Regulatory concerns that stand behind DeFi/NFT transactions

abdelaziz Fathi

Decentralized finance, or “DeFi”, is a term that encompasses all crypto activities trying to replicate functions of legacy financial systems through the use of blockchain technology and smart contracts.

Although the nascent sector presents a panoply of opportunities, it also poses inherent risks for investors and the financial markets, as well as unique challenges for regulators. With major hacks and scams plaguing the fast-growing industry, the regulatory bodies are becoming increasingly concerned about the risk of crime as well as harm to investors.

As with the entire cryptocurrency industry, regulators have yet to stake out the DeFi territory and its various applications. Recent news coverage has also highlighted the emergence of Non-fungible Tokens (NFTs).

That said, the regulation of these transformative technologies is blurry. There is no such federal agency that has clear authority over a particular DApp, NFT, or even the entire industry.

Who regulates the DeFi space?

This regulatory silence, however, didn’t provide relief for users or firms active with these technologies. There is a minimum compliance burden that’s likely incumbent on all parties. So, regardless of the current regulatory landscape, it is wise for associated institutions to consider compliance aspects to protect their business.

Max Dilendorf, Esq. and Micaela Baldner from Dilendorf Law Firm addressed these issues in an article entitled “Regulatory Concerns Regarding DeFi/NFT Transactions.” The authors have tried to answer existential questions at this critical time for the digital asset industry.

What happens after one transacts on a DeFi network or buys an NFT? What process must be used to transfer decentralized earnings into a centralized financial institution? Do banks accept decentralized earnings without a detailed transaction history? If not, what are banks’ standards for filing suspicious activity reports (SARs) with the Financial Crimes Enforcement Network (FinCEN)? 

Dilendorf’s legal experts recommend that entities and users in the DeFi space should begin their compliance process now by implementing basic rules for compliance with the AML measures overseen by FinCEN. The latter is the US Financial Information Unit to whom other US agencies report suspected violations. It also collects and analyzes information about financial transactions to combat money laundering, terrorist financing, and other financial crimes.

FinCEN’s authority also includes settling lawsuits and other legal issues with violators, or referring them to federal prosecutors.

Dilendorf and Baldner further explain how the compliance steps may be taken to prevent any potential lapses from developing later.

Financial institutions are required to file complete, accurate, and timely SARs in order to provide FinCEN with a method of identifying emergency trends and patterns associated with financial crimes. The purpose of the SAR is to report known or suspected violations of law or suspicious activity observed by financial institutions subject to the regulations of the Bank Secrecy Act of 1970 (BSA).

Considering the serious financial implications associated with becoming the subject of a SAR, it is worthwhile to mention that financial institutions have not been transparent about the guidelines or standards used to determine when they will consider filing a SAR. Instead, they have stated that such determinations are made on a case-by-case basis, ultimately leaving both bank account holders and the public in the dark.

Crypto markets suffer from structural limitations

The NFTs are rapidly entering the mainstream without specific safeguards as they actually do not fit squarely within the parameters of traditional financial instruments. The authors, who have decades of combined experience as transactional attorneys, business consultants, commercial litigators, and entrepreneurs, examined this operational and regulatory dilemma.

For instance, take the individual who sold an expensive NFT on an unregulated marketplace and received payment from a wallet that he or she later found out was attached to an entity in a sanctioned jurisdiction such as Iran or North Korea. How can this individual protect his or her decentralized funds, or more importantly, how will a financial institution treat such individual’s funds?

From a business’ perspective, NFTs marketplaces and creators should also consider whether registration is required as a money services business or licensing as a money transmitter. Depending on facts and circumstances, anti-money laundering/Bank Secrecy Act (AML/BSA) obligations and securities laws may apply to their businesses.

Specifically, the article further reads, the BSA requires financial institutions to keep records of cash purchases of negotiable instruments, file reports of cash transactions exceeding $10,000, and to report suspicious activity that might signify money laundering, tax evasion, and other criminal activities. 

To further this aim, in December of 2020, FinCEN proposed a new anti-money laundering rule aimed at reducing the anonymity allowed by certain cryptocurrency transactions. The AntiMoney Laundering Act of 2020 requires financial institutions like bank unions and money services businesses to submit reports, keep records, and verify the identity of customers in relation to transactions related to digital assets held in digital wallets not hosted by a financial institution.

Financial institutions are also required to keep records for any transaction over $3,000 and provide that information to law enforcement upon request.

