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Decentralized Exchanges Under Fire: SEC Strikes Again

Decentralized exchanges may be the wave of the future. But that is increasingly looking like a distant future, at least if recent regulatory action is any indication. The Securities and Exchange Commission’s rebuke of EtherDelta, a smart contract-fueled decentralized exchange for ether and Ethereum-based tokens, sent smoke signals to the crypto industry that peer-to-peer trading may not be welcome in the U.S. 

EtherDelta runs on code, which makes it difficult to direct any charges against the exchange itself. That puts a bullseye on Zachary Coburn, who launched EtherDelta in 2016, leading the SEC to target him in their cease-and-desist order. Coburn has been largely cooperative with the Wall Street watchdog, ultimately agreeing to pay fines totaling nearly $400,000.

The order is a reminder that even without a formal regulatory framework for digital assets, the SEC is drawing lines in the sand. The Commission targeted Coburn for failing to register with the SEC as a “national securities exchange” while supporting buy and sell orders for ERC20-tokens, some of which the regulator says fit the bill as securities. Regulatory clarity on what comprises a security token, however, remains murky at best, suggesting they should define the parameters in which DEXs can operate in the U.S. first.


Did the SEC Score a Pyrrhic Victory?

In true decentralized fashion, EtherDelta continues to facilitate trading in ETH-based tokens. The greater concern, however, surrounds winning the battle but losing the war: a Pyrrhic victory. Greek King Pyrrhus of Epirus defeated the Romans but ultimately suffered devastating losses from the front lines, costing him soldiers who were key to carrying out his mission.

Fortunately for the crypto community, the generals who are fulfilling what Satoshi Nakamoto started aren’t about to let that happen. One blockchain pioneer told Crypto Briefing that the topic of decentralized exchanges is complicated, “especially in certain jurisdictions,” adding: “We have a strategy.” The founder kept the project’s cards close to the vest, “even though we are, of course, in favor,” he added.

Others tend to agree. Alex Wearn, who is at the helm of IDEX, weighed in on the trend of DEXs adopting know-your-customer (KYC) standards, saying during a recent debate:

It’s hard to predict exactly which it will go. I think it’s going to be jurisdiction-specific and it’s going to be at specific times. I think the U.S. is…certainly kind of leading the charge from a regulatory standpoint and I think a lot of other countries are going to follow suit.

If this is the case, then Australia and Canada are certainly paying attention.  


Crypto Exchange Landscape Starts to Shift

Nearly all visible crypto trading unfolds on centralized exchanges like Binance and Coinbase, where the interfaces are easier to navigate and functionality is more sophisticated. But even Binance is developing a decentralized version of its trading platform, one that CEO Changpeng Zhao expects to make its debut in 2019. And TRON unveiled the beta version of its DEX, TronWatch Market, last month.

Meanwhile, Coinbase has been playing nice with regulators to great success, as evidenced by their ranking as the most popular U.S.-based crypto exchange. While Coinbase has revised its listing model in anticipation of adding coins more frequently, that’s one area where centralized exchanges can’t compete with their decentralized counterparts. Perhaps that’s why Coinbase bought decentralized exchange Paradex, a relay platform that supports hundreds of ERC20 tokens that users can trade from their wallets.

Everbloom is one example of a decentralized crypto exchange that is reportedly pursuing SEC registration and a license from FINRA, which would pave the way to trading security tokens. Everbloom has decided that the cost and time of pursuing regulatory clearance are worth it in light of the alternatives. This could be a model for other DEXs in the U.S. to emulate.   

But the echoes of the regulatory pushback on EtherDelta can be heard in Everbloom’s virtual halls despite the latter’s regulation-compliant approach. That’s because Everbloom is built on top of “existing smart contracts and protocols,” the first launch of which supports the EtherDelta smart contract. Everbloom is also targeting the 0x protocol including 0x V2.

The appeal for decentralized exchanges is clear. Issuers and big whale investors can list as many ERC20 tokens as the market demands. The most attractive feature, however, is security, as users can store and control their funds with their own private keys without having to worry about falling victim to a hack on a centralized platform.


DEX’s Midnight Runners

Nonetheless, there’s no safety net or FDIC guarantee with decentralized exchanges, and as long as smart contracts command private keys, there never will be. But security breaches could still occur at the “fault” of the user such as a malware-infected computer, as pointed out by Eyal Hertzog, product architect at Bancor in the debate with IDEX’s Wearn – and a DEX might be even less likely to refund the money stolen by hackers and thieves than a centralized exchange.

Users are also drawn to the anonymity factor, but that is carrying less weight now that exchanges are moving toward the know-your-customer model that is required for institutions to trade.

Newcomers like Everbloom will have to compete with established players like Bancor and IDEX, not to mention the big exchanges like Binance and Tron. Bancor’s Hertzog also said in the debate that decentralized exchanges will evolve in such a way as to beat any other product in the market, and “any service that tries to compete will end up like…AOL or CompuServe trying to compete with the internet.”  

And as Hertzog points out, decentralized smart-contract agreements between users are not a tangible “thing.” Instead, he says, they resemble a language that “cannot really be stopped,” which could throw a wrench into the plans of regulators. He said in the debate:

If we go and implement some kind of a KYC on Bancor tomorrow, there’s nothing to prevent anyone who wants to use the network… and issue transactions on Parity or any client that supports that..It’s kind of a self-conflicting idea here.

Hertzog raised the possibility that “some kid from China” might create the user interface for a decentralized exchange without KYC, adding, “it would work.”

As a result, the question is not so much whether it makes sense for decentralized exchanges to operate in the U.S. The real question is, do smart contract-fueled DEXs have the upper hand?

The author has investments in Ethereum. 

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