Regulators Continue their Two-Front Attack on DLT Exchanges Clearing the Way for the hDEX

REGULATORS CONTINUE THEIR TWO-FRONT ATTACK ON DLT EXCHANGES CLEARING THE WAY FOR THE HDEX

This month, regulatory focus has intensified around conventional, centralized digital asset exchanges exposing their weaknesses and reminding the market that if you do not control your private keys, you do not control your assets.

In apparent anticipation of the vacuum that taking down large, centralized exchanges would create, regulators also ratcheted up their attacks on decentralized platforms. Though concerning, these actions make clear the need for a legal-first hDEX.

ACTIONS AGAINST CENTRALIZED EXCHANGES

Binance is facing an extensive international arbitration action after Binance limited the account access of hundreds of crypto traders from a broad swath of countries without any clear explanation or recourse. Binance undertook these drastic moves because regulators around the globe are cracking down on the exchange’s lax regulatory approach and lack of know your customer (“KYC”) programs. These actions by regulators led banks to stop doing business with Binance, which has led to the exchange suffering a severe capital crunch.

Poloniex LLC will pay nearly $10.4 million to settle claims that it acted as an unregistered exchange for digital assets that qualified as securities. This settlement occurred even though Poloniex implemented a digital asset "listing process" that examined whether listed tokens were securities, established an internal executive risk committee, and created an in-house "token" legal team. The SEC cited, among other things, the fact that Poloniex said internally that it wanted to be "aggressive" in listing tokens to support its position that Poloniex prioritized profits over compliance.

BitMEX recently settled with the Commodity Futures Trading Commission ("CFTC") and the Financial Crimes Enforcement Network (“FinCEN”) over allegations that it offered derivatives to U.S. persons without the requisite registrations, and did not have adequate AML/KYC controls in place which led to customers being able to trade on BitMEX after only collecting an email address and not effectively screening out U.S. customers who use a VPN. BitMEX agreed to pay $100 million to settle these civil actions, but still faces criminal investigations. Relatedly, Coinbase announced that it plans to use a substantial part of its $4 billion cash stockpile to prepare for greater scrutiny in the U.S. and elsewhere.

ACTIONS AGAINST DECENTRALIZED EXCHANGES

In response to the increasing regulatory pressure on centralized exchanges, blockchain developers and traders have turned to decentralized finance (“DeFi”). DeFi should alleviate the need for increased oversight since these platforms do not custody customer funds. However, Gary Gensler, Chairman of the Securities and Exchange Commission (“SEC”), has contended that DeFi projects that allocate tokens or other incentives to project participants could warrant regulation without regard to their level of decentralization.

Gensler also recently argued that the DeFi label is often a misnomer because few projects are actually decentralized. As a result, simply claiming that a project is decentralized will not be enough in the eyes of regulators.

These comments by Gensler are not isolated. Earlier this month, the SEC brought its first enforcement action against a DeFi company, Blockchain Credit Partners. The SEC argued that the project’s creators misled investors and sold $30 million in digital tokens in violation of U.S. securities law. The SEC drew attention to the fact that the project’s leadership was divided between two people and the holders of governance tokens had “no role in running [the company]’s core business.” As a result, the project’s purported “decentralization” did not save it.

In this period of increased regulatory scrutiny, Gensler has asked congressional representatives for additional authorization with a focus on DeFi platforms. This is important because Gensler wants to regulate blockchain further but feels that he must secure congressional authorization to extend the SECs reach to do so. Blockchain regulation, particularly focused on DeFi projects, will be a major part of Congress’ legislative agenda moving forward. The desire to “capture DeFi” probably motivated the restrictive reporting language in the infrastructure bill affecting cryptocurrency and blockchain users.

The House Rules Committee has formally voted to block further amendments to the infrastructure bill, meaning that it will be very difficult to change the blockchain reporting provisions before it is signed into law. The Blockchain Association is exploring a way to temper the impact of the bill’s current language, which includes a future tax extenders package or modifying the language in the upcoming reconciliation legislation.

As the pressure to regulate intensifies, regulators seen as being friendly to blockchain such as CFTC Commissioner Brian Quintenz have shouldered the burden of tempering regulatory excesses. Quintenz recently defended the CFTC's jurisdiction against potential SEC overreach when he asserted sole jurisdiction over a futures contract on ETH. However, Brian Quintenz plans to step down by August 31, and it is yet to be seen how the CFTC’s posture will evolve.

DeFi presents an incredible opportunity for technological innovation and consumer protections, but it must abide by existing regulations and anticipate how regulators will act in the near future. For instance, DeFi projects should have a risk-based anti-money laundering program; they should be “Legal First.”

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