Decentralized, Not Deregulated — The Future Of DeFi Is Changing Following Onslaught Of Lawsuits And Criminal Investigations

A slew of lawsuits and investigations have brought crypto platforms and decentralized autonomous organizations (DAOs) under increasingly intensifying scrutiny over the past few months. For all the innovation that DAOs allow, the organizational structure is also being used by some to evade regulation. 

They do this primarily by classifying their tokens as utility tokens, which are not subject to regulation, rather than as security tokens, which are subject to regulation. But the decentralized and autonomous nature is also being used in some lawsuits to evade accountability for illegal activities. Here’s a quick rundown of some of the latest legal developments that are testing the definitions and regulatory status of DAOs and what it means for financially sensitive protocols, especially in the decentralized finance (DeFi) space. 

DAOs Have Been Used As A Loophole For Avoiding Existing Market Regulations

Take the recent case of bZeroX, later Ooki DAO, which was a platform where users could trade and lend crypto tokens on margin. With any other commodity or security, this kind of leveraged trading platform would have had to be registered as a designated contract market as well as a futures commission merchant. 

Part of that registration process would have included implementing a know-your-customer (KYC) procedure to verify the identity of participants. Said KYC could have prevented or at least reduced the collateral damage that occurred when the platform was hacked in November 2021, allegedly resulting in over $50 million in losses for crypto investors. 

When a traditional trading platform like E-Trade MS or Robinhood HOOD sustains losses, it has no effect on the account balances of individual traders on their platforms. Even if the platform an investor traded stocks or commodities on went under, that investor would still be entitled to withdraw the balance of their account.

When an unregistered DAO goes under, though, investors on the platform are at risk of being left in the lurch. In the bZeroX case, for example, DAO participants are in the midst of a legal battle over whether or not they are entitled to repayment for their losses and, if so, from whom.

Though the failure appears to be exactly the same as those of the centralized exchanges, the DAO formation made things even worse. In buying the governance token, the defendants allege that investors were equal partners in the DAO and, therefore, equally liable for the security gaps that made the platform vulnerable to hacking. But investors argue that they bought the tokens for the purpose of trading and the tokens didn’t give them sufficient control over how the DAO operates. 

In a statement on a similar case, the Securities and Exchange Commission (SEC) charged Genesis Global Capital with selling unregistered securities to investors on its Gemini Earn crypto lending platform, Gurbir S. Grewal, Director of the SEC’s Division of Enforcement said that the recent collapse of the platform underscored “the critical need for platforms offering securities to retail investors to comply with the federal securities laws. As we’ve seen time and again, the failure to do so denies investors the basic information they need to make informed investment decisions.”

Though Genesis is arguably clearly an centralized entity, what should be particularly alarming to DeFi lending protocols is the categorization of security assigned to crypto lending products. The thorny issue then becomes whether a decentralized organization can evade security law.

Recent cases like these are venturing into uncharted territory over how best to regulate crypto markets broadly and financial DAOs specifically. As the contrasting bZeroX and Genesis cases show, there are no easy answers. A tactic called “legislation by litigation” might be used heavily by regulators to curb what they believe as abuses while awaiting legislative actions, i.e., “shoot first and ask questions later”.

Regulation Is Coming, But What It Will Look Like Remains Unclear

While clear and unified legislation might still be some way off, what seems clear is that some kind of regulation will be necessary to better protect investors, clarify the parameters and risks of their investments, and generally restore trust in crypto. Commenting on the Genesis case, Former Chief of the SEC’s Office of Internet Enforcement, John Reed Stark, said, “The perilous crypto-ecosystem is a mammoth, opaque and incestuous clandestine marketplace with no transparency, no meaningful regulatory oversight and no consumer protections.”

Stark noted that an “SEC enforcement sweep” was looming which would bring more trading platforms and lending protocols under scrutiny. “Expect more crypto-runs to trigger, more crypto-defendants to be charged and more crypto-story to be told,” Stark said in a tweet earlier this month. 

As this unfolds, DAOs, especially in the DeFi space, will likely need to take steps now to prepare for new and varied compliance requirements. Different jurisdictions are likely to implement different requirements and regulations may vary depending on the nature of the DAO’s activities. 

That means readiness, flexibility, and adaptability could be vital so that the organization can pivot with as little disruption as possible along the path where new regulations form and take effect. DAO toolkits like Ink Finance offer a realistic plug-and-play solution for maximum flexibility in adaptation, the much needed integrity components for KYB/KYC, and greatly enhanced security & accountability features that can better protect against hacking while helping compliance.

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