Decoding DeFi: Breaking Down the Future of Decentralized Finance (U.S. House Committee on Financial Services, Subcommittee on Digital Assets, Financial Technology, and Inclusion)

Hearing	Decoding DeFi: Breaking Down the Future of Decentralized Finance
Committee	U.S. House Committee on Financial Services, Subcommittee on Digital Assets, Financial Technology, and Inclusion
Date	September 10, 2024

 

Hearing Takeaways:

• Decentralized Finance (DeFi): DeFi refers to a novel technology that enables parties to make instant or near-instant transactions globally on a 24/7 basis. DeFi transactions occur without traditional intermediaries (such as financial institutions and governments) and use automated code-based rules. DeFi systems are often built upon blockchain networks that are open, can be reviewed in real-time, and can be audited by anyone. Subcommittee Republicans, Rep. Wiley Nickel (D-NC), Mr. Avello, Ms. Rettig, Ms. Tuminelli, and Mr. Van Valkenburgh expressed optimism that DeFi technology can make the financial system more accessible, transparent, efficient, innovative, and inclusive. However, several Subcommittee Democrats and Mr. Hays raised concerns that DeFi technology can pose dangers to the financial system and consumers due to its governance, efficiency, and anonymity.
  • DeFi Applications: Subcommittee Republicans, Mr. Avello, and Ms. Rettig highlighted how there currently exist both financial and non-financial DeFi applications. The financial DeFi applications often involve payments, lending, and foreign aid transfers. The non-financial DeFi applications encompass a broad range of areas, including (but not limited to) government title management and agriculture. Ms. Rettig mentioned how her company, Polygon Labs, maintains an open-source database of blockchain technology applications and use cases and indicated that the non-financial applications and use cases outnumber the financial applications and use cases.
  • Decentralized Autonomous Organizations (DAOs): Rep. John Rose (R-TN) and Mr. Avello highlighted DAOs as one notable type of DeFi application. DAOs are blockchain-based governance systems that bring parties together over a shared interest in a given project (such as DeFi, investments, or social interests). DAOs rely upon collective decision making from members and typically involve a governance token. Several Subcommittee Democrats and Mr. Hays expressed concerns however that DAOs can often function like unincorporated associations and facilitate illegal activities.
  • Real World Assets: Mr. Avello discussed the growth of real world assets and explained that these are on-chain representatives of off-chain assets. Real world assets provide users with access to either interest bearing opportunities or alternative assets, as well as near real time execution and settlement with easily verifiable accounting. Mr. Avello indicated that real world assets can include government securities, corporate credit, and tokenized funds and allow accredited and institutional investors to access various sources of yield on-chain.
  • Web3 Technology: Rep. Mike Flood (R-NE), Ms. Rettig, and Mr. Van Valkenburgh expressed interest in the potential for Web3 technology. Web3 refers to the concept of a decentralized internet (typically based on blockchain technology) where users own and control their own data and assets. Rep. Flood, Ms. Rettig, and Mr. Van Valkenburgh stated that Web3 technology could reduce the current influence of large technology companies (such as Meta and Google) and facilitate censorship resistance, autonomy, and privacy. Ms. Rettig stated that progress regarding Web3 technology is “very far along” and asserted that this progress is moving at an “exponentially rapid pace.”
  • Governance Concerns: Several Subcommittee Democrats and Mr. Hays raised concerns that DeFi systems are not as decentralized as their proponents claim. They noted how small groups of users often control most of the governance tokens on many DeFi platforms and cautioned that this control can be non-transparent. They stated that this concentration of ownership of governance tokens can enable these users to unfairly manipulate these platforms and undermine the ability of these platforms to achieve their promised benefits. Full Committee Ranking Member Maxine Waters (D-CA) further stated that opaque DeFi platforms with unclear governance and control mechanisms may impede the efforts of regulators to establish responsibility and accountability for compliance.
  • Use of DeFi in Scams and Illicit Activities: Several Subcommittee Democrats and Mr. Hays also raised concerns over how bad actors will often use DeFi to engage in scams and illicit activities (including sanctions evasion tax evasion, money laundering, drug trafficking, and human trafficking). They stated that that the anonymity that DeFi applications provide enable bad actors to engage in these activities undetected. Full Committee Ranking Member Waters and Mr. Hays further expressed concerns over fraud within the cryptocurrency space and how influencers can drive up the price of cryptocurrencies through promotional activities. Mr. Hays stated that cryptocurrency fraud has particularly harmed people from communities of color and low-income neighborhoods. Ms. Rettig remarked however that there exist various ways to identify and address bad actors. She recommended the creation of a new category for critical communications transmitters that would adopt enhanced risk mitigation measures to support financial integrity. She elaborated that her proposed critical communications transmitters would make immediate reports to the U.S. Financial Crimes Enforcement Network (FinCEN). She further stated that public-private partnerships involving the U.S. Federal Bureau of Investigation (FBI) and the U.S. Department of Justice (DoJ) have proven effective in quickly tracing wallets involved in illicit activities. 
  • Tax Avoidance Concerns: Rep. Brad Sherman (D-CA) expressed particular concerns that that the anonymity provided by DeFi systems can enable tax evasion. He warned that the legitimization of DeFi would eventually cause a larger number of wealthy people to evade their tax responsibilities. Subcommittee Republicans, Ms. Tuminelli, and Mr. Van Valkenburgh noted however that DeFi systems operate on transparent blockchain networks, which should allow for the government to assess whether tax evasion is occurring using DeFi systems. They further criticized the U.S. Internal Revenue Service (IRS) for failing to provide clear guidance to cryptocurrency users and platforms on assessing and reporting federal taxes involving these assets.
  • Zero-Knowledge Proof Protocols: Mr. Avello suggested that DeFi systems could employ zero-knowledge proof protocols to identify and ban bad actors in their systems. These zero-knowledge proof protocols could ensure that DeFi system actors are reputable without disclosing the identities behind the users. Rep. Bill Foster (D-IL) stated however that zero-knowledge proof protocols remain unready for deployment and still require a trusted third party to control their privacy budgets.
  • Impact of Quantum Computing on DeFi: Rep. Frank Lucas (R-OK) raised concerns that quantum computing could wreak havoc on DeFi systems through breaking the cryptography that serves as the basis for these systems. Mr. Van Valkenburgh acknowledged that while quantum computing may pose security threats to DeFi systems, he also stated that quantum computing-enabled hacks would provide real time-signals to update DeFi systems. He noted how large centralized banks, financial institutions, financial services providers, and internet corporations may get hacked and fail to rapidly disclose these vulnerabilities. He stated that the openness of DeFi systems would enable vulnerabilities to be immediately patched. He also stated that the value in DeFi systems means that there exists a strong “bug bounty” to draw people to fix these vulnerabilities.
