DeFi Is the Vanguard of Crypto Fraud. Whistleblowers Can Stop It

As the federal government cracks down on the crypto industry, crypto traders and entrepreneurs are likely to shift their investments to decentralized finance markets. In the immediate aftermath of the Securities and Exchange Commission’s early-June complaints against Binance and Coinbase, DeFi trading volume reportedly surged 444%.

Investors aren’t the only ones interested in DeFi. Two months earlier, the Treasury Department released a report that found “illicit actors, including ransomware cybercriminals, thieves, scammers, and Democratic People’s Republic of Korea (DPRK) cyber actors, are using DeFi services in the process of transferring and laundering their illicit proceeds.”

Fighting money laundering and protecting investors in the DeFi space will depend on whistleblowers.

What is DeFi?

DeFi is amorphous but generally refers to loaning or trading cryptocurrencies without a centralized exchange such as Binance, FTX, or Coinbase. DeFi transactions, which typically occur on a decentralized exchange or DEX, are automated and peer-to-peer with no intermediaries taking custody of the funds.

Critically, most DEXs and other DeFi protocols are run by their users through a decentralized autonomous organization, or DAO. Oversimplifying here, DAOs are groups of users who vote on how to run a DeFi project.

Regulatory Challenge

DeFi is often more centralized than it appears—which provides an opportunity for regulators. How is a regulator to enforce compliance against the hundreds or thousands of people in a DAO, who are sometimes spread across the world?

Civil enforcement depends on finding someone who can pay a fine and also—in the opinion of regulators exercising their enforcement discretion—deserves to pay a fine. Because DeFi projects are rarely as decentralized as advertised, there are often people who can and should be held responsible for regulatory violations.

According to the same Treasury report that found DeFi facilitates money laundering, “DeFi services often have a controlling organization that provides a measure of centralized administration and governance.”

A good example is Ooki DAO. In early June, Judge William Orrick of the US District Court for the Northern District of California came to the much-anticipated (in the crypto world) decision to enter a judgment against Ooki DAO for operating an illegal trading platform, unlawfully acting as a futures commission merchant, and failing to implement know your customer and anti-money laundering procedures.

It’s unclear whether the individual members of Ooki DAO will ever be held individually responsible for the DAO’s actions. The court didn’t address that question in its ruling.

But months earlier, last September, the project founders agreed to settle with the CFTC. In its order, the CFTC noted the founders had participated in DAO governance, “including by participating in many discussions in online governance forums, making other governance proposals, and voting … in favor of such proposals.”

Also relevant was that the founders had handed control of the project over to the DAO to stymie regulators. As one founder said on a public call, “really what we’re going to do is take all the steps possible to make sure that when regulators ask us to comply, that we have nothing we can really do because we’ve given it all to the community.”

Call for Whistleblowers

Whistleblowers are needed to identify who controls a DeFi project.

Unlike the Ooki DAO founders, the people who control some DeFi projects remain anonymous or hide their control behind a “decentralized” project while they quietly maintain a controlling stake or find ways to override DAO decisions. Identifying those people isn’t always easy.

Whistleblowers are needed to support regulators by identifying the people who run DeFi projects that defraud users or facilitate money laundering, tax evasion, and sanctions evasion. Fortunately, the federal government has strong programs to pay qualifying whistleblowers between 10% and 30% of monetary sanctions.

With the massive sanctions already imposed in crypto enforcement cases—some in the eight or nine figures—there is significant upside to the often-difficult decision to blow the whistle.

As the cryptosphere turns toward DeFi, whistleblowers will be needed to ensure the industry is safe for investors and not for criminals.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Daren Firestone is a partner at Levy Firestone Muse, and a former federal prosecutor and White House attorney.