Can the White House protect DeFi?

Alexander Urbelis is an internationally recognized technology attorney and cybersecurity expert, a Professor of Law at King’s College, London, and the General Counsel / CISO of the Ethereum Name Service. Bridging the gap between legal and technical expertise, Alex is also the architect of an award winning cyber threat intelligence platform designed to identify hallmarks of impending cyber attacks, counterfeiting, and other malicious activities. 

In this article he explores how crypto progress in Washington has failed to advance the cause of decentralization. He warns that if this approach is not rectified, it could be too late.

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America Is Becoming The Crypto Capital of CeFi. Here’s Why That Must Change

Bo Hines left his perch in the White House without making much progress on decentralized crypto. Here’s how his successor Patrick Witt can become a champion of DeFi.

As Bo Hines left his post as Executive Director of the President's Council of Advisors for Digital Assets, he credited himself and David Sacks, the White House A.I. and Crypto Czar, with positioning “America as the crypto capital of the world.” But his eight-month tenure, which he exited to take a lucrative position at a highly centralized crypto firm, largely consisted of big wins for centralized crypto. None bigger than the passage of the GENIUS Act legislation in July, which rolled out the red carpet for stablecoin companies like Circle.

This legislation has been conflated with support for Decentralized Finance (DeFi), but it is the opposite. Decentralization is being boxed out.

With Hines’ successor, Patrick Witt, who previously served as his deputy, now in the role, Witt should demonstrate a deep appreciation for the power of decentralization. Otherwise the U.S. risks becoming trapped within Centralized Finance (CeFi) structures. 

The promise and power of crypto cannot be divorced from the principle of decentralization.

How the U.S. Supports CeFi at the Expense of DeFi

The GENIUS Act only allows permitted payment stablecoin issuers to operate in the U.S., overwhelmingly favoring centralized companies like Circle. Broadly, to be a permitted entity means having received federal approval from the Office of the Comptroller of the Currency (a federal banking regulator) or an equivalent state regulator, having anti-money laundering (AML) and Bank Secrecy Act (BSA) compliance programs in place, and being subject to regular audits. While decentralized companies can technically form a U.S. legal entity, become licensed, and meet all requirements, this would effectively centralize them.

These limitations put companies like Circle, which issues the $73.55 billion USDC, at a clear advantage. In fact, it now appears that global leader Tether, the company behind $171 billion USDT, has to catch up in the U.S. The company recently hired the aforementioned Hines as a senior advisor and he will be CEO of Tether USA₮, a new company dedicated to the USA₮ stablecoin that will apply to be an issuer under GENIUS. 

CeFi Is Too Risky to Be the Cornerstone for DeFi Legislation

The collapse of FTX in 2022 showed the crypto industry how CeFi can be a breeding ground for bad actors. Sam Bankman-Fried and Alameda Research secretly and illegally colluded in the misuse of user funds. Ultimately, FTX was forced to file for bankruptcy after it didn’t have enough liquid assets to cover withdrawals, resulting in billions of dollars in losses. And critically, let us not forget that this led to a cascade of liquidity crises because of inter-company lending within CeFi, resulting in bankruptcy filings of Voyager, Celsius, and BlockFi, among others.

Showing resiliency in the face of market turmoil, non-custodial DeFi protocols like Uniswap and Curve continued processing trades without interruption, providing a necessary and safe exit for funds rapidly parting ways with the troubled CeFi platforms on the brink of collapse. 

Centralized companies have also faced similar issues. In 2018, Tether allegedly gave collateral underpinning its stablecoin to its sister exchange, Bitfinex, to help cover a hole in its balance sheet without telling investors or clients. The firm ultimately paid an $18.5 million fine to settle the charges with the New York Attorney General. Then, in 2022, the TerraUSD stablecoin/LUNA DeFi ecosystem, which at one point was worth $40 billion, collapsed when an elaborate system of financial engineering and secret deals to support the asset failed to keep the peg. The project’s founder, Do Kwon, pled guilty to two U.S. charges of conspiracy to defraud and wire fraud in August. Even Circle faced a depegging crisis in 2023 when it had $3.3 billion in USDC collateral trapped in Silicon Valley Bank. 

Despite this history, CeFi remains a comfortable starting place for regulators since its business structures often mirror traditional financial firms. This is not a cornerstone on which DeFi legislation should be built.

How to Protect Decentralization

As Witt gets acclimated to this new role, protecting decentralization is more important than ever. With the GENIUS Act now in the rearview mirror, focus is turning to long-awaited market structure legislation that will adjudicate key questions such as whether the U.S. Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC) has regulatory primacy. 

Inherent in this debate is determining how projects are deemed decentralized. Most of the industry agrees that the Howey Test, a 79-year-old judicial framework for deciding whether something is a security, is outdated when it comes to crypto. But finding an appropriate replacement that allows for innovation, while ensuring that genuine securities adhere to the law, is paramount.

The most recent draft of the CLARITY Act, a piece of market structure legislation that passed the U.S. House of Representatives in July, allows projects to self-certify as decentralized. While this may seem positive, it could muddle what constitutes decentralization in the minds of regulators and the industry alike. A better approach would be to craft language in the bill that focuses on decentralization based on control of a given protocol. Ideally, I would also like to see the Act support community governance of projects through recognition of token-based voting and DAOs when there are major substantive changes proposed for a protocol.

This last part is particularly important given a growing trend of projects now eschewing DAO governance under this new administration. 

Look Past the Platitudes

As we move into the fall, key decisionmakers in Washington, D.C., are saying all of the right things, but decentralization remains under assault. 

On July 31, the SEC unveiled “Project Crypto,” a new initiative to rewrite outdated rules to modernize digital assets legislation and bring U.S. financial markets onchain. SEC Chairman Paul Atkins called this the new North Star for the agency, which has historically been harsh on the crypto industry, making many bullish on the future of crypto.

In line with this, Atkins has advocated for an “innovation exemption,” a policy that would enable new tech and business models by exempting them from having to comply with burdensome regulatory requirements that do not neatly fit within the SEC’s existing rules and regulations. 

The terms “innovation” or “innovator” appear over 20 times throughout the body of Chairman Atkins’ speech announcing Project Crypto. He even went so far as to say, “the SEC will not stand idly by and watch innovations develop overseas while our capital markets remain stagnant.”

And yet, on Aug. 6, a little under a week after Atkins unveiled Project Crypto, Roman Storm, a co-founder of Tornado Cash, a privacy protocol that breaks onchain links between senders and receivers of funds, was convicted for knowingly operating an unlicensed money transmitter under the U.S. Department of Justice (DOJ), sending a chill through the industry. 

Why Decentralization Matters

The word “decentralization” is thrown around often these days, and it’s important to remember why it is essential. Decentralization changes power dynamics: it prevents a single entity or government from dictating rules, distorting markets, or seizing funds. Decentralization is democratizing: it promotes user control, transparency, accountability, and resilience. Indeed, the U.S. Constitution itself — with its checks and balances, separation of powers among branches of government, and its deliberate protection of individual rights — is very much an ongoing and quite successful example of decentralization. 

Nominal support for crypto, like underwriting a Bitcoin treasury company, doesn’t make someone a champion of decentralization. Putting Bitcoin into a centralized company and letting people buy shares rather than own the Bitcoin itself makes the decentralization of the chain pointless. 

A Bitcoin strategic reserve isn’t much better, exchanging the ownership of a centralized company for the custody of a central government. 

By continuing to tolerate centralized structures masquerading behind promises of future decentralization, the industry risks making this mistake a final time.