SEC’s Gary Gensler Suggests DeFi Raises New Challenges for Investors and the SEC, Acknowledges Growth

The chairman did take note of its recent rise in attention, indicating further belief in the potential of the sector.

Gensler’s Testimony About Crypto

In a prepared testimony to the Subcommittee on Financial Services and General Government, Gary Gensler acknowledged the significant growth and valuation of crypto tokens but also cites concerns on DeFi. The former Professor of the Practice of Global Economic and Management, MIT Sloan School of Management was cautious in dealing with the growth and interest with crypto assets and specifically acknowledged the challenges posed by DeFi (decentralized finance) platforms.   


Addressing Regulatory Concerns

As the chairman has stepped into his new role, Gensler has been setting his sights on addressing the gaps that exist in the crypto market. The current chief of the Securities and Exchanges Commission (SEC) had addressed the same concerns in his interview on May 7th with CNBC regarding investor protection. Citing concerns of fraud in a volatile market, he claims that regulators have to step in to protect the investors. 

Quoting a statement made by Gensler in the interview with CNBC, he said: 

“To the extent that something is a security, the SEC has a lot of authority. And a lot of crypto tokens — I won’t call them cryptocurrencies for this moment — are indeed securities.”

The purview of the SEC, however, has a well defined role. It is a creature born from the Securities Exchange Act 1934 and has the responsibility of ensuring an orderly and functioning securities market. The SEC clarified that Bitcoin and Ethereum are not securities way back in June, 2018. The current case of SEC v Ripple Labs is one that will hopefully set the precedent for clearer definition. The definitional constraint has to be addressed first before the industry players can be made to comply with regulatory requirements, but the intricate and unique qualities of DeFi requires an infrastructural regulatory system that is applied individually based on the project. 

DeFi and the Risk it Poses

DeFi (Decentralized Finance) is a revolutionary platform that enables its participants to participate in financial products that are made available on a public decentralized blockchain network. DeFi is built on smart contract platforms such as Ethereum and was initially meant to cater for traditional financial services such as lending and prediction markets. However, blockchain technology is disruptive in nature. Many new DeFi protocols have emerged which were previously unheard of. Concepts such as yield farming, flash loans, liquidity mining and ‘money legos’ have sprung out of DeFi, showing off its impressive potential.

These DeFi products are financial products. In the traditional market, regulatory clearance is required. However, the speed of innovation in DeFi outpaces the existing regulatory framework, causing confusion in compliance. These new concepts have no comparable alternatives to serve as a guide. Therefore, unless clearer boundaries are drawn by the regulators first, the stakeholders would have a clearer picture. Here the stakeholders would involve investors and the platform developers.  

The dangers of an unregulated market have been correctly identified by Gensler. The call for investor’s protection is greater now than ever before. Events such as exploits in the DeFi space recently using flash loans and draining the liquidity from LP (liquidity pools) are becoming more rampant.  

DeFi is here to Stay

DeFi took off significantly after the March, 2020 crash. DeFi market capitalization today stands at $93 billion, and has been fueling a flurry of activities on the smart contract platforms that are DeFi enabled. It has use cases and it serves a functional purpose, hence it is unlikely to disappear overnight. 

Source: The DeFi Market Cap at time of writing

The Regulatory Dilemma 

Stakeholders within the DeFi space do concede that it is a space that must be regulated. It cannot be a ground for fraud and dubious activities.  In an opinion on The Regulatory Review, the author notes: 

“Although DeFi projects do not fit well within the existing U.S. financial regulatory paradigm, it does not follow that policymakers or regulators should not, or cannot, regulate the activity. As DeFi projects scale, it has become increasingly apparent that they may present the same types of risks that U.S. financial regulation is designed to address.”

The existing regulatory rubric may no longer be applicable. Parties must be prepared to set policy frameworks and design new regulations through collaborative efforts to address this pressing concern. Every DeFi protocol presents different parameters that must be accounted for, and it must be treated on its own accord based on its qualities.

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