Friday, August 20, 2021

SEC, CFTC officials discuss DeFi at Chamber of Digital Commerce event

By Mark S. Nelson, J.D.

SEC Commissioner Hester Peirce and CFTC Commissioner Dan Berkovitz spoke about regulatory issues surrounding the emerging field of decentralized finance or DeFi at the virtual Parallel Summit All Things DeFi event, hosted by the Chamber of Digital Commerce. While Peirce and Berkovitz agreed that the SEC and CFTC have done a good job of coordinating on emerging technology issues, they disagreed on the some of the finer points of what regulation in the DeFi space should look like. Joe Schifano, Global Head of Regulatory Affairs, Eventus Systems Inc., a provider of surveillance and risk solutions regarding equity, commodities and digital markets, moderated the panel discussion with Peirce and Berkovitz.

The "learning curve." DeFi is a type of blockchain-related application supported by virtual currencies that purports to enable traditional financial services but without the intermediaries that are often present to maintain centralized control over financial transactions or trading. This is an amalgam of multiple definitions available via Internet searches, each of which offer slightly different views of DeFi, although the composite definition is consistent with the description of DeFi offered by other panels at the Parallel Summit All Things DeFi event.

Responding to a question from Schifano in which Schifano cited several recent events, including the SEC’s first DeFi enforcement action, Peirce acknowledged that the SEC is still trying to get its arms around the topic. Berkovitz also noted that DeFi was only about one year old and that it was a new area for the CFTC with its own "learning curve," but that DeFi was on the agency’s radar screen.

Berkovitz noted that the CFTC already had some DeFi expertise. In April 2021, Jason Somensatto became the Acting Director of LabCFTC, the agency’s clearinghouse for information on financial technology. Somensatto previously was senior counsel to a DeFi startup firm and a board member at the Blockchain Association. By contrast, Peirce said the SEC would need to bring in additional expertise to more fully address DeFi.

Peirce reiterated some general themes she has expressed in prior speeches and remarks on blockchain and virtual currencies. For Peirce, the preferred SEC approach would involve guidance, but she said the one-off enforcement approach in blockchain matter was likely to continue with DeFi. Peirce also said she remains concerned that the SEC’s approach could stifle innovation. In concluding remarks, Berkovitz said DeFi could live up to its potential only if it is regulated although he said he was optimistic DeFi can work within the regulated system. Peirce concluded that she could not predict where technology will go but that she hopes that the fundamental right of individuals to interact with each other will be upheld.

Although some of the above remarks have been pulled from different portions of the panel discussion, in their re-combined form they provide a glimpse into the regulatory philosophies of Peirce and Berkovitz regarding the panel’s primary focus on the SEC’s and CFTC’s jurisdiction over DeFi, the role of intermediaries in finance, and enforcement in the DeFi space.

Jurisdictional separation. Although neither Peirce nor Berkovitz mentioned it, it was apropos for them to discuss the jurisdictional divide between the SEC and the CFTC in the days after it became known that Philip McBride Johnson, the former CFTC Chair and namesake of the Shad-Johnson jurisdictional accord between the two agencies, had passed. Berkovitz observed that the CFTC regulates commodities, but that in more nuanced terms, that means the agency mostly regulates derivatives on commodities or, in even simpler language, anything you can have a futures contract on such a the more recent trading in Bitcoin futures. He said the Dodd-Frank Act also granted the CFTC authority over swaps. However, regardless of the technical, legal definitions contained in the Commodity Exchange Act (CEA), Berkovitz explained that it is the nature of the underlying financial instrument, not the structure of an entity, that brings something within the CFTC’s authorities.

Peirce recited the familiar concept of the investment contract and the Supreme Court’s Howey opinion as the basis for SEC authority in blockchain matters. Under Howey, an financial transaction is an investment contract and, thus, a security, if it involves an investment of money in a common enterprise with an expectation that others will generate profits. According to Peirce, DeFi’s lack of intermediaries could make it harder to reconcile the highly decentralized DeFi business model with existing securities regulations.

