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Compliance Guide for DeFi Entrepreneurs: How Do DeFi Platforms Comply with Current Laws?
Written by: JJ Tang
Compilation: Luffy, Foresight News
Of all the practices of blockchain technology in the past 5 years, decentralized finance (DeFi) is one of the most controversial areas. The focus of the US government’s regulation of blockchain technology is also closely related to DeFi. For those who don’t know, DeFi is a broad term that describes financial instruments built on top of the blockchain that allow users to lend, trade, exchange, and sell cryptocurrencies, among other functions.
In 2023, both the US Commodity Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC) have stepped up investigations and prosecutions of projects in the Web3 field, and they will work together to dominate the current Web3 landscape. The CFTC oversees any commodity swaps and futures transactions; while the SEC oversees any securities transactions and securities-based swaps.
Recently, the CFTC filed a lawsuit against Binance, Asia’s largest cryptocurrency exchange, and its CEO, Changpeng Zhao, for violating the Commodity Exchange Act (CEA) and CFTC regulations. The CFTC said that Binance did not require U.S. customers to provide identity verification information before trading on the platform when it was obliged, or after imposing restrictions on U.S. customers, it instructed U.S. customers how to circumvent such restrictions. They further stated that Binance "acted in effect as a derivatives exchange without registering with the CFTC as required." [1]
On the other hand, the SEC has also been frequently taking action against numerous DeFi participants. In March 2023, the decentralized exchange SushiSwap was subpoenaed by the SEC for allegedly selling unregistered securities. Since the SEC only issued a press release after the action was over, there were rumors that the SEC had a negative impact on Kraken. [2] 、Lido [3] , Binance [4] 和 Coinbase [5] A similar move was taken, and they account for 64% of deposits in the DeFi market. That percentage doesn’t even include the smaller DeFi platforms, which also received SEC action letters but didn’t make the news.
What laws might DeFi platforms violate?
Securities Law
To understand how the SEC and CFTC are regulating DeFi, we refer to the regulatory status of cryptocurrencies and their related platforms. As I said before about ethereum [6] As explained in the Security Tokens article, the SEC oversees anything that is deemed a security by the Howey test, which states that “when money invested in a common An investment contract exists when a profit is made from it.”
Platforms sell tokens to investors before features are implemented, with the promise that the proceeds will be used to develop those unbuilt features. If these features are built in, investors can reasonably assume that the price of the token will increase as adoption of the platform increases. The SEC may consider that this condition fails the Howey test enough to constitute an investment contract. Such a token may only be considered a utility token if the platform has fully built these features before selling the token. But for most platforms, this is not the case.
Additionally, any DeFi platform or cryptocurrency exchange that facilitates the sale or marketing of such security tokens would also be in violation of the Securities Act of 1933 (33 Act) and the Securities Exchange Act of 1934 (34Act). Specifically, Proposition 33 requires any sale of securities in the United States to be registered or exempt from registration with the SEC. Prop 34 requires anyone operating as a specified entity to register with the SEC.
Under Proposition 34, the following must be registered with the SEC or the Financial Industry Regulatory Authority (FINRA):
In 2023, Kraken was charged by the SEC over its staking service program [9] , the scheme amounted to the sale of unregistered securities. While staking itself is not necessarily a security transaction, by pooling tokens and promising returns through Kraken's staking service, Kraken effectively creates a security that meets all the elements of Howey's test. Likewise, Nexo settles with the SEC [10] , Nexo sells unregistered securities by borrowing crypto assets from U.S. users and offering interest in return.
In March 2023, cryptocurrency trading platform Beaxy was charged for failing to register as a national stock exchange, broker and clearinghouse [11] . Beaxy acts as an exchange by accepting securities orders for buyers and sellers. Beaxy acts as an intermediary for payment and delivery when matching orders and maintains client assets while acting as a clearinghouse. Beaxy is also in the business of trading security tokens for others and therefore also acts as a broker.
Commodity Law
CFTC takes broader action to designate any virtual currency as a commodity [12] . The CFTC thus has jurisdiction over any swap or derivative transactions of tokens.
In 7 US Code § 1a [13] In the CEA, a swap is defined as any contract or agreement in which, other than the transfer of full ownership, any transfer of risk of profit or loss in tokens may be considered a swap.
Although the CFTC's jurisdiction includes virtual currencies, the CFTC generally does not impose legal requirements on token transactions in general. However, the CEA has extensive requirements for both swaps and the intermediaries that participate in the swap market. The CEA requires the following parties to register with the CFTC, as defined in 7 US Code § 1a:
In addition to registration requirements, the CEA also introduces the concept of a "qualified contract participant". Eligible Contract Participants (ECPs) are large institutions such as insurance companies, large banks, etc. The CEA generally prohibits retail clients from trading on margin, but allows ECP trading. The CEA also allows ECPs to trade certain commodity derivatives that retail traders are prohibited from trading.
In 2020, Coinbase stopped margin and leveraged trading because certain spot trades may be considered futures under the CEA. By allowing retail traders to buy Bitcoin on margin, an exchange or DeFi platform can delay the delivery of Bitcoin beyond a 28-day window, which can be considered a futures contract.
In September 2021, the CFTC will [14] Kraken was fined $1.25 million for illegally margining retail commodity transactions and failing to register as a futures commission merchant. By offering a margin product, the product may never be delivered but instead be liquidated. Such transactions are illegal as they require trading on a designated contract market. By accepting funds and orders to trade, Kraken also acts as an unregistered futures commission merchant.
Finally, in 2016, BitFinex was fined by the CFTC [15] , because it is not only an unregistered futures commission merchant, but also operates a wallet and mortgage deposit business in violation of regulations.
How can DeFi platforms comply with current laws?
Since DeFi is such a broad financial term, the laws discussed here must be applied on a case-by-case basis. However, with almost all DeFi platforms, some form of registration is likely to be required. Penalties for violating such laws are severe and will likely cripple most emerging DeFi startups. Additionally, in certain circumstances, founders may be barred indefinitely from selling securities. Given the SEC's view that most cryptocurrencies are securities, an injunction would prevent such people from using cryptocurrencies. Since any startup trying to raise capital is selling securities, and most securities law exemptions require founders not to run afoul of the SEC.
Due to the CEA's regulations and further agreements between the SEC and the CFTC, the SEC could sue that the platform sold tokens as unregistered securities, but if the SEC lost the case (the tokens in the case were not securities), the CFTC could still sue under the CEA. Almost the same terms are being sued against the same platform.
Unless a DeFi platform is willing to trade only Bitcoin, Ethereum, and USDT/USDC, it always runs the risk of listing "securities". Likewise, unless a DeFi platform kicks out Bitcoin, Ethereum, and USDT/USDC transactions, it will forever deal with commodities. Therefore, it is inevitable that any DeFi platform will want to deal with the SEC and CFTC on a legal basis.
Fortunately, the SEC and CFTC have expressed their willingness to cooperate and find a way forward for any DeFi platform that comes forward to obtain a proper license.