Is decentralization the answer to DeFi's SEC problem?

The creators of the third and fourth largest DeFi (decentralized finance) protocols, Synthetix and Aave, this week took steps to further relinquish control over the networks to their token holders, ending their reign over the networks they have spent the last few years building.

Decentralizing the network is a common card played by DeFi projects to give control to their users, who can use it to vote on the future of their network without having to rely on some centralized organization.

Decentralizing also keeps regulators off the protocol creators’ backs. They generally operate without licenses—but if nobody controls the network, nobody can be held accountable by government authorities, including for securities violations, which were the downfall of crypto startup fundraising through ICOs. 

Lawyers told Decrypt that DeFi projects are destined to draw the ire of regulators, who are starting to pay more attention to the thriving, $4 billion industry. Since June 1 the amount locked up in Synthetix has quadrupled to $496 million; Aave on Sunday peaked at $600 million, a nine-fold increase.

“Developers who create a market for synthetic securities are playing with fire, period,” Josh Garcia, a partner at New York law firm Ketsal, told Decrypt. 

But the founders of Aave and Synthetix told Decrypt that there was never any risk to begin with. And even if regulators found a way to prosecute them? “It’s unstoppable,” said Stani Kulechov of Aave, the decentralized lending protocol he founded.

Out of their hands

First came the announcement from the Synthetix Foundation, the non-profit that heretofore acted as a steward over its decentralized exchange for tokenized stocks, fiat currencies and commodities. On Tuesday, the Foundation announced that it would dissolve into three DAOs (decentralized autonomous organizations). 

Decentralized lending protocol Aave followed a few days later. “Aavenomics,” proposed Kulechov, would be the latest milestone on “the journey towards a more decentralized governance.” Aavenomics introduces a bolstered governance system that lets token holders vote on future network upgrades. “In practice, we build whatever our community decides,” he said. 

There’s another angle: regulators are starting to pay more attention to decentralized finance. Earlier this month, the US Securities and Exchange Commission and the CFTC, pounced on San Francisco-based crypto stocks platform Abra, and prevented it from offering tokenized versions of stocks and fiat currencies. 

That’s similar to the product offered by Synthetix—only Synthetix’s users trade among themselves and the protocol’s owners don’t collect fees, whereas Abra is a for-profit entity that executes trades on its platform on behalf of its customers, Kain Warwick, the former director of the Synthetix Foundation, told Decrypt. 

Both Kulechov and Warwick said that their announcements this week were not related to the Abra case. Kulechov said he’d been working on Aavenomics since the day after Aave launched, January 8, and that he published the proposal as soon as his protocol swelled with money. “We feel that our team should not govern the future of something that is [a] public goods in its nature,” he said. 

Warwick said that his announcement followed the commencement of the Australian tax year—not Abra. He has gunned for the Foundation’s dissolution ever since 2018—it was a “mistake” to create it, he said; hiding behind a non-profit is a “net negative” for a decentralized protocol, he wrote on Tuesday. 

Still, perhaps their announcements came just in the nick of time. The Abra case made things clear: regulators are quickly picking up on crypto finance. 

“Without naming names, DeFi is littered with apparent [regulatory] violations that regulators have yet to enforce against,” Preston Bryne, a crypto-specialist for legal firm Anderson Kill who said he was unfamiliar with Synthetix or Aavenomics, told Decrypt. Those promoting DeFi projects “are taking a very big gamble by doing things in a noncompliant fashion,” he said.

Projects that aren’t sufficiently decentralized could soon be caught out. Kulechov previously told Decrypt that he’s lawyering up. “In our case, we have to increase our legal resources and ensure that our protocol is sufficiently decentralized,” he said. 

But neither Warwick nor Kulechov are deeply concerned by regulators. Warwick said that his company has been careful to avoid the missteps of previous crypto projects. “We've been very careful to ensure that any clear lines that regulators have drawn—we didn't step across.” He added, “we've never actually had a regulator reach out and raise any questions or concerns about what we've been doing.”

Garcia added that the SEC may still come for DeFi just like it came for ICOs, the fundraising method du jour for crypto projects a couple years ago. Kik, Telegram, Gladius and Block.One are among projects that have bled money fighting lawsuits.  “The SEC is likely to hold – and has historically held – developers responsible for launching unregistered securities exchanges,” he said.

Kulechov said his plan is to become sufficiently decentralized—i.e. with no central point of accountability for a regulator to bite at. “From a regulatory perspective, for example, Ethereum is seen as decentralized enough [because] it does not have an entity behind [it],” he said.

The term, “sufficiently decentralized,” was coined by SEC's William Hinman in a speech about Ethereum and the Howey Test in 2018. Should a network be “sufficiently decentralized,” he said–“where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts”–then “regulating the tokens or coins that function on them as securities may not be required.”

Kulechov said It’s tough to tell whether Aave is currently at risk. “I think it’s difficult to assess as there is no framework for decentralized finance at the moment, but I guess all protocols need to mind that some regulation might apply if they are not sufficiently decentralized. The ‘sufficiently’ part is the challenging one.”

It’s a gray area, one he said is “painful for regulators.” Since Kulechov doesn’t actually operate the protocol, nor does he collect any fees, it’s a stretch for regulators to call it an unlicensed money transmitter, he said. “It’s [a] peer-to-Smart-Contract system.” 

Garcia, the lawyer, said that “decentralization” is a mushy word. “When people say ‘decentralized,’ it can mean a dozen different things. For instance, a project can claim to be decentralized but may have centralized administrative rights or governance control over the core protocol. 

“A term without definition cannot be a reliable shield,” he said. “Regulators will look to the facts and circumstances of each case, and will not rely on a company’s marketing to make an enforcement decision.”

Should anyone doubt him, there’s a graveyard full of “decentralized” ICO projects, buried due to their cases with the SEC, that would beg to differ.