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Here is why DeFi will get sued.

There is this invisible battle taking place between the U.S. regulator and the (so far still but now less) crazy unregulated crypto world. Generally, the crypto people would be like “look man, none of this are securities, it is different, it runs on blockchain by itself,” while the SEC is quiet and then with a 3 year delay, it charges them for something that makes everyone in the crypto world uneasy because they’ve already moved onto something that is even worse.

In 2017, initial coin offerings were very exciting and for a while it was assumed that if you do an IPO with a token you’re fine because, hey, it’s crypto. That was, of course, wrong and now SEC has a whole section devoted to how wrong that was and it has brought down a lot of enforcement actions against ICO issuers for doing unregistered securities sales.

It didn’t stop there, though, because, naturally, if (some of the) ICO tokens were securities then places where they could be traded were security exchanges, and you need a license for that. And so, this month (mind you after 4 years), the SEC has charged one of the exchanges for doing just that, operating an unregistered security exchange:

The SEC’s order finds that from July 2017 through November 2019, […], Poloniex operated a web-based trading platform that facilitated buying and selling digital assets, including digital assets that were investment contracts and therefore securities.

And I mean this is not only bad news for the crypto exchanges, many of which allowed trading in tokens-that-were-really-securities in the past; it could be bad news for DeFi as well. We chat here often about decentralized finance (DeFi):

To put it simply, DeFi is rewriting financial infrastructure into code on blockchain with no human involvement or control whatsoever. So, convert your fiat to cryptocurrency and you suddenly emerge in a world where you can use your crypto to perform large number of functions that are traditionally performed by the traditional financial infrastructure, but in a completely humanless way, i.e. by sending your crypto to smart contracts, which are themselves just lines of code on blockchain with certain rules embedded.

You can see where the crypto crowd’s “not securities, runs on blockchain by itself” argument comes in again. And, well, this time they are right that DeFi does not fall neatly into the definition of law. If you think about what DeFi does, it goes something like:

  1. people send cryptocurrencies to a pool
  2. a smart contract takes that money to invest it, lend it or trade with it or do something else to earn a return
  3. the profit is shared among the people who put the money in

Now, you would have to replace the words “smart contract” with the word “person” (or “company” or “investment fund”, etc.) to match the U.S. securities law’s description of investment contract, which is: “the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

And it is not “others”. In DeFi it is a line of code.

But, I am really not sure that this will stop the SEC, and can imagine reading headlines like “SEC charges smart contract programmers for $2B unregistered security issuance” rather soon.

It has been shown before that the U.S. financial system can be very very far-reaching. Three New York men robbing banks in Eastern Europe, for example, were successfully jailed in NY for money laundering. Sure, anything can be money laundering if you need to catch them. The case is that they have used U.S. financial system (like their credit card) to buy things (like air tickets) to get to Eastern Europe to commit the crime. So, sure, money laundering.

Similarly, it has been shown that anything can be a securities fraud. Goldman Sachs, for example is still being sued for securities fraud because before 2008 it had said about itself things like “our clients interests always come first.” So what? Well, then the global financial crisis happened, and it came out that Goldman Sachs has maybe sometimes traded against its clients, and their stock price went down. Fraud.

You could say that both cases are pretty expansive — they are stretching the limits of the law’s definition, but that they are doing it because the substance is more important than the form. Its like catching Al Capone for tax evasion.

Really, I sort of get it. Crypto crowd might make the argument that the current rules don’t apply to DeFi; that there is something genuinely novel to them, which the Congress could not have seen coming when it passed the law in 1930s. But, it is not that different, and in fact quite analogous to a securities offering. We may well see the rules stretched by the SEC in order to protect people and I do get why.

When it comes to money, the U.S. is not like other countries. The U.S. citizens maybe need more protection? This is not meant in any condescending way. Money and investing is much closer to an average American than, say, an European. Just look at this case: a CBO at Medivation, a biopharma company bought massive quantities of (out-of-money, so at the time cheap) call options in Incyte, a company similar to Medivation, whose stock usually moves with the stock of Medivation when he learned that his company will be acquired by Pfizer.

I mean, think about. The man knew well that he has some insider trading info, trading on which would be a 100% jail time, so he had two choices: leave it and go home, or speculate by buying other related stock and hope no one notices.

A European CBO would go cycling and maybe, like, have a beer later.

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Thoughts on money and culture.

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George Salapa

George Salapa

Thoughts on money & culture. Wrote for Forbes and Venturebeat before.

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