DeFi Identified as Potential Focus for CFTC Enforcement Action

Jones Day

CFTC Commissioner asserts that Decentralized Finance ("DeFi") likely violates the Commodity Exchange Act ("CEA") and that the regulator should respond accordingly.

DeFi is an umbrella term encompassing a range of blockchain financial markets designed to offer financial services through a distributed platform that does not involve traditional financial intermediaries such as banks, exchanges, and brokerages. DeFi proponents argue that removing these intermediaries increases efficiency and grants consumers more control over their investments and trading activities. This is especially so in the cryptocurrency space. For example, over $20 billion in cryptocurrency was traded using DeFi as of January 2021—a twenty-fold increase from the prior year. In response to this demand growth, DeFi platforms are quickly proliferating.

Perhaps because the DeFi floodgates are opening further, CFTC Commissioner Dan Berkovitz recently expressed significant reservations about DeFi platforms—even going so far as to say that those platforms, by their very nature, may violate the CEA.

In a June 8 speech, the Commissioner stressed that the CEA requires derivatives like futures and options to be traded on CFTC licensed markets. Since DeFi platforms are unlicensed, the Commissioner could "not see how they are legal."

Moreover, the Commissioner asserted that the unregulated platforms raise customer protection concerns. He emphasized that financial market intermediaries monitor for fraud, prevent money laundering, and safeguard deposits. He cautioned that in a pure DeFi system, none of these safeguards exist.

Commissioner Berkovitz also seemingly signaled that enforcement actions in the DeFi space may be imminent. He urged that financial regulators "not permit DeFi to become an unregulated shadow financial market in direct competition with regulated markets," and that the "CFTC, together with other regulators, need to focus more attention to this growing area of concern and address regulatory violations appropriately."

The CFTC's actions follow the March 2021 publication by the Financial Action Task Force of its "Draft updated Guidance for a risk-based approach to virtual assets and VASPs," which adds proposed definitions for decentralized exchanges and decentralized finance and specifies who might be held liable for enforcing KYC requirements for DeFi platforms.

While "regulation by enforcement action" is far from ideal, any cases that do come will begin to rough out some parameters in the DeFi space for what may be out-of-bounds under the current rule sets. Further rulemaking will ultimately be necessary to get to a better fit. For the time being, market participants exploring DeFi should consider the opportunities before them with a particular focus on how well or poorly they fit within existing regulatory frameworks for banking, securities, and commodities.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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