Whither the intermediaries? The panel discussion then turned to the role that intermediaries play in the traditional financial system and how intermediaries are largely absent from DeFi projects. Schifano’s questioning focused initially on Berkovitz who, in a June 8, 2021 speech, outlined what he sees as the drawbacks to DeFi projects—namely the lack of legally accountable intermediaries. A few quotes from the concluding DeFi section of Berkovitz’s otherwise wide-ranging speech underscore his remarks during today’s panel discussion:
  • "A system without intermediaries is a Hobbesian marketplace with each person looking out for themselves. Caveat emptor—'let the buyer beware.’"
  • "Not only do I think that unlicensed DeFi markets for derivative instruments are a bad idea, I also do not see how they are legal under the CEA."
  • "Apart from the legality issue, in my view it is untenable to allow an unregulated, unlicensed derivatives market to compete, side-by-side, with a fully regulated and licensed derivatives market. In addition to the absence of market safeguards and customer protections in the unregulated market, it is unfair to impose the obligations, restrictions, and costs of regulation upon some market participants while permitting their unregulated competitors to operate wholly free of such obligations, restrictions, and costs."
During the panel discussion, Berkovitz explained that intermediaries (in the June 8, 2021 speech he identified "banks, exchanges, futures commission merchants, payment clearing facilities, and asset managers") reinforce the stability of U.S. markets. For example, intermediaries provide access to markets, they provide information to customers, they safeguard funds, and they act as clearinghouses that back up trades so that when things go wrong customers can be made whole. Berkovitz further explained that the point of existing regulations has been to focus on intermediaries and that, if there are no intermediaries, regulations may fall on individuals.

Schifano then asked Peirce about the benefits of having fewer intermediaries. According to Peirce, the benefits of DeFi’s lack of intermediaries are the potential to help with unequal access to the financial system and the potential to ensure the transparency of financial transactions with all participants operating on the same terms via smart contracts. But Peirce cautioned that DeFi may put the onus on individuals to be more reliant on their own due diligence and she suggested that people should be warned about the risks of DeFi if they unsure of how to use the technology. Peirce also suggested that DeFi could evolve such that the part of it that interacts with customers may look more like traditional finance with the DeFi part in the back office.

Early DeFi enforcement. The SEC’s recent settled administrative action brought against Blockchain Credit Partners (aka DeFi Money Market) provided the focal point for the panel’s discussion of enforcement in the DeFi field. In that matter, the SEC alleged that DeFi Money Market and two individuals raised $30 million over a one-year period by using DeFi enabled by smart contracts to sell unregistered securities without an applicable exemption in the form of interest-bearing tokens and "governance tokens" purporting to confer upon investors voting rights, a share of the profits, and access to a secondary trading market.

The SEC charged the entity and the two individuals with violating the Securities Act’s registration requirement and the Exchange Act’s antifraud provisions. In addition to a set of undertakings and five-year officer and director bars for the individual respondents, the individuals and the company were ordered to pay disgorgement and prejudgment interest of more than $13 million and the two individuals were ordered to each pay civil money penalties of $125,000. All of the respondents agreed to the order without admitting or denying the SEC’s findings.

In a press release announcing the settled matter, the SEC billed the matter as its first DeFi enforcement action. The SEC’s newly appointed Enforcement Director, Gurbir Grewal, said that "[f]ull and honest disclosure remains the cornerstone of our securities laws – no matter what technologies are used to offer and sell those securities." Moreover, Daniel Michael, Chief of the SEC Enforcement Division’s Complex Financial Instruments Unit, explained that "[t]he federal securities laws apply with equal force to age-old frauds wrapped in today’s latest technology."

In reply to Schifano’s more general opening question at the beginning of the panel discussion to Peirce and Berkovitz, Peirce had described the DeFi Money Market matter as not really being a DeFi case because it was centralized finance in substance and more of a run-of-the-mill misrepresentation matter. Peirce would later state that there is a need to get the balance right so as not to disincentivize new technologies. She also said she had been critical of the SEC in some enforcement matters because of her concern that the agency thinks its guidance is clear and that she was not sure the agency would do better regarding DeFi. Peirce, however, was careful not to "condemn[]" SEC staff while reiterating that the SEC needs to figure out how to embrace technology.

Berkovitz emphasized that enforcement is just one tool available to regulators. He explained that the CFTC also has LabCFTC, can issue guidance, and that those regulated by the agency can seek no-action relief. Berkovitz also cautioned that rapid technological developments can make it hard to lay down guidelines because the thing to be regulated may change within a period of months. Berkovitz said that balancing flexibility and regulatory certainty is the key.