We've seen a range of regulatory attacks against crypto in the past few weeks. Most recently, the U.S. Securities and Exchange Commission (SEC) went after the trading platform Kraken. Although Kraken decided to settle, and they did not agree to any wrongdoing, the regulatory action still cost them substantial time and money -- roughly $30 million in the settlement alone.
Core to the SEC's offense was that Kraken is a centralized custodian with staking products that function as investment contracts. Many legal scholars view their interpretation as fundamentally incorrect -- that lending and staking are qualitatively different because the former has counterpart risk and the latter does not -- but that has not stopped the SEC from going after many crypto companies and to legislate through regulatory action.
But setting aside the important differences between staking and lending, there is an even more important question about the degree of centralization in a platform. Put simply, one of the criteria for defining a security -- even according to the most stringent definition taken by the current SEC with the Howey Test -- is that there is "common enterprise." That's clearly the case with centralized crypto, but what about with decentralized finance and decentralized exchanges?
Recent advances in cryptography are making it possible for DeFi to comply with KYC/AML regulation without having to give away the identities of its users. These methods -- often referred to as zero knowledge proofs -- involve the presentation of extremely computationally intensive problems that a user can present a solution to only if they are the entity they are claiming to be. (Think of the most complicated puzzle and being asked to show the solution; you don't need to give away any of the secret steps, but just show that you have the answer, recognizing that there is no way to get the answer unless you really did the work to put all the pieces together and are telling the truth.)
If DeFi can comply with KYC/AML regulations, then they are in a qualitatively different class than their centralized counterparts when it comes to facing regulatory risk as a security.
Some people might argue that the rise of DeFi simply reflects regulatory arbitrage -- people trying to escape regulation. But my recent research in the Journal of Corporate Finance presents the results of an event study where we look at trading activity before/after a regulatory action taken by three U.S. federal agencies among decentralized and centralized exchanges; we do not find any systematic difference in trading with DEXs. In this sense, greater regulatory flexibility is a byproduct of DeFi's many benefits at empowering users.
Nonetheless, centralized platforms still have an important role to play in helping onboard new users. We'll need to figure out a middle ground because the current regulatory environment -- at least in the U.S. -- is unsustainable for innovation and economic freedom.
https://www.sciencedirect.com/science/article/abs/pii/S092911992300007X
