On September 7, 2023, the Commodity Futures Trading Commission (CFTC) simultaneously filed and settled charges against three decentralized finance (DeFi) platforms, signaling an important step toward CFTC regulatory oversight in the DeFi space. All three DeFi platforms offered or made available for trading contracts based on various cryptocurrencies and digital assets, including swaps and other derivatives under the Commodity Exchange Act (CEA) and CFTC regulations.
The CFTC’s enforcement actions targeted Opyn, Inc., ZeroEx, Inc., and Deridex, Inc., accusing each company of illegally offering financial products, including derivatives, to U.S. citizens without proper registration with the CFTC.(1) Many legal analysts say the recent enforcement actions herald the end of DeFi activities in the United States.(2) Although these claims may seem exaggerated, they are not without merit.(3) The US Treasury Department’s recent book “Illicit Finance Risk Assessment of Decentralized Finance” warned decentralized operators that the more centralized and concentrated control a defined group exercises over a protocol (even a protocol claiming to be decentralized), the greater the risk. to be recognized as an “unincorporated association” and therefore a target for regulatory enforcement.(4)
Some market participants view these regulatory measures as a targeted response to growing apprehensions about the risks associated with unregulated leveraged and margin retail trading in the rapidly evolving DeFi sector.(5) However, a significant portion of the industry and regulators argue that rather than stifling DeFi’s growth, these coercive measures could serve as a necessary push to cultivate more robust and transparent operational frameworks, thereby promoting the sustainable development of the sector.
OPYN, INC. : oSQTH AND REGULATORY COMPLIANCE
Opyn, Inc. offered a digital asset derivatives token known as oSQTH through its Opyn protocol.(6) The token’s value was tied to Opyn’s proprietary index, Squeeth, which “tracked the price of ether squared against USDC.”(7) Opyn allowed users to enter long and short oSQTH positions. The CFTC determined that oSQTH tokens represented swaps and leveraged retail commodity transactions, placing their offering within the CFTC’s regulatory framework, and charged Opyn with failing to register as a trading center Swap Execution Facility (SEF) and neglecting to limit retail access to eligible contract participants, as is the case. required for SEF under the CEA.(8) Despite some efforts to comply with CEA requirements, “such as preventing users with U.S. Internet Protocol addresses” from accessing the Opyn protocol, these efforts were not entirely “sufficient to actually prevent U.S. users from accessing the Opyn protocol.” Opyn protocol”, in accordance with the CFTC. position.(9) Opyn was also accused of engaging in activities that should have been exclusive to registered futures commission merchants (FCMs), including deploying the Opyn protocol for leveraged trading and failing to establish a customer identification program consistent with Bank Secrecy Act (BSA) requirements.(ten) Additionally, Opyn lacked the necessary prerequisites “to implement KYC and anti-money laundering procedures” by not requiring users to provide identifying information when registering on the platform.(11) Opyn was ordered to pay a civil penalty of $250,000.(12)
DERIDEX, INC. : PERPETUAL CONTRACTS AND REGULATORY WASTE
Deridex, Inc. has faced similar allegations regarding its Deridex Protocol. The Deridex protocol used smart contracts to offer positions in leveraged derivatives, which the CFTC characterized as swaps within the meaning of the CEA (that’s to say, “perpetual contracts” without delivery of a commodity), further emphasizing the position firmly held by the CFTC that so-called perpetual contracts are swaps.(13) Deridex was also instructed to operate as an unregistered SEF by facilitating trades between multiple participants and engaging in activities exclusive to registered FCMs, such as soliciting users to deposit assets for retail transactions of leveraged raw materials.(14) Like Opyn, Deridex failed to implement a customer identification program and took no effective steps to exclude U.S. users.(15) Deridex was ordered to pay a civil penalty of $100,000.(16)
ZEROEX, INC. : OX PROTOCOL AND REGULATORY IMPLICATIONS
ZeroEx, Inc. was charged for its Ox protocol and front-end application, Matcha, which allowed users to trade various digital assets, including leveraged tokens from third-party issuers.(17) The CFTC alleged that these leveraged tokens were retail commodity transactions “with customers who were not eligible contract participants or eligible business entities,” requiring registration and compliance with the regulations of the CFTC and CEA.(18) ZeroEx, Inc. was ordered to pay a civil penalty of $200,000.(19)
DISSENTING OPINION AND REGULATORY CONCERNS
Notably, a dissenting opinion from CFTC Commissioner Summer Mersinger accompanied these coercive measures.(20) She raised concerns about the basis for imposing sanctions on DeFi protocols, noting that the CFTC provided no “indication that customer funds (had) been misappropriated or that market participants (had) ) been victims of the DeFi protocols on which the Commission (had) released its enforcement powers.(21) Commissioner Mersinger also questioned whether enforcement measures were suitable to address the complex regulatory questions posed by DeFi protocols, suggesting that rulemaking and stakeholder engagement could provide a more comprehensive approach.(22) She highlighted the need to balance regulatory oversight with the promotion of responsible innovation and stakeholder engagement.(23)
The CFTC’s recent enforcement actions demonstrate its commitment to addressing regulatory challenges in the digital assets space, particularly in response to the growing demand for regulatory intervention in the DeFi sector. The CFTC has remained steadfast in its position that when offering commodity derivative products based on digital assets to the public, whether in a centralized or decentralized manner, laws and regulations must be followed.
In the absence of comprehensive regulations specific to digital asset products, retail clients have been left vulnerable and without established safeguards that are present in traditional asset classes. The prevalence of information asymmetries within DeFi protocols, even in regulated markets, presents risks that must be mitigated to protect customers. These enforcement measures demonstrate a subtle but important challenge for DeFi platforms: striving to integrate the pioneering and decentralized nature of their technologies while respecting the complex and particularly demanding compliance framework of US law. The promise of transparency and efficiency of DeFi platforms through blockchain technology may be compromised by operational designs that centralize certain functions “off-chain,” leading to a lack of transparency and regulatory clarity. The CFTC’s actions aim to strike a balance between innovation and protection of market participants while addressing the challenges posed by DeFi protocols.
The CFTC’s recent tough approach to regulatory enforcement has sparked a debate about whether the current trend toward regulation by enforcement threatens the viability of DeFi in the United States. To preserve the dynamism of the US crypto industry (barring or perhaps in conjunction with more definitive legislation), fostering collaborative and practical regulation for DeFi companies will be essential.