DeFi lending: high interest and maybe high risk

26 July 2021 | Applicable law: US

Co-authored by M. Ridgway Barker and Joseph Bambara, CIPP/US

DeFi, shorthand for decentralized finance, is an ecosystem of blockchain-based applications that offer financial services like those provided by traditional banks and other financial intermediaries. The main difference being, these decentralized applications, known as “dapps,” run autonomously without any third party acting in the middle. That’s because each dapp is powered by smart contracts, which are computer programs that automatically function when certain predefined conditions are met.

Crypto lending is just one type of traditional financial service that is now accessible through dapps. Similar to depositing funds into a savings account to receive interest payments, crypto investors can now lock up their funds or use them to provide liquidity across a range of decentralized dapp platforms and receive regular interest payments. Many of the interest rates offered on these dapps are significantly greater than anything currently available in the traditional financial space, making it a highly attractive passive income stream for crypto holders. For example, US-based crypto exchange, BlockFi offers 8.00% on stablecoin USD Coin (“USDC”). See, The average interest rate for savings accounts nationwide was 0.06% on June 30, according to

In recent years, institutional lenders such as Genesis, BitGo, and Galaxy and their DeFi counterparts Compound, Aave, and Maker have drawn a tremendous amount of liquidity into the market. Just as banks do with fiat currencies, DeFi lending protocols pay interest on savers’ cryptocurrency deposits from the margin generated through loan issuance. Lending protocols can be utilized by individuals or businesses, with smart contracts automating the process through a decentralized network rather than an intermediary. In other words, the protocols which are typically Ethereum-based provide the technology to facilitate borrowing and lending, rather than taking custody of clients’ assets and manually managing the operation. At present, DeFi lending protocols generate over $650 million in annual interest. While these numbers are minuscule compared to the traditional credit market, they are growing all the time. And as the price of assets like Bitcoin and Ethereum rise, more people are likely to put their savings to good use by locking them up to earn yield. The community controls the protocol via a Decentralized Autonomous Organization (DAO), enabling active participation of token-holders in the direction of the platform. The terms of crypto lending depend on which asset you are depositing or borrowing, as well as the time period specified for repayment. A snapshot of current rates is available via LoanScan tracking providers, from Nexo and BlockFi to Yearn, dYdX and Curve. Interest rates start from around 0.03% and rise in some cases to over 50% APY.

BlockFi is one of few crypto exchanges based in the United States. With a 4% APY on BTC and 8% on stablecoins, the BlockFi Interest Account (BIA) is one of the most competitive cryptocurrency interest accounts on the market. The company is valued at over $3B from its most recent Series D and has attracted attention from cryptocurrency and traditionally non-crypto audiences alike. Projects such as BlockFi provide cryptocurrency investors with diversification of revenue streams. BlockFi has more than 90 institutional clients, including international financiers and private hedge funds, raising $14.7 billion.

On July 20, the state of New Jersey ordered BlockFi to stop offering interest-bearing accounts. A cease and desist order from New Jersey’s Bureau of Securities said BlockFi’s accounts were not registered with that office or exempt from registration and that their sale violated New Jersey securities laws. The Bureau’s position is that a BIA is a security defined in N.J.S.A. 49:3-49(m). According to the order, investors can buy BIA’s by depositing cryptocurrencies such as Bitcoin and Ethereum with the company, which uses them to fund lending operations and proprietary trading. The order notes that BIA’s lack federal deposit insurance. The order takes effect on July 22, 2021, and does not affect existing BIA’s. The New Jersey Bureau’s action comes amid rising concerns over the proliferation of decentralized finance platforms like BlockFi that seek to reinvent traditional financial systems such as banks and brokerages for digital asset investors. The order’s findings include that BlockFi fails to disclose to investors that its BIA’s are securities and not registered. BlockFi said it disagreed with the order because the BIAs were not securities. It also said it remained fully operational for existing New Jersey clients and believed its products are “lawful and appropriate for crypto market participants.” That said, the question is whether the DeFi lending projects like BlockFi BIA’s are pooled investments in proprietary trading, i.e., securities, or just loans to projects like BlockFi denominated in cryptocurrencies, not securities. In U.S. law, the “Howey test” says that something is a security if “there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others". Do Automated Market Makers (“AMMs”) protocols pass the “efforts of others” test? AMMs are smart algorithmic contracts allowing digital assets to be traded without permission and automatically by using liquidity pools instead of a traditional market of buyers and sellers.

The SEC has not addressed this yet, but on May 26, 2021, SEC Commissioner Gensler testified that there are many challenges and gaps for investor protection in the DeFi lending market. Tokens currently on the market that are securities may be offered, sold, and traded in non-compliance with the federal securities laws. Furthermore, none of the exchanges trading crypto tokens has registered yet as an exchange with the SEC. Altogether, this has led to substantially less investor protection than in traditional securities markets and to correspondingly greater opportunities for fraud and manipulation. The Commission has prioritized token-related cases involving fraud or other significant harm to investors. He stated that, crypto lending platforms and so-called decentralized finance (“DeFi”) platforms raise a number of challenges for investors and the SEC staff is trying to protect them. The SEC also is seeking comment on crypto custody arrangements by broker-dealers. U.S. Sen. Elizabeth Warren (D-Mass.) gave the Securities and Exchange Commission (SEC) until the end of this month to figure out its role in regulating cryptocurrencies. The senator, who chairs the Senate Banking Committee’s Subcommittee on Economic Policy, said in a letter to SEC Chair Gary Gensler that she needs answers by July 28. Despite the rising popularity of crypto, a “lack of common-sense regulations has left ordinary investors at the mercy of manipulators and fraudsters,” Warren said.

The SEC must use its full authority to address these risks, and Congress must also step up to close these regulatory gaps,” Countries like Germany and Switzerland have already created legal frameworks that allow tokenized securities to fall under the same regulatory compliance requirements as traditional investment instruments. Hopefully, decentralized finance protocols and regulatory agencies like the SEC will work together to provide well-reasoned regulations and enable the niche crypto market to integrate with and improve real-world finance.

Our Withers attorneys can assist and educate clients from a legal and technical standpoint to incorporate these emerging technology trends safely and efficiently to help your businesses stay ahead of the competition. Please contact your regular Withers attorney or the author of this piece with any questions.

Stay tuned for our next Withers articles on DeFi lending, staking, and liquidity.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.


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