• Regulation of DeFi: Subcommittee Members and the hearing’s witnesses also expressed interest in the U.S.’s current regulatory approach toward DeFi and the potential adoption of new regulations for this space. Subcommittee Chairman French Hill (R-AR) criticized the Biden administration for its use of rulemaking and enforcement actions to oversee the DeFi space and asserted that these actions threaten DeFi’s existence and future domestic use. Subcommittee Chairman Hill also highlighted how the U.S. House of Representatives had recently passed the Financial Innovation and Technology for the 21st Century (FIT21) Act. He mentioned how this legislation had directed the U.S. Department of the Treasury, the U.S. Securities and Exchange Commission (SEC), and the U.S. Commodity Futures Trading Commission (CFTC) to study DeFi issues together and to report back to Congress on their findings and recommendations. Subcommittee Ranking Member Stephen Lynch (D-MA) and Mr. Hays raised concerns however that this legislation would provide special rules to the DeFi industry, which would pose consumer and investor protection risks.
  • Application of Current Federal Regulatory and Legal Frameworks to DeFi: Subcommittee Republicans, Mr. Avello, Ms. Rettig, Ms. Tuminelli, and Mr. Van Valkenburgh raised concerns over the U.S.’s application of current regulatory and legal frameworks to the DeFi space. They argued that these regulatory and legal frameworks were designed for a financial system with centralized intermediaries and that DeFi’s decentralized peer-to-peer ecosystems render these frameworks inappropriate. Ms. Tuminelli elaborated that current regulatory frameworks for centralized intermediaries are based on the notion that these intermediaries are often opaque, discriminatory, and subject to human bias or subjective error. She stated however that the risks associated with DeFi systems are more related to the actual technologies (such as vulnerabilities in code), consumer protection, and consumer education. Several Subcommittee Democrats and Mr. Hays raised concerns that the DeFi industry is simply seeking to exempt itself from basic investor and consumer protections and national security laws. They stated that these existing rules are key for promoting market transparency, price discovery, and market stability, as well as protecting investors from fraud and market manipulation. They added that the centralized natures of many DeFi platforms necessitate the application of these existing regulatory and legal frameworks to DeFi.
  • IRS Digital Asset Broker Reporting Rules: Rep. John Rose (R-TN), Ms. Tuminelli, and Mr. Van Valkenburgh raised concerns over how the IRS had proposed a 2023 rule that would require broker reporting of sales and exchanges of digital assets. They criticized this rule for its broad definition of the term “broker” and stated that this rule would impose significant compliance burdens on these brokers. Ms. Tuminelli applauded the IRS for working to learn more about the DeFi space before finalizing their proposal to apply to the DeFi space.
  • DoJ Prosecutions Against Digital Asset Software Developers: Mr. Van Valkenburgh criticized the DoJ for prosecuting software publishers as unlicensed money transmitters. He asserted that the DoJ is offering unjustified interpretations of the Bank Secrecy Act (BSA) to pursue these prosecutions.
  • U.S. Office of Foreign Asset Control (OFAC) Bans of Certain DeFi Software Tools: Mr. Van Valkenburgh also criticized OFAC from banning Americans from using certain DeFi software tools, including for domestic and entirely legitimate purposes.
  • The SEC’s Exchange Rule: Subcommittee Chairman Hill, Ms. Tuminelli, and Mr. Van Valkenburgh criticized the SEC’s recently proposed rule to expand the definition of an exchange to capture DeFi system developers and protocols. Mr. Van Valkenburgh raised concerns that this proposed definition would raises First Amendment concerns because it seeks to regulate people making available a communications protocol (which should be protected under publishing speech). Mr. Hays stated however that the Securities Exchange Act of 1934 had intended for the definition of the term “exchange” to be expansive to cover many different scenarios. He remarked that the SEC’s rulemaking regarding the definition of “exchange” would provide clarity based on the functional nature of how exchanges operate. He stated that this rulemaking indicates that a party that matches a buyer and a seller should be considered to be an exchange.
  • 2019 FinCEN DeFi Guidance: Rep. Rose and Ms. Tuminelli expressed frustration that the Biden administration is refusing to recognize the validity of 2019 FinCEN guidance that had provided legal clarity for DeFi developers and businesses. They noted how the DeFi industry had relied upon this guidance to ensure that their actions were legal and that the Biden administration’s rejection of this guidance fosters uncertainty for DeFi developers and businesses.
  • Foreign Regulation of DeFi: Subcommittee Republicans, Rep. Wiley Nickel (D-NC), Mr. Avello, Ms. Rettig, and Mr. Van Valkenburgh highlighted how many foreign jurisdictions have pursued their own regulatory frameworks for DeFi. These foreign jurisdictions include the European Union (EU), the United Kingdom (UK), the United Arab Emeries (UAE), Japan, and Singapore. They warned that these foreign regulatory frameworks for DeFi are causing U.S. DeFi companies and innovators to move abroad so that their businesses and projects can receive regulatory certainty. They contended that the U.S. must develop a regulatory framework for DeFi to ensure that the U.S. DeFi industry remains competitive and ensure the U.S.’s global leadership in financial markets.
  • Liability for DeFi Protocol Creators and Operators: Rep. Sean Casten (D-IL) and Mr. Hays argued that DeFi protocol creators and operators should face some liability when their protocols are used to facilitate illegal conduct. Mr. Hays noted how DAO platform developers and administrators will often intervene to stop transactions. He asserted that these interveners should be held accountable when the transactions that they are helping to facilitate result in support for illicit activities. Subcommittee Vice Chairman Warren Davidson (R-OH) and Ms. Tuminelli stated however that a party that creates a neutral tool should not be held responsible when another party uses the neutral tool to commit a crime.
  • DeFi Disclosures: Rep. Bryan Steil (R-WI), Mr. Avello, and Mr. Hays expressed interest in developing standardized disclosures for DeFi projects and systems as a means for providing consumer protections. Mr. Avello stated that these mandatory disclosures should include clear explanations of the technology, detailed information on token distributions, and transparency regarding governance. He asserted however that mandatory disclosures should not be considered a panacea for addressing DeFi’s issues or a total substitute for other forms of regulation.
  • Cybersecurity Vulnerabilities: Subcommittee Chairman Hill and Ms. Tuminelli expressed interest in addressing current cybersecurity vulnerabilities within the DeFi space. Ms. Tuminelli noted how the cryptocurrency industry has created several cryptocurrency Information Sharing and Analysis Centers (ISACs) that specialize in addressing cybersecurity risks. She indicated that these ISACs will intervene during hacks and work to support the return of stolen funds from victims. She also mentioned how the cryptocurrency industry has worked to address consumer education and protection. She further stated that many of the risks associated with DeFi could be addressed through addressing DeFi as critical infrastructure.
  • Free Speech and Privacy Concerns: Subcommittee Vice Chairman Davidson, Ms. Rettig, Mr. Van Valkenbugh raised concerns that many proposed DeFi restrictions would infringe on rights to speech and privacy. Mr. Van Valkenburgh contended that the U.S. should have robust anonymity within the DeFi space and commented that this anonymity is an American constitutional right. He elaborated that Americans have a constitutional right to make anonymous transactions that support organizations and causes that defend against discrimination and violations of U.S. constitutional rights. Ms. Rettig also stated that adopting identity requirements for DeFi protocols would import intermediaries into disintermediated systems. She warned that this approach would disadvantage the U.S. from a global competitiveness perspective. Rep. Casten argued however that identity requirements are common within the traditional financial system and that these requirements are key for combatting illicit activities.

