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Regulators Will Crush DeFi Unless It Becomes Truly Decentralized

DeFi needs to live up to its name if it wants to survive scrutiny from U.S. regulators.

Shutterstock photo by By Ruigsantos

Key Takeaways

  • Abra was conducting synthetic swaps, drawing the attention of U.S regulators
  • DeFi protocols need to decentralized their governance mechanisms
  • Only two DeFi protocols with more than $100 million of locked liquidity have mitigated major regulatory risks

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After the SEC and CFTC’s orders against California based Abra, the next target could be DeFi more broadly. All of the major DeFi protocols must further decentralize their governance if they want to avoid the wrath of regulators.

Making Sense of the SEC’s Actions

Abra is paying a $150,000 fine to both the SEC and CFTC for “offering and selling security-based swaps to retail investors without registration and for failing to transact those swaps on a registered national exchange.”

To elaborate, Abra is a financial application that gives its users an easy way to trade cryptocurrency and equities. The company would rout customer orders to a company in the Philippines that took the other side of the customer’s position. All of this was done synthetically, meaning the actual security wasn’t changing hands; it was just a derivative contract.

Abra’s actions violated securities laws and derivatives trading laws, forcing both SEC and CFTC to hound the company.

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Many believe this is a strong reason to turn to DeFi. However, with the way DeFi is structured today, the SEC could crush these projects Whether they can successfully shut down dApps run by foreign teams is only one side of the story. Even if the Commission can’t shut down companies, they can crash token prices through regulatory actions, crippling DeFi users in the United States.

How DeFi Makes it Out Alive

The only solution is to streamline the process of decentralizing protocol governance beyond mere tokens that facilitates on-chain voting.

A governance token decentralizes decisions that are to be put into force, but it doesn’t decentralize execution. For example, COMP holders get to vote on whether a new form of collateral is added to the protocol and what the risk parameters should look like.

The entity proposing the change can even submit the code that needs to be implemented for the proposal to go live. However, the actual act of putting that new code into the existing codebase can only be done by whoever has the admin key to make protocol changes. In this case, that is Compound Labs.

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The SEC can cut blood flow to the Compound ecosystem by targeting Compound Labs, an incorporated entity under the purview of the SEC. Yet, even with this critical point of failure, Compound is still considered DeFi. If the admin keys were in the hands of a DAO governed by thousands of people, this would be an entirely different story.

For protocols like Synthetix, the risk of the SEC coming to bite them is much higher. Synthetix listed synthetic variants of Japan’s NIKKEI index and the UK’s FTSE 100 on its exchange. Despite user demand for the S&P 500, this wasn’t a choice when Discord members voted on which indices to include, presumably to avoid drawing the ire of U.S. regulators.

Synthetix has promised to transition to a fully decentralized governance framework. The first steps are already in place via the ProtocolDAO. However, this risk will exist until the admin keys are transferred out of the hands of a few core members.

Of the top DeFi protocols, only Maker, Uniswap, and InstaDapp are not as susceptible to this risk as core members do not control admin keys. Most dApps have timelocks on admin changes so users can decide to either keep their funds if they are in support of the change or move their funds from the protocol. This control is useful in giving users a choice and headstart but doesn’t mitigate regulatory risks.

In short, there is only one thing DeFi can do to save itself—decentralize, and decentralize fast. Considering the speed at which adoption of the niche is picking up, regulators may already have their sights on DeFi.

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