Pegged to be the next frontier of fintech innovation, decentralized finance (DeFi) has grown exponentially over the past year. In 2020, less than $20 billion worth of value was locked in various DeFi products. In 2021, the total value locked in DeFi was $250.55 billion, suggesting a growth rate of more than 1,000% in just a single year.
The growth in the DeFi market has fuelled U.S. regulators to increase regulatory oversight on the industry. In a public statement issued in June 2021 by the Commodities Futures Trading Commission (CFTC), the agency’s former Commissioner, Dan M. Berkovitz signaled potential CFTC enforcement action in the DeFi sector. Berkovitz stressed the fact that “the Commodities Exchange Act (CEA) requires any (derivative) facility that provides for the trading or processing of swaps to be registered as a designated contract market (DCM) or a swap execution facility (SEF).” Noting that presently, most DeFi platforms, markets or websites are neither registered as DCMs nor SEFs, Benrkovitz could “not see how they are legal.” He reminded the DeFi industry that when it comes to registration, the CEA does not contain any exceptions for digital currencies, blockchain, or smart contracts.
The panelists in Merkle Science’s Regwatch DeFi webinar predicted that “since DeFi can provide unique services without provisioning the same investor protection as provided in traditional finance, the supervision in DeFi is likely to take an enforcement-first approach.”
On January 3, 2021, the CFTC took its first enforcement action of the year when it entered an order filing and simultaneously settling charges against Polymarket, owned and controlled by Delaware as Blockratize, Inc., for operating as an illegal unregistered facility. In the public statement issued by CFTC, Acting Director of Enforcement Vincent McGonagle issued a warning stating that “all derivatives markets must operate within the bounds of the law regardless of the technology used, and particularly including those in the DeFi space.” He urged the market participants to “proactively engage with the CFTC to ensure that our markets remain robust, transparent, and afford customers the protection provided under the CEA and our regulations.”
What happened?
CFTC filed an enforcement action against Polymarket alleging that it violated federal commodities laws and regulations by offering prediction markets in the U.S. without registering with the agency.
Polymarket is a crypto betting service that allows users to pick one of at least two options on given trades, such as who will win the 2020 U.S. presidential election. According to the CFTC’s order, Polymarket offers at least 900 such markets over the last 18 months beginning in June 2020 and continuing through the present. Polymarket allows users to build a portfolio based on forecasts. Users buy and sell “shares” by committing USDC stablecoin against a liquidity pool based on how a future event may resolve.
According to the CFTC, these shares are actually binary option contracts that constitute swaps and should thus be subject to the CFTC’s jurisdiction and related regulatory obligations. Under the CEA, generally, swaps can be offered on a bilateral basis only amongst a) eligible contract participants or b) platforms registered as DCM or SEF. Since Polymarket did not seek registration either as DCM or SEF, it was operating its markets in violation of federal law and CFTC regulations.
Additionally, the CFTC observed that though Polymarket relied on smart contracts, it is not a completely decentralized platform as any dispute in the market resolution — ambiguity or dispute in deciding winner or looser contracts — is completely resolved by Polymarket’s market integrity committee. Notwithstanding, CFTC ordered Polymarket to pay a fine of $1.4 million and shut down its markets, and offer users full refunds on charges the company failed to register with the regulator.
Moving forward, Polymarket promises to prioritize compliance
Recognizing Polymarket’s substantial co-operation with the Division of Enforcement’s investigation, the CFTC reduced Polymarkets civil monetary penalty.
Further, Polymarket also released a statement regarding the investigation, civil penalty, and future of the company. Clarifying that it will not be shutting down, Polymarket stated “we are pleased to confirm that we have successfully agreed to a settlement with the CFTC and are excited to move forward and focus on the future of Polymarket. We have been encouraged by our learnings through this experience and have built out an exceptional compliance team and robust internal practices and procedures, which will ensure that compliance remains an integral pillar of Polymarket’s global business going forward.”
However, it remains to be seen whether Polymarket will be able to continue running a prediction market in the U.S. and in case it does, how it plans on complying with the conditions of its settlement with the CFTC. Going forward, DeFi enabled prediction markets and other DeFi platforms will need to put compliance first and proactively engage with the CFTC and other regulatory authorities to understand how they can operate within the regulatory parameter.
How Can Merkle Science Help?
The U.S. regulators are increasing their oversight over the DeFi market and are strictly enforcing registration requirements. Therefore, DeFi platforms looking to stay compliant should directly reach out to the regulators and seek their assistance in meeting the registration requirements. DeFi platforms that are able to put in place robust compliance frameworks will be able to mitigate regulatory risks — giving them a clear competitive advantage.
Merkle Science’s highly customizable and easy-to-use platform provides businesses with 360-degree compliance support. Our predictive cryptocurrency risk and intelligence platform set the standard for the next generation of financial safeguards and criminal detection. Merkle Science proprietary Behavioral Rule Engine allows users to tailor the tool according to businesses’ own risk policies —based on the requirements set by each jurisdiction.