The authors addressed this point as the FinCEN Guidance provides three separate cryptocurrency market buckets: (1) users; (2) exchangers; and (3) administrators. They also refer to a mistaken majority view that if individuals trade on their own account, then they are to be classified as users. However, certain retail activities related to non-fungible tokens may implicate regulations of the Financial Crimes Enforcement Network.

There is case law suggesting that such individuals are still to be regarded as money transmitters, and several prominent white-collar criminal defense attorneys have been unable to uphold legal arguments stating otherwise. 

 A user is a person that obtains virtual currency to purchase goods or services, whereas an exchanger is a person engaged as a business in the exchange of real currency, funds, or other virtual currency. Lastly, an administrator is a person engaged as a business in issuing a virtual currency and who has the authority to redeem such virtual currency with the intent to inject it into the stream of commerce to use as a medium of exchange.

Understanding the distinctions between the three cryptocurrency market buckets is important because an individual classified as a “user” is not a money services business under FinCEN’s regulations and thus is not subject to FinCEN’s registration, reporting, and recordkeeping regulations.

Focus on risks of being non-compliant

By their nature, DeFi products are linked to a variety of different assets, which, in turn, represent numerous rights and obligations. Not only this makes them challenging to classify, but also hinders the ability of associated businesses to understand the vague areas where obligations interact with several regulators, from banking to securities to taxes.

That’s part of the problem and a particular worry for financial institutions, including crypto-friendly ones, the article explains.

They have been unable to confirm at the pre-deposit stage that they would not report DeFi earned funds to FinCEN. In fact, several financial institutions will not even allow clients to speak with their internal compliance departments before making a deposit. This is problematic as bank account holders are left with the difficult decision of whether or not to transfer their decentralized earned funds into traditional financial institutions without clear guidance as to whether such institutions will protect their funds from becoming the subject of a SAR.

While the blockchain technology that underpins cryptocurrencies is sometimes unfamiliar, decentralized finance activities still have close analogs within the FinCEN’s jurisdiction. This shouldn’t come as a surprise, considering finance is in the name and investing is often at the core of DeFi activity.

To date, FinCEN has not issued guidance specific to DeFi or NFTs. Instead, it has published guidance about how the regulations related to digital assets could apply. The guidance sets out a list of matters to which financial institutions need to pay attention when a customer carries out a cryptocurrency transaction.

Therefore, DeFi users need to take into account that transacting within a decentralized sphere also requires them to responsibly vet who they are transacting with and validate the legitimacy of such transactions to comply with current federal laws if and when they choose to move funds from a decentralized realm to a centralized one. 

This is not to say that traditional institutions should not be held to the same standard. Considering that equal access to financial opportunities, blockchain transparency, and individual autonomy lie at the heart of the cryptocurrency movement, traditional institutions’ argument that DeFi platforms are a dangerous and murky “wild west” is a paradox when such institutions themselves are unwilling, or unable, to provide uniform standards to guide and protect bank customers who are exploring within the DeFi sphere. 

Summing up

Without a common set of regulations, and functional systems to enforce minimum standards of disclosure and conduct, crypto markets participants will remain concerned about how they should take their legal obligations. Over time, this uncertainty reduces investor confidence and participation.

US regulators have a variety of tools at their disposal ranging from rulemaking authority to enforcement actions. In practice, they seem puzzled by the ‘Wild West’ of crypto, handing out confusing rulings, and ultimately there is no overarching framework.

Arguably, establishing well-regulated markets allow new technologies to flourish, and FinTechs are prime examples, the article concludes.

Overall, it is unarguable that the cryptocurrency industry would benefit from certain regulatory boundaries, however, to survive in a growing decentralized economy, it is also important for traditional financial institutions to practice what they preach and become more transparent regarding their standards, guidelines, and regulatory policies as the paradigm shift away from centrally controlled power (i.e., banks, governments, and corporations) and toward individual users has already begun.

About Dilendorf 

Dilendorf Law Firm offers practical and effective legal solutions to companies and individuals facing ordinary and extraordinary legal challenges related to growing their businesses or protecting their assets.

Our attorneys work with modern diversified asset portfolios, including traditional assets (such as money, securities and real estate), as well as digital assets (cryptocurrencies, digital securities) and intellectual property.

Our clients are established businesses, blockchain and fintech startups, entrepreneurs, individual investors, real estate owners and operators, private funds and family offices.

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