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SEC vs DEX: Two Lessons To Learn From EtherDelta Case

15 November 2018 13:58, UTC
Denis Goncharenko

Decentralized exchanges, or DEXes, were called the true route of “cryptonomics” development by the enthusiasts. These entities operate without a central authority acting as a third party. “One of the core features of blockchain was the removal of the need for centralized control, trading on a centralized exchange goes against that,” says Adam FUNNELL, Investor and blockchain consultant from the UK. DEXes provide increased privacy to traders, lower trading fees, etc — we described the benefits in our analysis. It is also about protecting the users, says Pier TUPIER, an investor from France: “Many people lost funds due to the exchanges getting hacked, owners running away with funds. So over time, as more people encounter bad experience, they will move to decentralized exchange.” For some traders and investors, the main appeal was the reduced risk of government regulation. Well, here is the “risk”, running full speed. Robert COHEN, chief of the SEC’s new cyber unit, stated that if an exchange doesn’t employ central HQ or governing body, it still cannot avoid the responsibility. “The focus is not on the label you put on something or the technology you’re using. The focus is on the function and what the platform is doing. Whether it’s decentralized or not, whether it’s on a smart contract or not, what matters is it’s an exchange,”  he stressed.

So the SEC made a certain step to investigate DEXes, claiming that they place customers, their assets and their overall privacy in jeopardy. The paradox is that decentralized exchanges were meant to solve the problem of funds safety. “You don't know what they do with your assets and you give up the control when you use central exchanges. At decentralized exchanges, this doesn't happen. There is no central party, the trades are peer-to-peer and you stay in possession of your assets. People understanding the technical background would never park a significant amount of crypto assets at a centralized exchange,” says Marco GAUER, a blockchain technology expert from Germany.

The watchdog is not just watching, it also started acting. So, is there any current legal interpretation of the ‘decentralized exchange’ term to take any action against it? We asked Selva OZELLI, the International Tax Attorney and CPA, to provide a comment on the decentralized exchange phenomenon. “On March 18, 2013, Financial Crimes Enforcement Network (FinCEN) issued interpretive guidance that required a money service business (MSB) to include virtual currencies as reportable financial transactions. It subjected foreign MSBs to registration requirements within 180 days since the beginning of operations, which required them to implement an effective anti-money-laundering (AML) program, maintain records, and file reports with FinCEN. A foreign-located business qualifies as an MSB if it does business as an MSB wholly or in substantial part within the United States. This could include a decentralized crypto exchange. A foreign-located MSB will have the same requirements as an MSB with a physical presence in the United States with respect to its U.S. activities. FinCEN will hold accountable foreign-located money transmitters, including decentralized virtual currency exchanges, wallets, prediction markets, hedge funds, asset management companies that do business in the United States when they willfully violate U.S. anti-money laundering laws," she explained.

Nevertheless, how exactly can decentralized exchange be held responsible then, if there is no central authority? Marco GAUER admits that there is no sense in regulating it: “No authority can stop Bitcoin, it's just accepted that it exists. There is no person to whom to send the letter. The same logic applies to the cryptocurrency exchanges. It's difficult to comply to the rules of 180 countries today and in future. If the exchange is decentralized, then there is nobody who can be asked to change it or stop it, and nobody can confiscate the assets.”

But it’s not so easy with the SEC. In their opinion, someone has to be in charge and thus take all the consequences. Surprisingly or not, but it’s the creators of the code to be implied with responsibility, according to Robert COHEN. He claimed that despite the developers are “not around” to oversee things in a direct manner, the customers are ultimately connected with their code. Following this logic, the code creators remain responsible as they would be if they were serving as executives to the organization, their responsibility must be acknowledged and handled appropriately. Zachary COBURN, founder of the decentralized EtherDelta token exchange faced problems already. The SEC charged him, and he agreed to pay a $300,000 disgorgement, $13,000 in prejudgment interest and a $75,000 penalty. The watchdog has already dealt with ICOs, crypto funds, brokers and similar personalities, but this is the first case against a crypto exchange. What kind of lessons can be learned from it?

The first one: if you are aiming at playing openly, be compliant, and legal-friendly, prepare to face liabilities if something goes wrong. Paraphrasing, you can call yourself whatever you like — if the SEC considers you as an exchange, and there is a slightest chance that there is a person or a group of people representing the whole entity, then they are the scapegoat to face it all. The EtherDelta case made it clear, you won’t be avoiding it.

Understanding that, OpenRelay, a decentralized exchange based in Kansas, USA, acted immediately. Austin ROBERTS, the founder, stated in company’s blog that they are going to take steps to ensure the compliance to the US laws and regulations. The exchange will change terms of use to make them obligatory; also it made a lot of changes in trading: “We have drastically reduced the list of tokens supported by our trading widgets to ones we are confident are not securities. Once we come up with a review process, we will start adding tokens back into our trading widgets.” After all, who wants to repeat the fate of EtherDelta? No one. Is that good for the industry? Probably not — this is a barrier, unfortunately. “If we are to drive true decentralization of currency, tokens, and trading, we can't be held hostage by the minimum business requirements of centrally controlled exchanges. If exchanges remain centralized then we are perpetuating the existing central wealth creation philosophies that pervade the existing fiat system,” comments Kaish VOHRA, CEO of decentralized mining operator.

There is a second lesson, however — it is absolutely unclear how the regulator might imply any responsibility to the decentralized exchanges with less cooperative or anonymous creators. The decentralized exchanges are blockchain-based and thus are nearly impossible to shut down. The will of the SEC to control the situation is to face difficulties. The confrontation can reach a new level in this regard. Right now it is obvious that the crypto enthusiasts bumped into another challenge. Unfortunately, the industry has to admit that the good deeds can’t go unpunished.