Hearing Witnesses:

1. Mr. Brian Avello, Chief Legal Officer, UDHC
2. Ms. Rebecca Rettig, Chief Legal and Policy Officer, Polygon Labs
3. Ms. Amanda Tuminelli, Chief Legal Officer, DeFi Education Fund
4. Mr. Peter Van Valkenburgh, Director of Research, Coin Center
5. Mr. Mark Allen Hays, Senior Policy Analyst, Americans for Financial Reform

Member Opening Statements:

Subcommittee Chairman French Hill (R-AR):

• He expressed interest in having the Subcommittee explore emerging topics, such as tokenization and DeFi, and stated that the Subcommittee must consider the potential costs and benefits of DeFi.
• He remarked that DeFi envisions a financial system that is permissionless, transparent, efficient, and built on top of blockchain networks.
  • He commented that DeFi is based on the idea that individuals should have the freedom to transact without the fear of illegal financial surveillance or abuse by governments.
• He stated that DeFi can shift the way that financial markets and transactions are currently structured and governed through substituting intermediaries with autonomous self-executing code.
  • He commented that DeFi would enable a peer-to-peer financial system where government leaders could not freeze the bank accounts of citizens that attend protests.
• He remarked that Congress can neither legislate thoughtfully nor conduct oversight of regulatory agencies without first understanding the technology that it seeks to address.
  • He described DeFi as complex, cutting edge, changing, and a “completely different way of working.”
• He stated that DeFi is fundamentally a technology that would reimagine how parties transact with one another.
• He discussed how the U.S.’s current regulatory and legal frameworks were designed for a financial system with centralized intermediaries.
  • He commented that these frameworks do not contemplate the decentralized peer-to-peer ecosystems made possible by digital assets and blockchains.
• He noted how foreign jurisdictions, such as the EU, have chosen to explicitly carve out DeFi in their digital assets legislation so that the jurisdictions can better understand the technology.
• He stated that the U.S. House of Representatives had taken a similar approach to DeFi in drafting the FIT21 Act.
  • He mentioned how this legislation had directed the U.S. Department of the Treasury, the SEC, and the CFTC to study DeFi issues together and to report back to Congress on their findings and recommendations.
• He criticized the Biden administration for its use of rulemaking and enforcement actions to oversee the DeFi space and asserted that these actions threaten DeFi’s existence and future use in the U.S.
• He remarked that the hearing would consider how decentralized peer-to-peer technology can preserve individual freedom and improve financial services for businesses and consumers.
  • He also expressed interest in improving the ability of Americans to assess and leverage DeFi technology in a safe and secure manner.

Subcommittee Ranking Member Stephen Lynch (D-MA):

• He noted how DeFi generally refers to virtual asset protocols and services that allow for automated peer-to-peer transactions through using blockchain technology.
  • He lamented however that there does not exist a consensus definition of DeFi among regulators or industry.
• He noted how DeFi providers claim to offer permissionless and interoperable payments, which enable efficiency and anonymity.
• He stated however that these features have made DeFi attractive to illicit actors seeking to engage in illegal activity.
  • He noted how bad actors are developing techniques to conceal the origins of their cryptocurrency funds (including chain hopping and the use of anonymity-enhanced cryptocurrencies).
• He mentioned how a recent U.S. Department of the Treasury risk assessment report had found that cyber criminals, scammers, and ransomware actors are taking full advantage of DeFi vulnerabilities to launder illicit proceeds.
  • He also commented that the DeFi space’s lack of compliance with Anti-Money Laundering/Countering the Financing of Terrorism (AML/CFT) laws makes this space especially susceptible to illegal activity.
• He remarked that there exists consensus regarding the need for faster payments, anonymity, and privacy and asserted that policy changes can enable these goals in legal and safe ways.
  • He highlighted his support for the Electronic Currency and Secure Hardware (ECASH) Act, which would direct the U.S. Department of the Treasury to explore privacy-preserving technology that facilitates permissionless, interoperable, and instant payments.
• He also expressed encouragement with the U.S. Federal Reserve’s progress in achieving a real-time payments system.
  • He expressed hope that the U.S. will pursue additional financial innovation projects, such Project Hamilton.
• He then discussed how the digital assets industry has experienced “episodes of implosion,” numerous enforcement actions, and various reports of scams and money laundering.
• He stated that the digital assets industry is seeking to become exempt from basic investor and consumer protections and national security laws.
  • He commented that the growing presence of the digital assets industry in the upcoming election cycle demonstrates the industry’s desire to remain unregulated.
• He remarked that the Subcommittee should have explored DeFi and tokenization issues “long before” digital assets legislation had been introduced.
• He noted how the FIT21 Act (which he had opposed) does not address DeFi services and urged the Subcommittee to refrain from advancing similar digital assets legislation.
  • He warned that such legislation would invite the same consumer and investor protection risks by legitimizing the digital assets industry.
• He remarked that the DeFi and digital assets industry’s claims cannot be trusted.
  • He asserted that the Subcommittee should instead explore policy changes that modernize the payments and banking systems and that encourage safe innovation.

