Decentralized Finance (DeFi) represents an emerging financial model that utilises distributed ledger technologies to provide functions like borrowing, investing, or trading digital assets, all without the need for conventional centralised intermediaries. Here is a quick update with what is occurring on the international stage.
On 7 September, the Commodity & Futures Trading Commission (“CFTC”) issued (and settled) charges against three digital asset DeFi businesses based in the United States: Opyn Inc.; ZeroEx, Inc.; and Deridex, Inc. Deridex and Opyn are charged with “failing to register as a swap execution facility (SEF) or a designated contract market (DCM), failing to register as a futures commission merchant (FCM), and failing to adopt a customer identification program as part of a Bank Secrecy Act compliance program”. All three are charged with “illegally offering leveraged and margined retail commodity transactions in digital assets”.
The facts leading to the charges can be found at the CFTC’s website. The nomenclature (SEF, DCM, FCM, registered exchange) is that of the U.S. regulations. The (rough) equivalents in the UK are “trading venue” and “broker”: activities which require authorisation and registration under the Regulated Activities Order in the UK.
In summary, Deridex and Opyn offered platforms for retail customers to trade tokens (or derivatives of tokens). The CFTC found that:
- these tokens were swap contracts which could only have been offered to retail customers on a “registered exchange”;
- the platforms could only offer trading and processing of these tokens and derivatives (as they were swaps) if they were registered as a SEF; and
- the business of deploying the smart contracts underlying the tokens (and the derivatives) was activity which could only be undertaken by a FCM.
This was not a unanimous decision of the CFTC Commissioners. One Commissioner expressed her concern that the CFTC’s enforcement actions are not the most suitable means of addressing DeFi technology and that the CFTC should engage with the public and other stakeholders through rulemaking and other tools (the “Policy Issue”). Also, she raised questions about the CFTC’s regulatory jurisdiction over DeFi protocols (the “Jurisdiction Issue”).
Dealing first with the Policy Issue: the majority ruling of the CFTC was that “unlawful transactions [do not] become lawful when facilitated by smart contracts”. As any adviser will tell their clients, the regulatory status of any token, protocol or smart contract will depend on what it says it does and what it actually does. The CFTC and the Securities Exchange Commission (“SEC”) may be taking a robust approach to the perimeter of its rules (i.e. what tokens, protocols and smart contracts fall within its regulatory mandate) as a matter of policy, however, the policy is being applied across the developed world to one extent or another. Financial markets infrastructures are adapting to being DeFi within the TradFi world and increasingly using TradFi nomenclature to describe the activities within DeFi. We should expect more of the same, and more established (often TradFi) participants to adopt DeFi as a result.
On the Jurisdiction Issue: there are two halves to this issue.
The first relates to the way in which the U.S. regulatory system is established. The CFTC has jurisdiction over “derivatives markets”, including commodity futures, options and swaps. The SEC has jurisdiction over the securities markets. If a product is a security, then the SEC, not the CFTC has jurisdiction. Conversely, if a product is a swap then the CFTC, not the SEC has jurisdiction. If a product is neither (or could be both) then either neither regulator has jurisdiction or the CFTC and SCE compete for jurisdiction. This does seem to be happening in the U.S.
The second related to the “engagement” point. It is understandable that regulators would take their “consumer harm” mandate seriously for matters where there was either an unambiguous risk of “consumer harm” or if consumers were concerned that they were at risk of “harm”. The difficult space for regulators to inhabit is the space where consumers feel that the risks of harm to them are outweighed by the benefits of increased choice and financial autonomy presented by DeFi. All regulators grapple with this issue. Often – particularly in the UK – the regulators sit on the side of caution. I express no personal views on this, save to say that at some point the adoption of DeFi will become sufficiently widespread that it will present a systemic risk.
It is worthwhile noting that IOSCO has just released – at the same time as the SEC decision – its policy recommendations for DeFi. While these recommendations will be the subject of another post, the principles conform to the SEC’s approach, namely that IOSCO’s recommendations have “been informed by a mapping of IOSCO Standards [on TradFi] to DeFi products, services, arrangements, and activities”.
While not new, it is worthwhile mentioning that the UK’s moves on “finfluencers” (and their role in marketing) have been mirrored in France.
In June this year, a law was passed in France defining “influencers” as “individuals or legal entities who, for a fee, mobilise their notoriety with their audiences” to promote goods or services online. I have written about the UK’s moves previously, and bemoaned the likely inability to enforce the FCA’s (well-meaning) rules. France has taken the approach that influencers within the EU and Switzerland must have liability insurance for their promotions and that influencers outside the EU and Switzerland must not promote the covered goods and services unless they have appointed a local agent/representative which carries insurance. A cynic would be reminded of the EU’s standard MO of “bringing everything onshore” and restricting access to its markets to anyone not under the direct jurisdiction of an EU regulatory body. My more upbeat view is that this deals, somewhat, with the problems I highlighted with the FCA’s approach.