CFTC Commissioner Dan Berkovitz Is Concerned About Decentralized Finance (DeFi)

During a speech on Tuesday (June 8), Dan M. Berkovitz, one of the five commissioners of the Commodity Futures Trading Commission (CFTC), shared his concerns about Decentralized Finance (DeFi).

The CFTC is “an independent agency of the US government created in 1974, that regulates the U.S. derivatives markets, which includes futures, swaps, and certain kinds of options”.

According to his bio page at the CFTC’s website, Berkovitz was nominated by President Trump to serve as a Commissioner on 24 April 2018. He was “unanimously confirmed” by the U.S. Senate on 28 August 2018 and “sworn into office” on 7 September 2018 “for a five-year term expiring in April 2023”.

His comments about DeFi were made during a keynote address (titled: “Climate Change and Decentralized Finance: New Challenges for the CFTC”) at the “Asset Management Derivatives Forum 2021” (June 8–9, 2021).

With regard to the DeFi portion of his speech, Berkovitz started with this definition of DeFi from Wikipedia:

Decentralized finance (commonly referred to as DeFi) is a blockchain-based form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial instruments, and instead utilizes smart contracts on blockchains, the most common being Ethereum. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.

He then said that the top Google search result for DeFi pointed him to a Coindesk article, which stated that “DeFi is short for ‘decentralized finance,’ an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries”.

Berkovitz argues that although DeFi tries to eliminate financial intermediaries, these do provide the public with a valuable service:

A threshold question is whether the public will benefit from disrupting the current financial system that relies extensively on financial intermediaries. Supporters of DeFi argue that cutting out intermediaries offers consumers more control over their investments.

But intermediaries such as banks, exchanges, futures commission merchants, payment clearing facilities, and asset managers—such as many of you at this conference—have developed over the past two or three hundred years of modern banking and finance to reliably provide critical financial services to support the financial markets and the investing public.

Intermediaries provide information, analyses, and advice to the public seeking access to financial markets. Intermediaries often have fiduciary or other legal duties to act in the best interests of their customers. They provide liquidity to the markets and support the stability of the financial system in times of stress. They provide custody of assets and safeguards for investments. They are responsible for preventing money-laundering through financial markets. Regulated and licensed intermediaries must meet established standards of conduct and can be held legally responsible for failing to meet those standards of conduct. Intermediaries can be held accountable when things go wrong.

He went on to say that in contrast DeFi markets do not offer such protections:

In a pure ‘peer-to-peer’ DeFi system, none of these benefits or protections exist.  There is no intermediary to monitor markets for fraud and manipulation, prevent money laundering, safeguard deposited funds, ensure counterparty performance, or make customers whole when processes fail.  A system without intermediaries is a Hobbesian marketplace with each person looking out for themselves.  Caveat emptor—’let the buyer beware.’

He also questioned the legality of “unlicensed DeFi markets for derivative instruments”:

Not only do I think that unlicensed DeFi markets for derivative instruments are a bad idea, I also do not see how they are legal under the CEA.  The CEA requires futures contracts to be traded on a designated contract market (DCM) licensed and regulated by the CFTC. The CEA also provides that it is unlawful for any person other than an eligible contract participant to enter into a swap unless the swap is entered into on, or subject to, the rules of a DCM. The CEA requires any facility that provides for the trading or processing of swaps to be registered as a DCM or a swap execution facility (SEF). DeFi markets, platforms, or websites are not registered as DCMs or SEFs. The CEA does not contain any exception from registration for digital currencies, blockchains, or ‘smart contracts.’

For these reasons, Berkovitz believes that the CFTC and other financial regulators should pay closer attention to the DeFi sector:

Apart from the legality issue, in my view it is untenable to allow an unregulated, unlicensed derivatives market to compete, side-by-side, with a fully regulated and licensed derivatives market.  In addition to the absence of market safeguards and customer protections in the unregulated market, it is unfair to impose the obligations, restrictions, and costs of regulation upon some market participants while permitting their unregulated competitors to operate wholly free of such obligations, restrictions, and costs.

Experience with the development of the ‘shadow banking’ system shows that competition between regulated and unregulated entities in the same market can result in the regulated entities assuming either more risks in order to generate the higher yields necessary to compete with the unregulated competition, or seeking less regulation for themselves to level the playing field. Either of these reactions can introduce significant risks into the financial system. 

For all these reasons, we should not permit DeFi to become an unregulated shadow financial market in direct competition with regulated markets.  The CFTC, together with other regulators, need to focus more attention to this growing area of concern and address regulatory violations appropriately.

DISCLAIMER

The views and opinions expressed by the author, or any people mentioned in this article, are for informational purposes only, and they do not constitute financial, investment, or other advice. Investing in or trading cryptoassets comes with a risk of financial loss.

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