Almost overnight, a hundred-billion-dollar alternative to Wall Street has sprung up, allowing cryptocurrency investors to use the tools of high finance without going through Wall Street. This system of decentralized finance, or DeFi, connects cryptocurrency traders directly with each other without using a centralized exchange or other middlemen.
But when innovations take off and money starts pouring in, regulators are not far behind. The Securities and Exchange Commission is now proposing a rule that could wreck DeFi before it fully develops. The 654-page proposal doesn’t target DeFi directly but could impose a regulatory and compliance burden that most DeFi platforms wouldn’t be able to handle. And it would defeat the purpose of DeFi by throwing up barriers between buyers and sellers. Like most regulatory overreaches, it would protect the incumbents, in this case the legacy exchanges and trading systems.
The required impact assessment for the new rule concludes that it would affect only 22 companies. But given the proposal’s vague language, it will likely ensnare many more. Neil Chilson, a former chief technologist at the Federal Trade Commission and now senior research fellow in technology and innovation at philanthropic organization Stand Together, says a more realistic impact assessment would note that the rule will hurt at least hundreds of companies. He and other critics argue that the SEC is stepping outside its authority and will kill innovative new financial products and services.
Taking Away Tools
The SEC proposal deals mostly with the U.S. Treasury market and the markets for other government securities, and doesn’t mention DeFi or cryptocurrency. But in practice it could shut down some of the key tools that traders use for buying and selling cryptocurrencies in the virtual, alternative Wall Street. Just as on Wall Street, investors and speculators can take part in prime brokerage, market-making, structured credit and other borrowing and lending activities. They can short crypto tokens and use interest-rate swaps to arbitrage between DeFi providers or different cryptocurrencies.
Until decentralized finance came along, the only way ordinary people could gain access to these investment opportunities was to buy shares in an investment bank, as The Wall Street Journal puts it. DeFi offers investment banking services—all in cryptocurrencies—without the cost of investment bankers or regulators, the paper notes. “People should care about this because this type of decentralized financial innovation makes it easier for average, everyday people to share in the engine of wealth creation that the U.S. economy is,” says Chilson.
The industry is lucrative and growing fast. That’s drawing well-known crypto investors, such as Shark Tank star Kevin O’Leary. The value of cryptocurrency transactions jumped 567% last year, to $15.8 trillion, from 2020, according to blockchain data platform Chainalysis. The value of assets deposited as collateral on DeFi platforms climbed from $10 billion at the beginning of 2020 to more than $110 billion in November, according to DeFi Pulse. But since then, the value has dropped as word of the SEC proposal spread. As of today, the value has fallen to $77 billion.
Little Time to Comment
A major complaint about the SEC action is that it allowed only 30 days for the public to review and comment on the far-reaching proposal. The comment period ended Monday, and now the SEC will decide whether to revise its proposal before adopting it. Commissioner Hester Peirce expressed deep concern over the proposal and the rushed timeline. “It is too wide-ranging and, given its length, too unwieldy to facilitate careful consideration,” she said in a statement. “I cannot comprehend why we insist on blindfolding ourselves… This change could deter innovation and dissuade new entrants from entering the market for trading venues and execution services… [It] would likely impose significant burdens.”
Attorney Gabriel Shapiro argues in a Substack essay that the “new rule would be banning a vast swathe of technologies, and free speech regarding those technologies, which is beyond the SEC’s authority and would constitute an unconstitutional violation of our civil and human rights.” He says there’s “no way mere coders or mere website operators can … track the identities and trades … occurring on decentralized autonomous blockchain systems or otherwise comply with the reporting and registration regime.” He says free-speech rights may be violated because the proposal restricts the “communication protocols” that allow buyers and sellers to interact and complete a trade.
Opponents also argue that the SEC did a poor job conducting the cost-benefit analysis. “It guesses about potential benefits from heavy regulatory systems, and states that it is not able to quantify the benefits,” says Andrew Vollmer, a senior affiliated scholar at the Mercatus Center and a former SEC deputy general counsel, in the comment he submitted on the proposal.
A Sneaky Maneuver
Hoping that the crackdown on DeFi would fly under the radar, the SEC proposal wouldn’t outlaw these platforms specifically. Instead it quietly changes the definition of a securities exchange to include “automated market makers,” the system that makes DeFi work. As Coindesk puts it, “automated market makers are autonomous trading mechanisms that eliminate the need for centralized exchanges and [standard] market-making techniques.”
The proposal is part of a trend at the SEC. The Democratic Party took control of the commission early last year and Chairman Gary Gensler, appointed by President Biden, has gone on a regulatory binge. He’s embarked on an ambitious agenda that includes forcing companies to report alleged risks from climate change and more information about their executives and workforces, and cracking down on the fees that private equity firms charge. At the same time, he’s shortened the comment period to the minimum 30 days for some of the proposals. Critics say all of the new rules, if adopted, will raise costs for consumers and companies, and will discourage companies from going public or staying public. In the case of this proposal on financial markets, the fate of the DeFi industry may be on the line.