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SEC Sends a Demoralizing Warning to DeFi, the Bank Killers

The SEC and the states slap a $100 million fine on crypto firm BlockFi and indirectly signal that no financial startup is out of reach.
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The agreement between the Securities and Exchange Commission and BlockFi shocked the world of decentralized finance, known as DeFi. 

The players in this emerging industry, which makes no secret of its intention to relegate traditional banks to oblivion and promises financial inclusion, are still analyzing the message the federal regulator and the states sent to them. 

But judging by the very few official reactions or the refusal to speak on the issue, it is an understatement to say that the SEC has sent over a bombshell into the industry.

The $100 million settlement "Is A Watershed Moment For Crypto Industry," wrote Anthony Pompliano, a crypto investor and one of the most important influencers in the cryptosphere.  

DeFi simply aims to offer financial services without intermediaries. In the traditional financial system, the banks are the main depositories of the funds and that guarantee the exchanges. With DeFi, users keep their funds in their personal wallets. Transactions are made directly from user to user via the blockchain and digital contracts (called smart contracts) created by specific apps.)

The Settlement: What Led Up to It?

BlockFi, one of the pioneer crypto startups, agreed with the SEC and states to settle an investigation into one of its star products. The crypto startup was fined $100 million.

Worse, BlockFi will have to register its savings-account product, BIA, as a security, which raises the question of its competitiveness against traditional banks.

The portfolio of BlockFi, one of the pioneering startups in DeFi -- no middlemen -- is the envy of rivals and mainstream banks. The group has developed a host of products including lending against crypto collateral, interest-bearing accounts, crypto exchange and a credit card whose benefits are remunerated in bitcoin. 

BlockFi is also known for developing interest-bearing accounts and the bitcoin credit card.

It is this product, BlockFi Interest Account (BIA), that has been the subject of SEC investigations since last summer. It resembles the savings accounts offered by traditional bank -- with the only difference that BlockFi offers a 9% interest rate, a huge opportunity in the current period of near zero rates (the Federal Reserve is expected to raise rates several times this year to curb inflation.

One of the reasons BlockFi and other DeFi firms offer high interest rates is that they share the majority of savings-account earnings with savers. You add to this an imbalance between supply and demand. 

BlockFi had calculated that by offering these accounts in bitcoin and cryptocurrency, instead of dollars, the company would not have to comply with the legal rules imposed on banks.

The SEC decided otherwise. As reported by TheStreet, the regulator declared that what the Jersey City, N.J., firm called BlockFi interest accounts were securities and required registration.

"The order finds that BlockFi operated for more than 18 months as an unregistered investment company because it issued securities and also held more than 40 percent of its total assets, excluding cash, in investment securities, including loans of crypto assets to institutional borrowers,” the SEC said.

If the SEC offensive is strongly criticized by crypto fans on social media, influential voices in the sphere do not share this anger. In addition to Pompliano, the billionaire bitcoin evangelist Michael Saylor spoke differently.

"If you are going to invest in any #crypto asset, operate a crypto business, or opine on the future of the crypto economy, you need to understand securities law," Saylor posted on Twitter.

What Are the Settlement's Implications for DeFi?

The SEC is taking a "pretty really proactive approach, offensive approach against the DeFi space," digital-asset attorney Max Dilendorf from the Dilendorf Law Firm told TheStreet. 

For Dilendorf, the SEC move strikes at the heart of the DeFi protocols business model.

"They turn the business model upside down, right! So if you want to operate in the United States, we think that the products that you're selling may be securities right? If you want to operate in the United States you have to pretty much go public; you have to file an S-1 statement," Dilendorf explained. 

"That's a really, really heavy burden. So a company like BlockFi may be able to pull it off, but can other smaller DeFi protocols that don't have a $3 billion valuation? They will get wiped out. How can a $20 million startup afford to become publicly traded?"

This is all the more worrying for DeFi since in January the SEC made public a document that caused a stir. 

In this 654-page document, which does not mention the words crypto and blockchain, the regulator says it now can regulate so-called "communications protocols systems." It did not define the term, but basically the agency can apply it to any decentralized exchange or to any sort of semidecentralized protocol, says Dilendorf.

"Because those definitions are so broad. So if you and I were trading on a decentralized protocol exchange, technically, we can both fall under the exchanger definition. And what this means is if we're both exchangers, right, then we become subject to a so-called Bank Secrecy Act. If we're subject to a Bank Secrecy Act, then we have to be registered with" the U.S. Treasury's Financial Crimes Enforcement Network, Dilendorf added.

The settlement with BlockFi has thrown even more confusion into the regulation, he said. Dilendorf says more cases will be coming out in the next six to nine months, explaining that communication protocols apply to DeFi platforms.

He advised DeFi platforms to "slow down, evaluate what's happening, and to try to understand whether or not [the] Bank Secrecy Act applies to you."

As for DeFi traders, Dilendorf said they should call their banks and tell them they technically cannot explain the source of funds as they don't know the identities of the people with whom they are trading.

What Do DeFi Players Think? 

Industry players who have agreed to speak officially agree that the accord between the SEC and BlockFi augurs for a tightening of regulation for DeFi. They differ, however, on the meaning to be given to the SEC offensive.

"I believe this could be an indicator of heavier regulation coming for the industry," said Yubo Ruan, founder of Parallel Finance, a DeFi platform. "Many DeFi products offer unregistered securities and will be required to comply if regulators increase their focus on DeFi."

Ruan urged his peers to be cautious: "The SEC is very likely to pursue big DeFi brands. Overall this settlement is a positive step towards clearer regulation, which enables more stability for users of DeFi ultimately."

Brian Mahoney, co-founder at Alkemi Network, agrees. He sees the settlement as "a step in the right direction from a regulatory clarity perspective."

The settlement "shows they are willing to work with crypto players to find common ground," he said. "However, for Defi, regulatory clarity still remains unclear. BlockFi is a centralized player offering yields through custody of users' funds. This is a fundamentally different approach to how DeFi functions."

On the other hand, Ran Hammer, vice president at blockchain infrastructure provider BizDev Orbs, is unhappy with what he calls the lack of clarity arising from the case.

"There is no real difference between this settlement with a centralized company," he said. "BlockFi actively managed deposited funds and its ability to pay interest was based on this entity's business decisions, and the SEC's position on this type of platform is clear. We are still waiting for clarity on how the SEC (and the courts) would treat a decentralized platform that doesn't have a specific person that makes decisions."

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