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DeFi and Credit Risk
Gary Gensler, chairman of the Securities and Exchange Commission, often quotes James Whitcomb Riley when asked about cryptocurrencies. Riley once said, "When I see a bird that walks like a duck, swims like a duck, and quacks like a duck, I call that bird a duck."
According to Gensler's "duck test," the great majority of cryptocurrency ventures are actually unregistered securities with little room for doubt. Gensler believed that almost all of them satisfied the more traditional Howey Test criterion for that.
Although it's a lovely statement, the analogy might not be the best. After all, a more well-known literary allusion uses the image of the duck to warn kids that initial impressions aren't always accurate.
A newborn cygnet is wrongly believed to be a member of a barnyard mother duck's brood in Hans Christian Andersen's classic fairy tale "The Ugly Duckling," and is ridiculed for being so unattractive in comparison to the other ducklings. It eventually runs away from the farm and develops into a stunning, graceful swan.
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Let's face it, many cryptocurrency ventures are first quite unattractive.
When Bitcoin was four years old, in 2013, its blockchain experienced an unintentional hard fork when miners mistakenly began creating two different chains due to a failure to reconcile two versions of its code. One year later, a hacker leveraged the alleged "malleability issue" to assault the Bitcoin network in a debilitating denial-of-service attack, and other users of the same exploit used it to steal bitcoin from the failed exchange Mt. Gox. Then, in 2016, a hacker discovered a flaw in the smart contract code for the decentralized investment initiative The DAO and drained it of $60 million worth of ether, throwing the two-year-old Ethereum into a major crisis.
The decisive leadership of core teams of Bitcoin and Ethereum developers allowed for the resolution of the problems in all three instances. In the first and third cases, the interventions required organizing a rollback in the blockchain with user agreement to undo transactions that had already been made following the attack. This indicates the existence of some level of centralization during the early stages of protocol development, when it is crucial to effectively address defects and performance issues that blatantly harm the network.
Notably, as the networks for Bitcoin and Ethereum have expanded, both have grown more decentralized, making coordination of core code updates more difficult. The fact that it has taken Ethereum developers years of development work and consensus-building to transition the blockchain from proof-of-work to proof-of-stake, which is about to happen next month, is a significant indicator of this.
According to SEC statements, the latest iterations of Bitcoin and Ethereum appear to have been exempt from securities registration due to this advanced stage of decentralization. Both now fail the portion of the Howey Test that states an investment scheme is a security if investor returns depend on the labor of a select few persons. The creator and early adopters of Bitcoin are no longer involved, and the creators of Ethereum no longer have the power to impose modifications on the network.
The response taken by the SEC to these problems suggests that the transitory experiences of Bitcoin and Ethereum are the exception, not the rule. First coin offerings (ICOs), through which many cryptocurrency ventures raised their initial capital, have been referred to be securities by Gensler, who has stated that he agrees with his predecessor Jay Clayton's claim that "every ICO I've seen is a security."
Decentralized exchanges (DEX) have also been advised by him to register with the SEC. These protocol-based systems face a hurdle as a result of this: Who would decide to file the paperwork among their decentralized user and developer communities? Whose authority is this?
Such semantics won't prevent the SEC from acting if it chooses, probably against the DEX founders. The recent insider trading case against a former Coinbase (COIN) employee, which at the same time classified nine Coinbase-listed tokens as securities, serves as a reminder that, according to the general "duck test" viewpoint, all token projects besides Bitcoin and Ethereum are open to SEC enforcement.
Because of the Damocles Sword danger, many potentially lucrative ventures are forced to take unnecessary precautions, such barring users with U.S. IP addresses, which naturally limits innovation in the market.
But what's to say that other cryptocurrencies won't develop into swans in the future if Bitcoin and Ethereum did? And shouldn't policy take into account the possibility of that shift from an initial, unavoidably centralized structure to a later, uncontrollable decentralized structure? Enforcement actions have the power to derail otherwise highly promising enterprises and doom them to perpetual ugly duckling status.
The goal of SEC Commissioner Hester Peirce's proposal for a safe harbor provision for crypto projects is to facilitate this possibility of transition. It would grant cryptocurrency projects a three-year grace period to create a strong, decentralized functionality that would free them from the requirements of securities registration.
Sadly, Peirce's strategy hasn't really taken off with the other commissioners.
It's crucial that we ponder this. Since William Hinman, a former director of the SEC's Division of Corporate Finance, advanced the idea that the Ethereum network had grown "sufficiently decentralized" over time and had thus lost the security status it had at launch, it looks that Ethereum has been granted a pass.
The SEC has attempted to separate itself from what it called a "personal errand" by Hinman in its action against Ripple Labs over its XRP token, arguing that his concept on transition does not necessarily represent agency doctrine. However, Judge Sarah Netburn gave Ripple a significant victory last month when she decided that a draft of the speech, which might demonstrate how SEC employees influenced Hinman's thinking, might be included as evidence in the trial. On this one, the popcorn is ready.
Let's assume that the Hinman doctrine exists. Why would people be against giving token initiatives a chance to sufficiently decentralize? Maybe because American authorities don't see the advantages of decentralization They value having a someone they can answer to. They argue that without it, they won't be able to defend American civilians from criminals.
They fail to recognize that decentralization is essential to cryptocurrencies' fundamental value proposition. They are useless without it.
Bitcoin's decentralization makes it possible for peer-to-peer money transfers and censorship resistance. For instance, a contributor in the U.S. can give BTC to a Russian activist without the intervention of Putin's administration or another centralized body. It's also a prerequisite for achieving the programmability required by decentralized finance (DeFi) protocols to carry out settlement and collateral contracts automatically. There is no assurance of automaticity because it could be interfered with if a third party has control over the system. Loss of programmability.
Decentralization is a laudable objective if we want a financial system that is more transparent, flexible, and equally accessible, and one that is not vulnerable to political and economic manipulation by Wall Street's too-big-to-fail intermediary institutions. Since widely decentralized DeFi protocols like Aave and Compound outperformed centralized finance (CeFi) providers such as Celsius and Voyager in the industry's de facto stress test, the recent major failures in crypto-lending ventures were centered in the former.
Really, it's fairly straightforward: If there is a centralized institution in charge of the finances of its clients, it has the power to misappropriate, lose, or otherwise harm those monies against the wishes of those clients. Only the customer can lose money if there is no custody. There is practically no one to regulate in that situation.
Regulators will only introduce the same risks into the system and obstruct the development of workable decentralized models if they continue to impose rules that favor centralization, such as the demands made on cryptocurrency providers to block accounts using the Ethereum-based mixing service Tornado Cash (see The Conversation below).
Let the young, ugly ducklings develop.
