U.S. regulators’ enforcement action against alleged market manipulation on a decentralized digital asset exchange is a positive for the decentralized finance (DeFi) sector, as it foreshadows the development of oversight, says Moody’s Investors Service.
In a new report, the rating agency said allegations of fraud and market manipulation filed last week by both the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) involving trading on the Mango Markets platform represent a “credit positive” for the sector, as it marks a step toward a safer, more credible market for both institutional and retail investors.
The SEC and CFTC’s enforcement actions allege that a rogue trader manipulated Mango Markets’ so-called “governance token,” a stablecoin pegged to the U.S. dollar, to steal US$116 million in digital assets.
“The two enforcement measures reveal that even in this regulatory environment, malicious actors perpetrating fraudulent activities must face consequences,” Moody’s said.
“The actions could improve oversight of the DeFi industry, which has been difficult to regulate because of the lack of clarity regarding jurisdiction over open-source protocols.”
The regulators allege that the accused trader was able to engage in a wash trading strategy because of the anonymity provided by the DeFi protocols.
The report said concerns about the lack of KYC controls have been a topic of discussion in the DeFi industry for some time.
“Because of heightened regulatory scrutiny, numerous DeFi startups whose products target institutional investors have embraced KYC requirements. For instance, some platforms offer access to permissioned lending pools and tokenized ETFs to investors who have cleared the KYC onboarding processes,” it noted.
Additionally, while DeFi proponents argue that smart contracts are the final arbiters of transactions in the DeFi environment, the SEC and CFTC’s actions “demonstrate that ‘code is not above the law’,” Moody’s said. “If someone commits an act that is shown to be unlawful, it remains unlawful, even if it was permitted by the relevant code.”
In Europe, regulators have “taken a preventive stance on smart contracts enforcement,” the report said. Proposed legislation includes a provision that allows smart contract administrators to stop the execution of self-executable contracts, which “is aimed at precluding scenarios in which protocol design flaws could lead to unintended consequences in the absence of human intervention.”
Additionally, the European Commission has initiated work to create a technical solution for embedded supervision of DeFi activity.
“Initiatives like these set the stage for regulators to create a regulatory and supervisory framework that can aid in preventing fraudulent conduct inside the DeFi ecosystem and can offer an opportunity for companies to innovate in the crypto economy,” Moody’s said.
While it will likely take years to develop regulation that’s embedded directly into distributed ledger technology, “regulators are already making the DeFi ecosystem safer by taking action against alleged wrongdoers,” it said.