Although there are various discussions on the legal basis and supervisory mechanisms of decentralized finance, which started to be talked about after the use of blockchain technology in the field of finance and the widespread use of cryptocurrencies, which has reached a significant volume today, the risks and opportunities of this phenomenon, which have not been fully adopted yet, have been determined by the US Securities and Exchange Commission (SEC) is a matter of curiosity.
In August 2021, the US Securities and Exchange Commission (SEC) first launched an investigation against the directors of a DeFi project for illegally offering shares under the name “DeFi” and misleading investors . In November 2021, an article titled “Disclosure on DeFi’s Risks, Regulations and Opportunities” was published by SEC Chair Caroline A. Crenshaw.
Based on the article, we wanted to address the risks along with the opportunities brought by DeFi, to explain the views and role of the SEC on the subject, and to share our comments.
Decentralized Finance (DeFi) is open and decentralized finance contracts built on blockchain contracts, regulating relationships such as borrowing, credit, trade and investment. In other words, it is an alternative finance system based on blockchain.
Especially since 2018, many studies, innovations and developments have been made on DeFi.
In terms of DeFi, in addition to market risk, credit risk, liquidity risk, technology risk, there are also legal risks for the project, its participants and investors.
Many DeFi offerings and products are similar to products and functions in traditional financial markets.
For example, individuals can obtain an asset or loan after collateral, much like traditional secured loans, through decentralized applications running on the blockchain.
In this sense, DeFi developers do not only produce digital asset tokens, as is believed. They are also developing smart contracts that enable individuals to invest, engage in leveraged and various derivative transactions, and transfer assets between platforms and protocols quickly and easily.
Such DeFi projects continue to develop rapidly. However, DeFi does not just offer a product, and DeFi users are not just consumers. DeFi is basically about investing and these investments involve some speculative risks.
Most DeFi platform providers warn (buyer beware) that DeFi is risky, the investment may be lost, all risks belong to the buyer, therefore the buyer is the party that needs to be cautious and careful, and the buyer beware . states that it has been undertaken.
However, DeFi involves more risks than users can take.
Although DeFi produces effective alternative methods to create, record and perform transactions, there are also aspects that are not suitable for the economy and human nature.
- Unless mandated, projects will not invest adequate compliance and internal control.
- As the detection of illegality, the likelihood of being caught and the severity of sanctions decrease, some individuals will be able to exploit their regulatory shortcomings for sufficiently high financial gains at the expense of others.
- When the potential financial gains are large enough, some people will victimize others, and the likelihood of these grievances will increase as the likelihood of being caught and the severity of sanctions decrease.
- Due to the lack of mandatory reporting requirements, there will be information asymmetry between wealthy/large investors and people in the project or those who are closely related to them (insiders) and small investors, causing wealthy investors and insiders to gain more and easily, and small investors to lose more and easily. can be.
Accordingly, the “buyer beware” approach, which implies that all risks are with the buyer, will not constitute a sufficient basis for this emerging market. In the absence of certain principles and a functional system that implements these principles, abuse, corruption, fraud, cartel-like activities and information asymmetries may occur. Over time, this will break investor trust, reduce participation and harm the ecosystem.
On the other hand, it has been stated that well-regulated markets tend to develop and the US capital markets are one of the best examples of this. Accordingly, the USA is a preferred country for investors and organizations with its reliability and minimum reporting and behavior obligations. In this sense, the US securities legislation does not only impose certain obligations and burdens; it also provides a lot of support for the functioning of the market.
The point underlined here is that it will be beneficial to organize in a spirit and content that will develop the ecosystem with all its stakeholders, increase investment and contribute to the financial markets.
Legal regulation of DeFi
DeFi’s fall under the jurisdiction of various institutions in the USA. These agencies include the Department of Justice, the Financial Crimes Enforcement Network (FinCEN), the US Internal Revenue Service (IRS), the US Commodity Futures Trading Commission (CFTC), and the US Securities and Exchange Commission (SEC). State institutions also have authority in this regard, as well as the federal institutions we have mentioned.