Witness Opening Statements:

Mr. Brian Avello (UDHC):

• He remarked that DeFi has evolved “rapidly” since 2017 and recounted his previous experience serving as general counsel for the Maker Ecosystem Growth Foundation.
  • He explained that the Maker Ecosystem Growth Foundation is a now dissolved software company that had worked with industry partners to bring a credit generation platform and a decentralized stablecoin to market.
  • He also mentioned how he has invested in various startup companies that bridge DeFi and centralized finance (CeFi).
• He remarked that a thoughtful regulatory framework is essential for DeFi to fully integrate into traditional financial systems.
• He described DeFi as an open-source technology movement that encompasses a broad spectrum of products operating outside of centralized financial institutions.
  • He noted how these products are built upon public permissionless blockchains (such as Ethereum) and involve various business models.
  • He commented that these products focus primarily on borrowing, lending, decentralized exchange, and real world assets.
• He highlighted how DeFi projects are open protocols, which mean that anyone can use these protocols to build new and innovative products.
• He noted how the leading DeFi applications currently range from borrowing and lending protocols to decentralized exchanges.
  • He explained that the borrowing and lending protocols enable users to lend their crypto assets in exchange for returns.
  • He explained that decentralized exchanges facilitate peer-to-peer trading through automated market makers.
• He also discussed the growth of real world assets and explained that these assets are on-chain representatives of off-chain assets that provide users with access to either interest bearing opportunities or alternative assets.
  • He also noted how real world assets offer users near real time execution and settlement and easily verifiable accounting.
  • He indicated that real world assets can include government securities, corporate credit, and tokenized funds and allow for accredited and institutional investors to access various sources of yield on-chain.
• He raised concerns regarding the regulatory landscape surrounding DeFi and commented that many users are underinformed regarding the complexities of DeFi protocols.
• He stated that the absence of traditional intermediaries within the DeFi space complicates compliance and noted how most (if not all) current financial regulations assume the existence of intermediaries (such as banks, brokers, and investment advisors).
  • He commented that these current regulations can be difficult to reconcile with peer-to-peer and peer-to-protocol transactions.
• He remarked that the U.S. could address these regulatory challenges for DeFi by enhancing consumer protections through mandatory disclosures.
  • He indicated that these mandatory disclosures should include clear explanations of the technology, detailed information on token distributions, and transparency regarding governance.
• He asserted however that mandatory disclosures should not be considered a panacea for addressing DeFi’s issues or a total substitute for other forms of regulation.
  • He commented that mandatory disclosures are one of several actions that the U.S. could take before DeFi is sufficiently regulated and integrated into the financial system.
• He remarked that a multi-agency regulatory framework for DeFi could ensure that DeFi users are fully informed about the protocols that they access and are protected from malicious actors.
  • He also stated that this regulatory framework would permit DeFi developers and user communities to compliantly innovate and scale DeFi technology within the U.S.
• He concluded that DeFi has shown remarkable growth and potential since its inception and that policymakers should focus on disclosure and consumer protection in regulating DeFi.

Ms. Rebecca Rettig (Polygon Labs):

• She noted how her company, Polygon Labs, is an international software development company that builds blockchain technology.
• She discussed how DeFi refers to a software system that allows users to engage independently in financial transactions and stated that DeFi is part of the larger Web3 movement.
  • She commented that the Web3 movement provides peer-to-peer transparent networks for increased competition and individuals with control over their own data.
  • She emphasized that there are no large technology companies or large financial institutions involved in DeFi transactions.
• She stated that the “hallmark” of DeFi is that users always retain custody and control over their assets and their data. 
• She explained how DeFi protocols are a set of automated code-based rules that allow for financial transactions when users provide instructions.
  • She commented that DeFi protocols are similar to the software protocols that underlie the internet.
• She noted how the code for DeFi protocols is open, can be reviewed in real-time, and can be audited by anyone.
  • She commented that DeFi protocols do not have a “proprietary black box,” which is the norm within the traditional financial sector.
• She remarked that the aforementioned features of DeFi protocols increase predictability for users and promote competition to build better user experiences.
• She discussed how DeFi protocols are built upon public infrastructure (such as blockchain networks) and noted how DeFi transactions are cryptographically settled on these networks via automated consensus of thousands of computers.
  • She commented that this infrastructure creates a transparent record of transaction data and that this infrastructure can be accessed and used by anyone with an internet connection.
• She also discussed how the U.S. Cybersecurity and Infrastructure Security Agency (CISA) oversees the U.S.’s technological infrastructure in collaboration with various other government agencies, including the U.S. Department of the Treasury and law enforcement agencies.
  • She asserted that DeFi could fall under CISA’s purview.
• She noted how DeFi currently enables users to exchange crypto assets for other types of crypto assets, provide crypto asset liquidity for borrowing, and engage in novel trading strategies.
• She stated however that DeFi remains nascent and noted how DeFi currently holds around $78.9 billion of crypto asset value.
  • She indicated that this amount is only 3.9 percent of the total value of crypto assets and 0.7 percent of global gross domestic product (GDP).
• She discussed how regulators have recognized that traditional financial laws cannot be perfectly applied to non-intermediated systems (such as DeFi systems).
  • She indicated that regulators that have recognized this dynamic include the International Monetary Fund (IMF), the Financial Stability Board (FSB), and the UK’s HM Treasury.
• She noted that EU, Japanese, Singaporean, and UAE regulators have implemented centralized cryptocurrency regulations and that these regulators have all not implemented DeFi regulations.
  • She highlighted how the EU’s Markets in Crypto-Assets Regulation (MiCA) specifically exempts services performed in a fully decentralized manner without intermediaries and requires a study of DeFi.
• She mentioned how other regulators have devoted time and resources to analyzing novel DeFi use cases.
  • She indicated that these regulators include the Bank of International Settlements (BIS), various central banks, and the Monetary Authority of Singapore.
• She then remarked that DeFi addresses many of the core policy considerations of traditional financial services in a different manner.
  • She elaborated that DeFi addresses these considerations through automation, transparency, and user control over assets and data.
• She also stated that many of the risks associated with DeFi could be addressed through addressing DeFi as critical infrastructure.
  • She mentioned how she had recently co-authored a paper examining how CISA and the U.S. Department of the Treasury’s Office of Cybersecurity and Critical Infrastructure Protection (OCCIP) could work together to mitigate cyber and system management risks to bring about policies to protect both users and markets.

