Understanding the Regulatory Landscape of DeFi in the US
DeFi (Decentralized Finance) has been one of the most disruptive innovations in the worlds of finance and crypto in recent years. Offering decentralized lending, borrowing, trading, farming and more as part of a new permissionless financial system separate from the existing one, DeFi platforms have gained immense popularity. However, with innovation comes government regulation and as the world’s largest economy, financial market and global reserve currency, United States regulation is a crucial factor for crypto projects to consider, including those based outside the United States.
In this article, we’ll provide a brief overview of the current regulatory framework for DeFi in the US.
The Regulatory Landscape
Existing laws apply to crypto and DeFi — there is no doubt about that. DeFi cannot “opt-out” of compliance with the law just because DeFi did not exist when the laws were written. However, because the laws were generally written before DeFi (or even the Internet) existed, there are a number of grey areas in their application.
In essence, it is difficult for crypto and DeFi projects to comply with laws and regulations that were written without taking into account their unique features. In particular, US financial market regulation is based on a paradigm of protecting retail investors and the wider public by regulating the intermediaries who enable retail investors to access the financial markets, and requiring such intermediaries to register with the government and meet various standards for transparency and disclosure.
This paradigm breaks down to some extent with DeFi and crypto because retail users and the public can access DeFi markets without an intermediary and the blockchain provides default transparency to all transactions in a way that the traditional financial markets do not. Therefore, it is difficult to apply laws designed to regulate intermediaries to the DeFi world. Governments often try (in the absence of anyone else) to regulate software developers who create crypto projects as intermediaries, but many feel this is not a satisfactory solution either.
As a result, many DeFi projects (which are based in the United States or which have users in the US — covering almost everyone) find themselves in a grey area where they may be subject to US laws and regulations but with no practical way to comply, and at risk of prosecution by US regulators like the SEC or CFTC.
US regulations can be bewildering for crypto projects. There are a wide range of laws, regulations and government bodies, both at the federal (central government) level and the level of the 50 states. However, the most important ones to keep in mind are:
- Securities and Exchange Commission (SEC):
The SEC regulates securities and considers many tokens offered by DeFi projects to be securities subject to federal securities laws. The Howey Test is a legal test that is often used to determine whether a token is a security under US law. If a token is deemed a security, that does not make it illegal — but it must comply with SEC regulations (registration with the SEC and requirements for disclosure etc) if the project has US users/customers. - Commodity Futures Trading Commission (CFTC):
The CFTC primarily regulates derivatives and commodities markets. While DeFi platforms generally deal with cryptocurrencies (which may be considered securities, commodities, derivatives or fall into other categories), the CFTC has indicated interest in regulating certain aspects of the DeFi space, particularly if they involve futures, options, or other derivatives. In particular, the CFTC recently fined Opyn, Deridex, and 0x (Macha) for >$500k as they were offering leveraged derivatives positions without complying with CFTC regulations and previously successfully sued the DeFi margin trading protocol Ooki/BZX. - Financial Crimes Enforcement Network (FinCEN):
FinCEN enforces Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations. DeFi projects subject to US laws and regulations must consider these regulations, especially if they facilitate large transactions or attract users involved in illicit activities. - State-Level Regulation:
Finally, DeFi companies often need to navigate state-level regulations, which can vary significantly. States like New York have introduced their own regulations, such as the BitLicense, which is an additional license that New York crypto businesses need to acquire.
The Role of the CFTC
The CFTC’s role in the DeFi space is particularly noteworthy. While its primary mandate is to oversee derivatives and commodities markets, it has shown interest in regulating certain aspects of DeFi. Here are some key areas where the CFTC may play a role:
It’s important to note that the regulatory landscape is evolving rapidly. Regulatory authorities are actively monitoring the DeFi space and are likely to issue more guidance and regulations in the future, as well as more enforcement actions and lawsuits against projects that they feel are in breach of US laws and regulations — both the SEC and CFTC have been active in this field in 2023. Therefore, DeFi projects should stay informed, compliant and be prepared to adapt to changing regulatory requirements.
In conclusion, the regulatory framework for DeFi in the United States is a complex and evolving landscape. While there is no one-size-fits-all answer to compliance, it’s crucial for DeFi projects to stay informed about federal and state-level regulations and work proactively to ensure they operate within the bounds of the law. Although there are no guarantees of safety or protection from legal liability, many projects outside the United States (such as DyDx) have chosen to block access to US citizens and residents (through technological and other means) as the best way to reduce their potential liabilities and obligations under US regulations.
September 2023
— CompliantDefi Team
www.compliantDefi.org
