SEC Warns DeFi Developers

Decentralized finance projects are disrupting the finance industry by offering consumers the prospect of market-beating returns.  De-Fi software enables peer-to-peer lending of digital assets executed through smart contracts. Unlike traditional financial products, loans made using De-Fi protocols are not administered by any centralized entity, resulting in ambiguity as to the application of legal standards drafted to regulate intermediaries in financial transactions.

SEC Commissioner Gary Gensler recently stated developers who write software to automate transactions could be participating in activities regulated by the SEC, likening such developers to “promoters” and “sponsors” of the offering of securities. Moreover, decentralized exchanges offer peer-to-peer trading in digital assets without safeguard to prevent money laundering such as know-your-customer verifications, which has caught the eye of the Financial Action Task Force and drawn scrutiny from various governmental organizations in the U.S. and abroad.

The comments by Commissioner Gensler depart from the prior remarks of former Commissioner William Hinman regarding “sufficient decentralization.” Previously, Mr. Hinman stated if the network on which a token or coin is to function is sufficiently decentralized the assets may not represent an investment contract, citing Bitcoin and Ether as examples of sufficiently decentralized networks.

Though the SEC has yet to provide clarity on what makes a network “sufficiently decentralized,” Commissioner Gensler has made clear developers of decentralized software that rewards participants may be regulated by the SEC regardless of a protocol’s level of decentralization. We expect the SEC will continue its trend of regulation by enforcement, leaving questions as to how longstanding statutes and legal interpretations may apply to revolutionary technological advancements in financial products.

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