SEC Commissioner Caroline Crenshaw has highlighted some perceived drawbacks of decentralized finance (DeFi) in a post on the SEC website titled “Statement on DeFi Risks, Regulations, and Opportunities”. She cited a lack of transparency and pseudonymity as two structural problems DeFi needs to overcome.
On the other hand, Crenshaw praised US capital markets for being “well-regulated,” adding that they tend to flourish because of their reliability. However, a closer look suggests they share some of the same problems DeFi is being scrutinized for in the SEC’s post.
Lack of Regulation In DeFi
Crenshaw stated that the unregulated nature of DeFi raises a number of structural limitations. She said that market participants who raise capital in legacy finance generally take on legal obligations, whereas there is no such thing in DeFi. Instead, DeFi projects disclose broadly that investments may result in losses and advocate a “buyer beware” approach.
She acknowledged that DeFi has been successful in disrupting legacy finance by providing more efficient alternative methods, but noted that “certain truths apply with as much force in DeFi as they do in traditional finance.”
Crenshaw admitted that rich investors and insiders have primary access to information in legacy finance, but claimed the same might be true of DeFi. She insisted that the regulatory force in TradFi seeks to address such problems and help the markets function better.
“In the brave new DeFi world, to date there has not been broad adoption of regulatory frameworks that deliver important protections in other markets.”
Nevertheless, Crenshaw noted that there are two specific structural problems in DeFi that stand out: a lack of transparency and pseudonymity.
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Transparency For DeFi vs. TradFi
In DeFi, transactions are recorded on a public blockchain that is easily accessible to everyone. In fact, it is for this reason that DeFi is considered to promote transparency, build trust among users, and encourage innovation. However, Crenshaw believes DeFi is not transparent, saying:
“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.”
One might argue that the above quote precisely describes TradFi, where alternative trading systems (ATSs), commonly referred to as dark pools, are opaque. Dark pools, which account for over 40% of the global equity market, obscure trades and eliminate transparency since orders don’t show up on the exchange’s order books.
All this became a matter of public knowledge when it was speculated whether Citadel Connect is a dark pool. For those not aware of the Robinhood saga in Janurary, after the hypocrisy with GME, it was revealed that Citadel Securities LLC, the largest Designated Market Maker (DMM) on the NYSE, accounts for a significant portion of Robinhood’s revenue.
Moreover, Crenshaw argued that since most of the public can’t read or write code, the fact that most DeFi code is open source and publicly available doesn’t really promote transparency.
“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.”
While the argument might be partially true, it fails to recognize that there are other means that retail and the public can use to make sure the code is solid. Decentralized platforms such as GitHub allow peer reviewing from coding experts to test and verify any written code is solid. Blockchain also has tools at its disposal to counteract bad actors and fix coding issues, such as the Ethereum community which reverted back to a previous block using a hard fork when the network was compromised, resulting in the creation of two networks: Ethereum and Ethereum Classic.
A report by the Financial Times also reveals that younger investors are shunned by traditional advisers, and are turning to apps and digital platforms for financial advice.
As per the report, independent financial advisers (IFA) hardly accept an average metropolitan millennial as a client. “Yet call up an IFA, and your youthful voice will be interpreted as the sound of a client with very little money and very few assets,” the report noted, adding that in 2017, half of all IFAs turned away clients with less than $67,000 (£50,000) to invest.
Consequently, younger investors turn to online digital wealth managers to get investment advice, sometimes for as little as $1. Similarly, retail investors can use such platforms to receive investment advice regarding DeFi projects at a considerably low cost.
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About the author
Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird’s US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firms specializing in sensing, protection and control solutions.