Ms. Amanda Tuminelli (DeFi Education Fund):

• She discussed how her organization, the DeFi Education Fund, is a non-profit and non-partisan group that educates lawmakers and the public about DeFi and advocates for sound DeFi policy.
• She remarked that DeFi would enable a more equitable and efficient financial system that would provide people with access to finance regardless of their location globally and regardless of the merits of their application.
  • She asserted that DeFi improves upon traditional finance because DeFi does not rely upon traditional intermediaries.
  • She also asserted that efforts to demand that DeFi look, function, and be treated like traditional finance are futile.
• She stated that DeFi enables peer-to-peer transactions where users self-custody their assets (similar to cash).
  • She noted how DeFi enables people to trade assets, make and take loans, and earn interest.
• She discussed how the traditional finance system relies upon intermediaries that often serve as “gatekeepers” and noted how traditional financial institutions can and do deny access to the system for discriminatory reasons or no reasons at all.
  • She indicated that DeFi by contrast is open access and emphasized how any user with an internet connection can access a DeFi protocol.
• She also stated that the traditional financial system is expensive to access and slow to use.
  • She elaborated that sending money through the traditional financial system typically involves paying fees to third parties and waiting days for the transaction to be approved or processed.
  • She indicated that DeFi by contract enables users to send money or execute more complicated transactions anywhere in the world on a 24/7 basis with nearly instant settlement.
• She further stated that DeFi is superior to the traditional financial system because it is self-custodial and noted how failures in the traditional financial system can cause customers to lose access to their assets.
  • She commented that DeFi users do not have to fear losing access to their money during a banking crisis because assets in a self-hosted wallet are always available to the user.
• She then remarked that the U.S. should not seek to apply existing rules for traditional finance to the DeFi space and asserted that this approach would be ineffective.
• She discussed how the traditional financial system requires intermediaries to function and noted how brokers impact stock trades and how clearinghouses settle transactions.
  • She commented that this system necessitates trust in intermediaries to do their jobs reliably and honestly and that existing rules have evolved to prevent the abuse of trust.
• She stated however that the purpose of DeFi technology is to eliminate the need for intermediaries and to empower people to transact directly with their peers.
• She discussed how existing laws assume that there exists some identifiable entity that can take possession of funds, collect information about transactions, and block trades.
  • She indicated however that such an entity does not exist within the DeFi space.
• She remarked that the “untenable” position between current law and DeFi technology has led to an increasing amount of regulatory uncertainty.
  • She stated that seasoned lawyers cannot provide their clients advice with certainty about whether their DeFi projects comply with the law.
• She noted how judges in multiple district courts across the U.S. have called on Congress to make new rules regarding digital assets.
  • She also mentioned how the U.S. House of Representatives has supported bipartisan efforts to address digital assets and has signaled that the status quo is not working for DeFi and digital assets.
• She remarked that the U.S.’s previous efforts to apply existing rules to DeFi technology has resulted in hostility toward innovation, which has caused U.S. jobs and businesses to move overseas.
  • She commented that most DeFi developers want to build a better financial system legally.
• She stated that the U.S. should seek to foster the domestic development of DeFi technology through providing a clear legal path for these developers.
  • She asserted that a domestic DeFi industry is key for U.S. national security and economic development.

Mr. Peter Van Valkenburgh (Coin Center):

• He discussed how financial intermediaries can and do learn the intimate information about their customers and noted how the U.S. Supreme Court had ruled in its 1976 United States v. Miller decision that Americans have no reasonable expectation of privacy in the records that they keep with third parties.
  • He noted however that many financial transactions no longer require a human intermediary and commented that this concept is known as DeFi
  • He also stated that the U.S. Supreme Court is poised to overrule its 1976 United States v. Miller decision.
• He remarked that technological innovation often follows a pattern of an initial loss of privacy followed by the advent of privacy-restoring technologies and the issuance of new laws and court decisions to protect expectations of privacy.
  • He commented that this pattern was evident in telephone communication and appears to be underway in financial transactions.
• He stated that while American dynamism and Constitutional law have historically driven these changes, he asserted that it is not inevitable that the U.S. will always lead in technological innovations.
• He warned that the U.S.’s failure to allow Americans to use and develop peer-to-peer financial systems will cause these systems to be used and developed overseas.
  • He further warned that re-intermediating and surveilling peer-to-peer financial transactions would reduce the U.S.’s global competitiveness.
• He expressed concerns that the U.S. is currently pursuing several policies that would hinder the development of peer-to-peer financial systems.
  • He first mentioned how the IRS is drafting rules that would force unhosted wallet software developers to monitor the users of their software (which he described as a form of re-intermediation).
  • He secondly mentioned how the DoJ is prosecuting mere software publishers as unlicensed money transmitters.
  • He thirdly mentioned how OFAC has banned Americans from using certain DeFi software tools, including for domestic and entirely legitimate purposes.
  • He lastly mentioned how the SEC is using enforcement activities to fit cryptocurrency activities into traditional regulatory frameworks that require intermediaries.
• He stated that these federal agencies are pursuing these “regressive” strategies without clear Congressional direction.
  • He asserted that the IRS’s rules are contradicting the language of the Infrastructure Investment and Jobs Act (IIJA), the DoJ is offering unjustified interpretations of the BSA, and the SEC is exceeding its jurisdiction through overzealous enforcement and an unconstitutional rulemaking.
• He remarked that Congress has a “pivotal” role to play in preserving American dynamism and stated that the Blockchain Regulatory Certainty Act, the Keep Your Coins Act of 2023, and the FIT21 Act would clarify the legal landscape for peer-to-peer financial systems and enable innovation within this space.
• He also mentioned how his organization, Coin Center, is working to educate Congress and the Executive Branch about DeFi technologies, advocate for reasonable regulation, and preserve constitutional rights.
  • He highlighted how Coin Center is involved in two legal challenges to regulatory overreach within the DeFi space.

