By Natalie DeCoste
The head of the Securities and Exchange Commission (SEC), Gary Gensler, indicated to decentralized finance projects that they are not immune to regulation in an Aug. 18 interview with the Wall Street Journal.
Decentralized finance projects, known as DeFi, is an open and global financial system built for the internet age that serves as an alternative to the current traditional financial model. These financial products are available to anyone with an internet connection and are primarily owned and maintained by their users. To date, tens of billions of dollars of crypto have gone through DeFi applications, and the numbers continue to grow.
The nature of DeFi means that once the software is developed, it can operate without a central authority in charge. The decentralization has led developers to argue that the setup defeats the need for oversight by the SEC. The SEC said in 2018 that some cryptocurrencies, such as bitcoin and ether, are not securities transactions due to their nature and therefore do not fall under the purview of the SEC.
However, Gensler said in his Aug. 18 interview that he disagreed with the developers’ assertions. Gensler argued that DeFi projects that reward participants with valuable digital tokens or other similar incentives have the potential to cross a line into activity that should be regulated by the SEC, regardless of how decentralized these projects claim to be.
“There’s still a core group of folks that are not only writing the software, like the open-source software, but they often have governance and fees. There’s some incentive structure for those promoters and sponsors in the middle of this,” said Gensler.
Gensler claimed that the very name, DeFi, is a misnomer. According to Gensler, while DeFi may be decentralized in some regards, other aspects of the project are very centralized.
Gensler compared the debate surrounding DeFi regulations to a debate 15 years prior over other peer-to-peer lending platforms. In that instance, lenders such as Prosper Marketplace Inc. and its rival LendingClub Corp. lined up individual investors to fund small loans to consumers that the companies made in partnership with banks. Companies could then sell interests in the loans in the form of promissory notes and would then give individual investors the interest payments as the loans were repaid.
At the start, the companies did not register the loans with the SEC, which in 2008 said they were securities. But following an SEC investigation, companies such as Prosper agreed to register the loans, which involved providing information to investors about the borrower’s creditworthiness.
Now the SEC and Gensler have turned their eyes to the growing world of cryptocurrency. Up until now, the SEC’s strategy has involved undertaking enforcement actions that target digital-asset issuers or exchanges on a one-by-one basis, as well as looking into crypto projects in need of regulation.
Just two weeks ago, Gensler promised to expand the SEC’s presence in the crypto space by cracking down on fraud and misconduct in the market. He has also said he would call on the help of Congress to fill regulatory gaps.
“The American public is buying, selling, and lending crypto on these trading, lending, and DeFi [decentralized finance] platforms, and there are significant gaps in investor protection. Make no mistake: To the extent that there are securities on these trading platforms, under our laws, they have to register with the commission unless they meet an exemption. Make no mistake: If a lending platform is offering securities, it also falls into SEC jurisdiction,” Gensler said.
