Why is the SEC investigating DeFi?

Always looking for something to do, the SEC has now turned its attention to decentralized finance (DeFi) platforms and the people behind them. This is a massive surprise, but it does represent the start of a new era in crypto’s regulatory environment. It’s hard to know what might come out of it, but Nik De writing for Cointelegraph believes there are precedents we can base some assumptions on.

The story started last week with the SEC’s announcement that it was conducting an investigation into Uniswap Labs and a few other DeFi platforms. What the SEC didn’t make explicit is whether it is simply on an information gathering exercise, or if it is looking with a view to bringing in new regulations. De says, “Regardless, this is a pivotal, if expected, development in the regulator’s oversight of the crypto market.” Furthermore, it may be critical in determining the future of DeFi platforms.

The SEC has been making noises about DeFi for a few weeks, and has now pinpointed Uniswap Labs as a place to start. Uniswap is the leading decentralised exchange (DEX). A DEX could be described as “a robot on the internet routing trades through various pools of funds, no middleman (beyond the software) needed,” which is how De explains it. he adds, “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.”

Looking at some pronouncements by the SEC chair, Gary Gensler, may help to point us in the right direction. He recently told European politicians “a lack of regulated brokers and clear-cut investor protection rules leaves “the investing public … vulnerable,” particularly to scams or other forms of abuse.”

That’s one of his concerns, but he has another: the ‘promoters and sponsors’ who write the DeFi software, because they create the governance mechanisms. It seems he is concerned about centralised players that might help create or power up DeFi projects. Regarding this, and in De’s estimation, “The SEC therefore doesn’t appear to be looking at the decentralized parts of DeFi…If a project isn’t fully decentralized in its earliest development stage, its backers may soon receive an inquiry.” He believes this is what is happening with Uniswap.

Looking further back in time, the SEC may also look at how a DeFi platform actually operates. Does it offer tokens that the SEC considers to be securities, and does it use its own order book? The case of EtherDelta, a decentralised trading platform, illustrates this. In 2018, the SEC brought charges against it based on allegations it acted as a securities trading platform. The SEC also specifically brought charges against Zachary Coburn, who founded the platform!

The upshot is: just because a platform is decentralized doesn’t mean the SEC won’t bring charges against a centralised party with a significant role in setting it up.

This will be a space to watch!

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