Mr. Mark Allen Hays (Americans for Financial Reform):

• He mentioned how his organization, Americans for Financial Reform, is a coalition of over 200 consumer, community, labor, civil rights, and other organizations that advocate for a financial sector that serves workers, communities, and the “real economy.”
  • He also indicated that Americans for Financial Reform seeks a financial sector that supports the advancement of economic and racial justice.
• He stated that the cryptocurrency and DeFi industries claim to provide alternatives to traditional finance through using technologies to bypass intermediaries and through offering new ways to build wealth.
• He asserted however that the cryptocurrency industry is volatile, scam-laden, and frequently predatory, which exposes investors to substantial financial losses.
  • He mentioned how the FBI had just reported that there were $5.6 billion in losses in 2023 alone associated with cryptocurrency.
  • He noted that while cryptocurrencies accounted for 10 percent of cases reported to the FBI, he indicated that cryptocurrencies accounted for 50 percent of the total losses reported to the FBI.
• He stated that the cryptocurrency industry experiences these problems because the industry does not comply with or is not subject to the same sort of investor and market protections found in conventional markets.
  • He commented that many Americans have lost their life savings because of the cryptocurrency industry’s practices and that these losses have particularly harmed people from communities of color and low-income neighborhoods.
• He remarked that cryptocurrencies and DeFi must be subject to the same kinds of investor protections and market regulations as other retail investment markets.
  • He commented that these rules promote market transparency, price discovery, and market stability, as well as protect investors from fraud and market manipulation.
• He stated that the aggressive promotion of new cryptocurrency products is responsible for some of the current risks within the cryptocurrency space.
  • He noted how this promotion often includes the use of celebrity endorsers to boost investor interest in digital assets with little real world tangible value.
  • He indicated that the most recent example of this type of promotion is the launch of World Liberty Financial, which has insinuated the involvement of public figures (including the Trump family).
• He asserted that these promotional activities for cryptocurrency products often harm consumers.
  • He referenced a study from Harvard University and Indiana University that had found that the value of cryptocurrency ventures promoted on influencer social media posts had fallen by 18 percent within three months.
• He disputed the DeFi industry’s claim that its technology democratizes finance and makes regulatory standards found in other markets less needed or entirely unnecessary.
  • He asserted that there exists “considerable” consolidation of the ownership, control, infrastructure, and economic relationships within the DeFi space.
• He remarked that DeFi is not significantly decentralized and commented that a limited set of powerful players control crucial elements of the DeFi industry.
  • He mentioned how one industry study had found that just 1 percent of DeFi platform users control 90 percent of the governance tokens on ten major DAOs.
• He also stated that DeFi technology has enabled or allowed multiple scams and hacks, which had amounted to $1.5 billion in losses in 2023 alone.
• He remarked that DeFi is composed of de facto cryptocurrency-based intermediaries that play similar roles and impose similar risks as traditional financial markets.
  • He commented however that DeFi entities are not covered by or abide by the protections and rules that exist in traditional financial markets.
• He stated that the DeFi industry is “replete” with risks and harms, including widespread hacks and cyberattacks, extractive and exploitive financial products and services, market manipulation, and illicit finance.
• He contended that these problems warrant a proactive regulatory approach to protect investors, cryptocurrency markets, and the financial system.
  • He lamented however that Congress’s efforts to advance cryptocurrency-related legislation (such as the FIT21 Act) have mostly proposed creating new, lax, and custom-made cryptocurrency and DeFi regulations or exempting the DeFi industry from existing regulatory oversight altogether.
• He remarked that Congress should work with regulators to use existing regulatory authorities to protect investors, consumers, and communities from the risks and harms that DeFi presents.
• He also stated that Congress should work with regulators to hold cryptocurrency and DeFi actors accountable for complying with existing rules and regulations.
  • He commented that while studying DeFi issues may be useful, he asserted that such studies should not preclude action to protect consumers.

Congressional Question Period:

Subcommittee Chairman French Hill (R-AR):

• Chairman Hill remarked that the U.S.’s regulatory and legal frameworks were designed for a financial system with centralized entities. He stated that it can be challenging to regulate DeFi and traditional finance the same because of DeFi’s permissionless peer-to-peer nature. He asserted that the risks posed by traditional finance differ from the risks posed by DeFi. He asked Ms. Tuminelli to identify the potential risks that regulators should be focused on when considering DeFi.
  • Ms. Tuminelli remarked that the inherent risks within the traditional financial system are related to intermediaries. She elaborated that these intermediaries are often opaque, discriminatory, and subject to human bias or subjective error. She stated that the risks associated with DeFi systems are more related to the actual technologies (such as vulnerabilities in code), consumer protection, and consumer education. She remarked that illicit finance poses risks in both the traditional financial system and the DeFi system. She asserted however that illicit finance risks must be addressed differently in the traditional finance system than in the DeFi system.
• Chairman Hill interjected to remark that the U.S. must authenticate DeFi systems and protect against bad actors in the DeFi space. He asked Ms. Tuminelli to indicate whether the U.S. faces significant cybersecurity vulnerabilities. He expressed opposition to efforts to build larger databases within the U.S. because these databases will become larger targets for bad actors. He asked Ms. Tuminelli to address how the U.S. can protect DeFi systems from hacks.
  • Ms. Tuminelli remarked that there exists a significant difference between a cybersecurity risk and a risk on the actual blockchain layer with the technology itself. She stated that cybersecurity risks are often localized to a single person or a small group of identifiable people. She commented that the U.S. knows how to address cybersecurity risks and has experience addressing these risks.
• Chairman Hill interjected to state that the U.S. has a poor track record of addressing cybersecurity risks.
  • Ms. Tuminelli noted how the cryptocurrency industry has created several cryptocurrency ISACs that specialize in addressing cybersecurity risks. She indicated that these ISACs will intervene during hacks and work to return stolen funds to victims. She also mentioned how the cryptocurrency industry has worked to provide consumer education and protection. She highlighted how several DeFi application developers have built fraud alerts and scam alerts into their front-end software to protect their users.
• Chairman Hill then noted how the SEC had recently proposed a rule that would broadly expand the definition of an exchange to capture DeFi. He asked Ms. Tuminelli and Mr. Van Valkenburgh to opine on the SEC’s proposed rule. He described the SEC’s proposed rule as a “massive overreach.” He asked Ms. Tuminelli and Mr. Van Valkenburgh to address how the exchange function should be considered within the context of DeFi.
  • Ms. Tuminelli criticized the SEC’s failure to define what constitutes a crypto asset security and commented that this definition is a precursor to the discussion around how an exchange should be defined. She remarked that the SEC’s proposed exchange definition is too broad and would encompass DeFi system developers and protocols. She asserted that these developers and protocols cannot comply with the SEC’s proposed definition for exchange.
  • Mr. Van Valkenburgh expressed agreement with Ms. Tumnelli’s answer. He also remarked that the SEC’s proposed definition for exchange raises First Amendment concerns. He noted how the U.S. Supreme Court had previously ruled in Lowe v. SEC that the SEC had been overzealous in its enforcement of the Investment Advisers Act of 1940​​ in regulating publishers of newsletters. He stated that the SEC is now seeking to regulate people that “make available a communications protocol.” He asserted that making available a communications protocol should fall under publishing speech, which would make the SEC’s proposed rulemaking unconstitutional.

