lending protocol like Aave or Compound, or trade on a decentralized exchange like Uniswap. Some $14 billion in crypto tokens has been lent out by Aave, while $1 billion or more can change hands on Uniswap in a day.

For many, DeFi is a way to bet on tokens they hope will skyrocket. But it’s also propelled by an undercurrent of libertarian ideals like protecting privacy and steering clear of government control, says Carol Goforth, a law professor and crypto specialist at the University of Arkansas. These offerings can be more egalitarian than the existing system, as DeFi may be designed to be open to anyone—regardless of their geography or credentials—as long as they fit certain programming protocols. There are also practical ambitions, like using DeFi to cut costs and save time by removing intermediaries.

“A central tenant behind bitcoin and many of the early altcoins at least was the goal of getting big business and the government out of individuals’ private business,” Goforth says. “The goal of privacy continues to be a significant motivator in the crypto space.”

Why regulators are scrutinizing DeFi

Privacy isn’t always compatible with the role of regulators, who are charged with keeping money and funds from flowing to terrorists and criminals (of course, this power can also be used to keep money from going to protestors or politically inconvenient opposition figures). With DeFi, it’s an open question as to who has the responsibility to collect and report information for anti-money-laundering procedures and the like.

The SEC has a parallel concern, Goforth says, which is making sure people have all the information they need about the products they’re investing in. Debt instruments like the one Coinbase proposed may very well be securities, which would put them under the SEC’s remit.

Most legal experts expect government watchdogs to bring DeFi into their orbit. When it comes to Coinbase, Duke University law professor James Cox says the SEC’s assertiveness is actually overdue. Investors need a certain baseline of protection and disclosure, he says, and the threat to sue Coinbase is a message to crypto projects: Take a step back, because your activities likely aren’t exempt from oversight.

But if token prices and collateral put up for use on DeFi platforms are any indication, that acknowledgment, while setting off a tremor in the world of crypto, is far from causing a major earthquake. DeFi’s proponents and pioneers are still betting the technology is here to stay.

“Regulatory uncertainty has been a risk in investors’ minds when it comes to DeFi,” Horsley says. “And regulatory clarity is ultimately what would allow DeFi to get much larger.”

This story has been updated in the third paragraph with a comment from Uniswap.

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