TLDR: If your DeFi platform has margin, lending, leverage or derivatives, speak with your attorney, you will very likely need to register with the SEC and/or CFTC.
Introduction
Of all the different ways blockchain technology has been implemented over the last five years, decentralized finance (DeFi) is a strong candidate to win the award for most controversial. As the US government cracks down on blockchain technology, its focus is closely related to DeFi. For those that do not know, DeFi is a broad term which describes a number of blockchain-based systems by which cryptocurrency and other financial instruments are loaned, traded, swapped and/or sold, sometimes including some kind of interest or yield.
In 2023, the Commodities and Futures Trading Commission (CFTC) and the Securities and Exchanges Commission (SEC) have both stepped up investigations and prosecutions into organizations in the Web3 space, implying a concerted effort to reign in the current Web3 landscape. The CFTC, is a US regulatory agency that oversees any trading of commodities, swaps and futures; whereas, the SEC, is a US regulatory agency that oversees any trading of securities and security-based swaps.
Recently, the CFTC has brought an action against Asia’s largest cryptocurrency exchange, Binance, and its CEO Changpeng Zhao for violating the Commodity Exchange Act (CEA) and CFTC Regulations. The CFTC argues that Binance did not require its US customers to provide identity-verifying information before trading on the platform despite its duties under the CEA, or thereafter, upon instating restrictions on US customers, proceeded to teach VIP US customers how to circumvent such restrictions. They further argue that Binance acted, “as a designated contract market or swap execution facility based on its role in facilitating derivatives transactions without registering with the CFTC, as required.” [1]
The SEC has also been active in bringing actions against a wide array of DeFi actors. In March of 2023, SushiSwap, the popular decentralized exchange, was subpoenaed by the SEC for selling alleged unregistered securities. As the SEC only posts a press release upon the conclusion of an action, rumors have it that the SEC has brought similar actions against Kraken [2], Lido [3], Binance [4], and Coinbase [5], accounting for 64% of the DeFi market by market deposits. This percentage doesn’t even account for any number of smaller DeFi platforms that have also received SEC action letters and do not receive news coverage.
What laws are DeFi platforms potentially violating?
Securities Laws
To understand how the SEC and the CFTC overlap in their oversight of DeFi, we refer to the regulatory status of cryptocurrency and its platforms. As previously explained in my article on Ethereum [6] and securities tokens, the SEC oversees anything which is considered a security as defined in SEC v. Howey Co., 328 U.S. 293 (1946) by the commonly named Howey Test [7], which states, “...investment contract exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
By instituting a road map, or otherwise touting a platform’s features before they are built, platforms are suggesting to a purchaser of a token that the funds the platform receives in exchange for the token, will be applied towards development of those unbuilt features. If those features are built, an investor could reasonably assume that the price of the token should increase as adoption of the platform also increases. The SEC could argue that this fails the Howey Test and is enough to constitute an investment contract. If the platform had fully built out the features before any sale of the token, perhaps such a token would be merely considered a utility token. However, we all know that for most platforms, this is simply not the case. Converting what would have been a utility token into a security token. This is why the SEC Chair Gary Gensler has previously stated [8] in 2022, that a vast majority of cryptocurrencies are securities.
Further, any DeFi platform or crypto exchange that facilitates the sale of or markets such security token (which includes most crypto exchanges), would also be in violation of the Securities Act of 1933 (33 Act) and the Securities Exchange Act of 1934 (34 Act). Specifically, the 33 Act requires that any sale or offer of securities in the United States be registered with the SEC or be exempt from registration. The 34 Act requires that any person operating as certain entities to register with the SEC.
According to the 34 Act, the following must be registered with the SEC or Financial Industry Regulatory Authority (FINRA), as defined in 15 U.S. Code § 78c:
An exchange is any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange.
A security-based swap execution facility is a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that— (A) facilitates the execution of security-based swaps between persons; and (B) is not a national securities exchange.
A broker is any person engaged in the business of effecting transactions in securities for the account of others.
A clearing agency is any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities.
In 2023, Kraken settled charges [9] from the SEC regarding its staking-as-a-service program which amounted to a sale of unregistered securities. Although staking itself is not necessarily a securities transaction, by pooling tokens and promising returns through Kraken’s staking management efforts, Kraken had effectively created a security which met all the elements of the Howey Test. Similarly, Nexo also settled [10] with the SEC for selling unregistered securities by borrowing crypto assets from US users and offering interest in return.
In March 2023, crypto trading platform Beaxy was charged [11] for failing to register as a national securities exchange, broker and clearing agency. Beaxy took orders of securities for buyers and sellers thus acting as an exchange. Beaxy acted as an intermediary in making payments and deliveries upon matching orders and maintained customer assets thus acting as a clearing agency. Beaxy also engaged in the business of effecting transactions for the account of others in securities tokens thus acting as a broker.
Commodities Laws
On the other hand, the CFTC has taken a broader approach defining commodities [12] as any virtual currency. The CFTC also has jurisdiction over any swaps or derivatives of tokens.
In 7 U.S. Code § 1a [13], the CEA defines a swap as any contract or agreement which “...transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with future change in any such value or level without also conveying a current or future direct or indirect ownership interest.” To put it simply, any transfer of the risk of profit or loss other than a transfer of full ownership in any token is likely to be considered a swap.
Although the CFTC’s jurisdiction includes virtual currencies, the CFTC generally does not set legal requirements for the trading of tokens in general. However, the CEA does have extensive requirements for both swaps and intermediaries which participate in a swap market. The CEA requires the following parties to register with the CFTC, as defined in 7 U.S. Code § 1a:
A futures commission merchant, an entity that is engaged in or soliciting or in accepting orders for futures, swaps, commodity options, margin trades, and retail commodity transactions (together, Commodities Transactions) and accepts money or property to margin, guarantee or secure such trade.