Subcommittee Ranking Member Stephen Lynch (D-MA):

• Ranking Member Lynch mentioned how the multi-service cryptocurrency platform De.Fi had recently estimated that DeFi platforms had lost almost $2 billion in crypto assets in 2023 due to hacks, thefts, and exploits. He indicated that De.Fi had provided 448 documented cases of these losses. He also noted how about 10 percent of these losses were recovered for investors according to De.Fi’s report. He stated that this $2 billion in crypto asset losses in 2023 was significantly less than the $47 billion in crypto asset losses in 2022. He discussed how the BSA, AML rules, and the establishment of the FDIC had been the result of previous financial industry crises. He asked Mr. Hays to respond to arguments that the U.S. does not need financial intermediaries, despite the prevalence of theft and fraud within the DeFi space. He also asked Mr. Hays to address how bad actors would benefit from the U.S.’s failure to apply AML and know your customer (KYC) rules to the DeFi space.
  • Mr. Hays expressed agreement with Ranking Member Lynch’s concerns regarding the large consumer losses associated with DeFi platforms. He noted that while there exists a focus on the role in which cybersecurity and the technology of DeFi platforms facilities some of these problems, he asserted that there always exists a human component behind these issues. He remarked that these problems have parallels in the traditional financial system and the economics of finance. He stated that existing regulatory structures seek to address these problems. He discussed how many hacks are inside jobs and noted how rug pulls involve insiders dictating how code is written and promoting tokens or products to investors with limited knowledge of those products. He contended that more disclosures and information (such as the requirements found in traditional securities regulation) would help investors to understand the parties behind predatory products and how these predatory products are being operated and offered. He commented however that such disclosures and information are not currently available within the DeFi space. He noted how white papers are not standardized and involve difficult to understand code. He also discussed how oracle attacks and the manipulation of real world price data demonstrate that DeFi platform interfaces can have design flaws and vulnerabilities. He then noted how money launderers look for gaps within the existing financial system and raised concerns that KYC controls often do not exist within the DeFi space. He lamented how the U.S. Department of the Treasury has just recently implemented many AML measures for different financial professionals that had been passed in the early 2000s. He attributed this delayed implementation of the AML measures to industry resistance. He warned that the U.S.’s continued failure to provide adequate AML enforcement within the DeFi space would cause the U.S. to remain vulnerable to money laundering. He asserted that the U.S. must therefore provide consistent rules for both the traditional financial system and the DeFi system.
• Ranking Member Lynch then asked Mr. Hays to address whether DeFi is as decentralized as DeFi supporters claim. He noted how there are studies indicating that small groups of people control DeFi systems.
  • Mr. Hays remarked that research from both industry and outside observers suggests that DeFi is not actually decentralized. He stated that DeFi cannot provide its offered benefits if decentralization cannot be defined and cannot be realized. He contended that the U.S. should take a precautionary approach to regulating DeFi. He commented that the U.S. should reign in DeFi activities before DeFi becomes fully integrated into the broader financial system.

Rep. Frank Lucas (R-OK):

• Rep. Lucas asked Ms. Rettig to discuss how blockchain technology enables decentralized digital ownership. He also asked Ms. Rettig to identify use cases for blockchain technology beyond DeFi.
  • Ms. Rettig discussed how DeFi protocols are deployed onto permissionless blockchain networks. She noted how blockchain networks (such as Ethereum) require large numbers of computers that must come into consensus to settle DeFi transactions. She indicated that these networks are “highly decentralized” at the base layer and that these networks may also be decentralized at the DeFi application layer. She stated that DeFi protocols that operate without intermediaries autonomously through software are decentralized. She then discussed how there exist several non-financial use cases for blockchain technology. She mentioned how Polygon Labs had launched an open-source database of blockchain technology use cases called the Value Prop. She noted that there are currently over 500 blockchain technology applications and 43 blockchain technology use cases. She indicated that the non-financial blockchain technology use cases outweigh the financial blockchain technology use cases. She mentioned how the California Department of Motor Vehicles (DMV) has digitized 42 million car titles to facilitate the title transfer process. She also discussed how GEODNET is a blockchain technology application that pulls satellite data to provide farmers with better predictability regarding their crops.
• Rep. Lucas asked Mr. Van Valkenburgh to discuss the impact of decentralizing the internet.
  • Mr. Van Valkenburgh remarked that the “paradigm shift” of DeFi is the removal of intermediaries. He stated that the cybersecurity threats facing the internet are part of this “paradigm shift.” He noted how hackers currently target centralized servers and noted how these centralized servers contain large amounts of user data. He asserted that the internet does not need to be built upon centralized servers. He noted how the internet was originally constructed with a focus on individual servers and commented that this system fostered censorship resistance, autonomy, and privacy. He stated however that large technology companies (including Facebook and Google) have subsequently built services on top of the internet and have established “moats” around their user data. He remarked that DeFi and other blockchain technology applications would return the internet to its original form. He stated that DeFi would enable people more freedom to create on the internet and provide people with ownership of their own data on the internet.
• Rep. Lucas then stated that while quantum computing has “enormous untapped potential” to solve the world’s most complex problems, he warned that bad actors could use quantum computing to wreak havoc. He noted how cryptography serves as the “backbone” for cryptocurrencies and asserted that this cryptography must be able to function in a world with quantum computing. He asked Ms. Tuminelli to discuss the attention that has been provided to post-quantum cryptography in the context of DeFi protocols as quantum computing further develops.
  • Ms. Tuminelli expressed agreement with Rep. Lucas’s description that cryptography serves as the “backbone” of blockchain and DeFi technology. She called cryptography “key and central” to the future of DeFi.
• Rep. Lucas remarked that quantum computing could have “dramatic” impacts on encryptions. He asked the witnesses to address how the U.S. could ensure that new quantum computing systems do not compromise DeFi systems.
  • Mr. Van Valkenburgh remarked that quantum computing could make many current cryptocurrency systems obsolete “in a dangerous way.” He stated however that quantum computing-enabled hacks would provide real time-signals to update DeFi systems. He noted how large centralized banks, financial institutions, financial services providers, and internet corporations may get hacked and may fail to rapidly disclose these vulnerabilities. He stated that the openness of DeFi systems would enable vulnerabilities to be immediately patched. He also stated that the value in DeFi systems means that there exists a strong “bug bounty” to draw people to fix these vulnerabilities.

