Please bear the following, from Commissioner Caroline A. Crenshaw statement, in your mind:

I recognize it is not the SEC’s role to prevent all investment losses. It is also not my goal to restrict investor access to fair and appropriate opportunities. But it is my job to demand that investors have equal access to critical information so they can make informed decisions whether to invest and at what price. I am similarly committed to ensuring markets are fair and free from manipulation. Given this, it seems that there are two specific structural problems that the DeFi community needs to address.

A. Lack of Transparency

First, although transactions often are recorded on a public blockchain, in important ways, DeFi investing is not transparent. I am concerned that this lack of transparency contributes to a two tier market in which professional investors and insiders reap outsized returns while retail investors take more risks, get worse pricing, and are less likely to succeed over time. Much of DeFi is funded by venture capital and other professional investors. It is unclear to me how well known this is in the DeFi retail investor community, but the underlying funding deals often grant professional investors equity, options, advisory roles, access to project team management, formal or informal say on governance and operations, anti-dilution rights, and the ability to distribute controlling interests to allies, among other benefits. Rarely are these arrangements disclosed, but they can have a significant impact on investment values and outcomes. Retail investors are already operating at a significant disadvantage to professional investors in DeFi, and this information imbalance exacerbates the problem. 

Some contend that DeFi is, in fact, more egalitarian and transparent because much of the activity is based on code that is publicly available. However, only a relatively small group of people can actually read and understand that code, and even highly-qualified experts miss flaws or hazards. Currently the quality of that code can vary drastically, and has a significant impact on investment outcomes and security. If DeFi has ambitions of reaching a broad investing pool, it should not assume a significant portion of that population can or wants to run their own testnet to understand the risks associated with the code on which their investment prospects rely. It is not reasonable to build a financial system that demands investors also be sophisticated interpreters of complex code. 

Put simply, if a retail investor has $2,000 to invest in a risky programmable asset, it is not cost effective for that investor to hire experts to audit the code to ensure it will behave as advertised. Instead, retail investors must rely on information available through marketing, advertising, word of mouth, and social media. Professional investors, on the other hand, can afford to hire technical experts, engineers, economists, and others, before making an investment decision. While this professional advantage exists historically in our financial markets, DeFi exacerbates it. DeFi removes intermediaries that perform important gatekeeping functions and operates outside the existing investor and market protection regime. That can leave retail investors without access to professional financial advisors or other intermediaries who help screen potential investments for quality and legitimacy. These provide meaningful fraud reduction and risk assessment assistance in traditional finance, but there are limited substitutes in DeFi. 

B. Pseudonymity

A second foundational challenge for DeFi is that these markets are vulnerable to difficult to detect manipulation. DeFi transactions occur on a blockchain, and each transaction is recorded, immutable, and available for all to see. But that visibility extends only down to a certain identifier. Because of pseudonymity, the blockchain displays the blockchain address that sent or received assets, but not the identity of the person who controls it. 

Without an efficient method for determining the actual identity of traders, or owners of smart contracts, it is very difficult to know if asset prices and trading volumes reflect organic interest or are the product of manipulative trading by, for example, one person using bots to operate multiple wallets, or a group of people trading collusively. There are specific U.S. securities laws prohibiting trading for the purpose of giving the false appearance of market activity or to manipulate the price of a security, because successful investing depends on reliable information and market integrity. Pseudonymity makes it much easier to conceal manipulative activity and almost impossible for an investor to distinguish an individual engaging in manipulative trading from normal organic trading activity. In DeFi, because markets often turn on asset price, trading volumes, and momentum, investors are vulnerable to losses due to manipulative trading that makes those signals unreliable. To the extent transactions occur off public blockchains, it is even more difficult to assess whether trading is legitimate.

I recognize that in some ways DeFi is synonymous with pseudonymous. The use of alphanumeric strings that obscure real world identity was a core feature of Bitcoin and has been present in essentially all blockchains that have followed. But in the U.S., investors have long been comfortable with a compromise in which they give up some limited degree of privacy by sharing their identity with the entity through which they trade securities. In return, they benefit from regulated markets that are more fair, orderly, and efficient, with less manipulation and fraud.   

In moving to DeFi, I suspect most retail investors are not doing so because they seek greater privacy; they are seeking better returns than they believe they can find from other investments.  While some in DeFi believe in absolute financial privacy, I expect that projects that solve for pseudonymity are more likely to succeed, because investors can then be comfortable that asset prices reflect actual interest from real investors, not prices pumped by hidden manipulators.  Projects that address this problem are also more likely to be able to comply with SEC regulations and other legal obligations, including requirements around anti-money laundering and countering the financing of terrorism imposed by the Bank Secrecy Act.

Dapplication tech is committed to helping users to overcome those deficiencies. We solve the problems taking over the DeFi space by developing ethical tools that prioritise the user’s protection. There are many exciting things coming your way!