A introducing broker, an entity that is engaged in or soliciting or in accepting orders for Commodities Transactions and does not accept money or property to margin, guarantee or secure such trade.
A commodity pool operator, an entity that engages in the business of an investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in Commodities Transactions.
A commodity trading advisor, an entity for compensation or profit, engages in the business of advising others, either directly or indirectly through publications, writings, or electronic media, as to the value of or the advisability of trading in Commodities Transactions.
A swap dealer, an entity that holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps with counterparties as an ordinary course of business for its own account; or engages in any activity causing the entity to be commonly known in the trade as a dealer or market maker in swaps.
A major swap participant, an entity that is not a swap dealer, and maintains a substantial position in swaps other than for hedging or mitigating commercial risk.
A derivatives clearing organization, an entity which acts as a clearinghouse, clearing association, clearing corporation, or similar entity, facility, system, or organization.
A designated contract market, an exchange that may list for trading futures or option contracts based on all types of commodities and that may allow access to their facilities by all types of traders, including retail customers.
A swap execution facility, a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that facilitates the execution of swaps between persons and is not a designated contract market.
In addition to registration requirements, the CEA introduces the concept of “eligible contract participants.” Eligible contract participants (ECPs) are large institutions such as insurance companies, large banks, and commodity pools, among others. The CEA generally prohibits margin trading for retail clients and allows them for ECPs. ECPs are also allowed to transact certain commodities derivatives which are prohibited to retail traders.
In 2020, Coinbase halted its offerings of margin and leveraged trading on its exchange as certain spot trades could be considered futures under the CEA. By allowing retail traders to purchase bitcoin on margin, an exchange or DeFi platform could delay delivery of the bitcoin until after a 28-day window, after which the purchase could be considered a futures contract.
In September 2021, the CFTC fined [14] Kraken $1.25 million for illegally offering margined retail commodity transactions and for failing to register as a futures commission merchant. By offering margined products, it was possible that the products were never delivered and instead liquidated. Such transactions were unlawful as they were required to be transacted on a designated contracts market and did not. By accepting money and orders for transactions, Kraken also acted as an unlicensed futures commission merchant.
Finally, in 2016, BitFinex was also fined [15] by the CFTC for not only operating an unregistered futures commission merchant, but also operating wallets and collateral deposits in such a way as to violate the CFTC’s rules on designated contract markets and exchanges. Highlighting that not only is registration key, but that registered organizations have required operating procedures that must be followed.
What can DeFi platforms do to comply with current law?
As DeFi is a term that covers a broad range of financial mechanisms, the laws discussed here must be applied on a specific case-by-case basis. However, for almost all DeFi platforms, it is highly likely that some form of registration will be required. The penalties for violating such laws are severe and are likely to cripple most budding DeFi start-ups. Furthermore, in some cases, the founders are barred from selling securities indefinitely. Considering the SEC’s viewpoint that most crypto are securities, such a prohibition would prevent such a person from working with crypto. It may also prevent them from being a founder entirely. As any start-up trying to raise capital is selling securities and most securities laws exemptions require that no founder has run afoul of the SEC.
Due to the way the CEA is written and further agreements between SEC and CFTC, the SEC can bring an action arguing that a platform is selling tokens as unregistered securities, but, if the SEC loses such a case (by a finding that the token in question was not a security), the CFTC may still bring an action against the same platform under the CEA for nearly the same charges.
Unless a DeFi platform is willing to only trade bitcoin, ethereum, and USDT/USDC, it will always run the risk of listing a token only to find out later that such token is a security. Unless a DeFi platform is willing to transact without bitcoin, ethereum, and USDT/USDC, it will always be dealing with commodities. Therefore it is inevitable for any DeFi platform that wishes to remain on the right side of the law to interface with both the SEC and the CFTC.
Fortunately, the SEC and CFTC have expressed willingness to cooperate and find a path forward for any DeFi platform that comes forward to become properly licensed. Furthermore, the 34 Act and the CEA have certain overlapping registrations where registration with one organization may act as a registration for certain activities with the other organization. There are also certain exemptions to registering securities and exemptions to registering as an exchange (which is extremely burdensome), such as registration as an alternative trading system.
About the Author
JJ Tang is an experienced corporate transactional attorney specializing in emerging growth companies. He is passionate about blockchain technologies and video games and regularly advises clients in these industries.
Previous work has included advising video game developers in implementing Web3 into their games, advising a Web3 investment fund with the legality of potential DeFi investments, and conducting various initial coin offerings.
JJ also represents clients in venture capital financings, commercial contracts, securities, mergers & acquisitions, IP licensing, debt facilities, and corporate governance.
In his spare time, you can find JJ acting as a business advisor to e-commerce projects and building things with his hands
References
[1] https://www.cftc.gov/PressRoom/PressReleases/8680-23
[2] https://decrypt.co/120902/sec-crypto-exchange-kraken
[3] https://www.bitcoininsider.org/article/207442/lido-daos-ldo-dips-amid-rumors-sec-wells-notice
[6] Why Ether and Ethereum is Not a Security
[7] https://www.investopedia.com/terms/h/howey-test.asp
[8] https://finance.yahoo.com/news/sec-chair-gensler-majority-cryptocurrencies-securities-124610154.html
[9] https://www.sec.gov/news/press-release/2023-25
[10] https://www.sec.gov/news/press-release/2023-11
[11] https://www.sec.gov/news/press-release/2023-64
[12] https://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-6
[13] https://www.law.cornell.edu/uscode/text/7/1a
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