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DeFi eliminates the need for an intermediary via its smart contracts and decentralized applications (dApps) that run on blockchains. As a result, many financial institutions integrate these dApps into their system using NFTs and DeFi popular digital currency bitcoin. However, while DeFi’s opportunities attract attention, it poses some challenges and risks for investors, financial institutions, and regulators like SEC.
Although the SEC commissioner had recently welcomed these DeFi opportunities, she emphasized that it needs compliance. According to commissioner Caroline Crenshaw, the idea is to enable DeFi to address the issues of Pseudonymity and transparency. This article explains why DeFi needs compliance, how the SEC would help DeFi handle these issues, and much more besides.
The Securities Exchange Commission had earlier announced her intention to apply the existing laws on securities to DeFi. This old security law applies to all blockchain-enabled projects with the related investment objective. However, the SEC commissioner explained this in her article for the inaugural issue of the International Journal of Blockchain Law.
She laid out her belief that DeFi has potential but needs better regulatory compliance. This compliance will help curtail its associated risk as explained below. It will also help retail investors take informed investment decisions before seizing any investment opportunity.
This is a state of disguised identity synonymous with DeFi and many users use it for privacy. They use it to shield their identity as part of a move towards self-sovereignty or for personal security. Crenshaw explained that DeFi’s propensity to pseudonymity is the reason why markets are vulnerable to manipulation. She noted that the SEC is responsible and capable of preventing this from happening.
DeFi pseudonymity makes it difficult to determine traders’ identity, smart contract owners, and trading volumes or asset prices. Hence, there would be no effective means of knowing when prices and trading volumes are real or manipulated. For instance, determining when a user operates multiple wallets or when a group of merchants trades collusively.
Lack of transparency is another risk that Crenshaw needs the DeFi community to address. The SEC commissioner stated that it is the regulator’s responsibility to allow investors access to important information that will guide their investment decisions. Although DeFi uses open-source code and records all transactions on a public chain, it still doesn’t make it transparent enough.
Crenshaw explained that DeFi is largely funded by venture capitalists and their contributions give DeFi access to many project arrangements. The fact that these professional investors have more ample resources makes them audit projects before investing in them. This makes the retail investors operate at a more disadvantageous level compared to the professional investors. They have lower resources and hardly audit projects, this imbalance in information only makes the problem get worse.
The rapid expansion and adoption of DeFi have attracted the concern of the regulators-Securities and Exchange Commission. The major pointer according to the SEC commissioner is the lack of traders' identity and transparency synonymous with DeFi. She emphasized that it’s the responsibility of the regulator to minimize these risks through their laws on securities.
Crenshaw, while disclosing her belief in DeFi opportunities, called on DeFi users to ensure involuntary compliance. Although they are not resorting to forcing anyone, she warned that defaulters would be sanctioned.
The Commissioner added that DeFi can remain a financial instrument maintaining its self-executing smart contracts. She warned that the regulatory body would likely enforce more actions against defaulters. She later advised promoters in doubt to quest for guidance before proceeding to market.