However, DeFi projects do not carry out adequate reporting and compliance activities compared to other regulated markets. For example, many DeFi projects fall under the jurisdiction of the SEC because of the securities in its operation or assets. However, no SEC-registered DeFi participants have registered so far.
At this point, it should be reminded that such investment opportunities realized outside the supervision of legal regulations are more risky for investors and other participants.
DeFi project developers may consult with the SEC’s Strategic Center for Innovation and Financial Technology (FinHub) or other SEC offices or units if they are in doubt as to whether their project falls within the SEC’s jurisdiction, or if the project in question is not fully compliant with SEC legislation.
According to the SEC Chair, FinHub has not refused any meeting so far and has not spared the necessary support and time. As a matter of fact, the fact that more teams come to consult on these issues will improve the technical knowledge of the SEC.
Although the SEC will not be able to give legal opinion as it will not know the project as much as the developers, it will be able to share its own views. Through this exchange of ideas, the SEC will be able to learn more about how such technologies can be integrated into its current legal regime.
The SEC Chairman stated that to the extent that DeFi offerings, projects and platforms violate securities legislation, the SEC will continue to intervene, but to achieve DeFi’s common goals, it would be much more appropriate to work together and comply with regulations rather than such interventions. .
According to the SEC Chair, some elements in DeFi’s structure can create some obstacles in terms of compliance with SEC legislation.
The purpose of the SEC is to ensure that critical information is equally accessible to all investors and that investors act in accordance with this information. In this context, there are two structural problems that DeFi developers should pay attention to.
Lack of transparency
Although all transactions are usually recorded on a public blockchain, DeFi investments are not completely transparent. The fact that these investments are not completely transparent creates an information imbalance between professional investors and insiders and individual investors, leading to a more risky situation for investors. Indeed, according to the SEC Chairman, while individual investors have a serious disadvantage in DeFi over professional investors, this information imbalance exacerbates this problem.
Although it is claimed that DeFi is more egalitarian and transparent and the activities are recorded on a public code; in fact, these codes can be read and understood by a relatively small group. As a matter of fact, DeFi needs to solve this problem in order to reach a large investment pool, given that even highly qualified experts overlook some flaws and dangers. Investors should not be assumed to have the ability to read, understand and interpret such codes. Indeed, it would be unreasonable to build a financial system on such an assumption.
Understanding Decentralized Finance (DeFi) Smart Contracts: How They’re Revolutionizing the Financial Industry
At this point, the individual investor can only act on the information presented in the market, circulating on social media or circulating by word of mouth. In turn, professional investors are able to appoint technical experts, engineers, economists. Although this type of advantage for professionals has historically existed in existing financial markets; DeFi exacerbates this situation. As a matter of fact, DeFi eliminates the intermediaries who act as a kind of watchdog. This may prevent individual investors from accessing professional market advisors or other intermediaries, in other words, from receiving professional support.
One of the challenges with DeFi is that manipulations are difficult to detect.
DeFi transactions take place on the basis of the blockchain, and each transaction is recorded immutable and publicly visible. However, this visibility goes down to a certain level. Due to aliasing, the blockchain only shows the trading blockchain address, but does not reveal the identity of the person controlling it.
In the absence of an effective method to determine the true identity of the participants, it will be very difficult to know whether asset prices and trading volumes are formed naturally or through manipulative trading transactions. For example, a person can transact in many wallets with the bot he uses.
U.S. securities laws prohibit buying and selling with the aim of giving the wrong impression or manipulating the value of a security. Because successful investment depends on reliable information and the integrity of the market. In contrast, aliasing is to make such manipulative activities quite easy to hide. In this context, it becomes difficult for the investor to distinguish between manipulative trading and an organic trading activity. DeFi initiatives that solve/try to solve this problem, on the other hand, become more compliant with SEC regulations and other legal obligations such as the prevention of money laundering and terrorist financing.
It is undeniable that the innovations brought by DeFi are very important.
However, it is necessary to create an ecosystem that allows the creation of a sustainable market for everyone, provides a fair chance of success to the average investor, reduces the information asymmetry between the parties and prevents manipulative activities as much as possible.
Regulators should work with and follow up with DeFi experts to ensure this area is regulated correctly and for the benefit of all stakeholders.
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