Rep. Bill Foster (D-IL):

• Rep. Foster asked the witnesses to address how bad actors are identified and effectively banned within the DeFi space. He also asked the witnesses to indicate whether there exists a concept of bad actors within the DeFi space.
  • Mr. Avello mentioned how UDHC has invested in a company that is building zero-knowledge proof protocols.
• Rep. Foster interjected to comment that zero-knowledge proof protocols are currently not ready to be deployed. He asked Mr. Avello to address how bad actors are identified and effectively banned within the DeFi space using existing technology.
  • Mr. Avello testified that the zero-knowledge proof protocol company that received UDHC’s investment has launched a product that is currently being used in the marketplace. He acknowledged that while this company has not built sizable market share, he stated that the company is growing “significantly.”
• Rep. Foster interjected to remark that zero-knowledge proof protocols have “fundamental” problems. He noted how these protocols still require a trusted third party to control their privacy budgets. He mentioned how he had reviewed the mathematics underlying zero-knowledge proof protocols and has personally programmed blockchains. He then asked the witnesses to address how bad actors could be identified and effectively banned in anonymous and self-hosted systems.
  • Ms. Rettig remarked that there exist three primary ways that bad actors are identified and banned in DeFi systems. She first noted how there exists an organization called the Security Alliance that monitors and works with law enforcement agencies to identify hacks and engage in other types of activities.
• Rep. Foster interjected to posit a scenario where a bad actor has been identified and then subsequently reappears with an anonymous self-hosted wallet. He asked Ms. Rettig to indicate how the bad actor in this scenario could be re-identified.
  • Ms. Rettig noted how law enforcement and blockchain analytics tools can trace much of this illicit activity.
• Rep. Foster interjected to remark that these law enforcement and blockchain analytics tools cannot trace all of this illicit activity. He asserted that all of this illicit activity must be traced and expressed doubts regarding whether such tracing capabilities are technically possible.
  • Ms. Rettig acknowledged that while the U.S.’s current system under the BSA for monitoring illicit activity is not perfect, she asserted that the U.S. should strive to fully police illicit activity within the DeFi ecosystem. She stated that there exist various ways to identify and address bad actors. She recommended the creation of a new category for critical communications transmitters that would adopt enhanced risk mitigation measures to support financial integrity.
• Rep. Foster interjected to ask Ms. Rettig to explain how DeFi systems identify and ban bad actors. He also asked Ms. Rettig to address how DeFi systems trace bad actors given how a single bad actor can operate multiple identities anonymously.
  • Ms. Rettig stated that her proposed critical communications transmitters would make immediate reports to FinCEN. She indicated that while these reports will not be identical to suspicious activity reports (SARs), she stated that these reports would contain information that would enable FinCEN and other law enforcement agencies to trace wallets and anything emanating from the wallets.
• Rep. Foster posited a scenario where one user is operating 12 anonymous wallets. He asked Ms. Rettig to explain how her proposed system of critical communications transmitters would address this scenario.
  • Ms. Rettig remarked that public-private partnerships involving the FBI and the DoJ have proven effective in quickly tracing wallets involved in illicit activities. She stated that these efforts to trace illicit wallets have been much quicker than the efforts to trace illicit funds within the traditional financial system.
• Rep. Foster asked Ms. Rettig to address whether her proposed system of critical communications transmitters could address the most deliberately anonymous financial products. He acknowledged that the answer to his question might involve classified information and that Ms. Rettig might not be able to answer the question at the hearing.
  • Ms. Rettig stated that she could not deeply discuss whether her proposed system of critical communications transmitters could address the most deliberately anonymous financial products given concerns over classified information. She stated however that funds from some of the worst bad actors are frozen today and cannot be moved due to the immediate identification of these bad actors based on the collaborative efforts of industry and law enforcement agencies.
• Rep. Foster asked Ms. Rettig to indicate whether the freezing of a party’s funds results in the freezing of activities in every anonymous wallet controlled by the party.
  • Ms. Rettig stated that the freezing of a party’s funds results in the freezing of the party’s identified illicit funds.
• Rep. Foster stated that there does not exist a way to ban a bad actor within the DeFi space. He commented that the bad actor could engage in illicit activities using another self-hosted wallet.
  • Mr. Rettig commented that a bad actor may engage in illicit activities using another self-hosted wallet.
• Rep. Foster interjected to discuss how investors within the traditional financial system are protected from predatory behaviors. He stated however that the same protections from predatory behaviors cannot exist in a system involving anonymous self-hosted wallets that can vote on governance issues. He asked Mr. Hays to indicate whether this situation could be addressed.
  • Mr. Hays expressed agreement with Rep. Foster’s concerns. He noted how there exists a concentration of governance token ownership across platforms. He stated that some venture capital firms are using their governance tokens to dictate the functioning of certain platforms. He commented that these venture capital firms are seeking to govern these platforms for their own benefit (rather than for the benefit of retail investors).
• Rep. Foster indicated that his question period time had expired.

Rep. John Rose (R-TN):

• Rep. Rose discussed how his state of Tennessee is a leader in blockchain technology investment and attributed the state’s leadership in this space to its “forward thinking” approach to regulation. He mentioned how Tennessee had recently passed legislation that allows for limited liability companies (LLCs) to register as DAOs. He noted how Tennessee was the second state in the U.S. to pass such legislation. He asked Mr. Avello to explain what DAOs are and why DAOs have become so popular.
  • Mr. Avello discussed how DAOs involve individuals leveraging blockchain technology to create a governance system without a centralized management team. He noted how DAOs have collective decision making across the members and typically involve a governance token. He indicated however that some DAOs do not have governance tokens. He then attributed the popularity of DAOs to their ability to bring people together with a shared interest in a given project. He stated that this interest can be related to DeFi, investments, or social interests. He commented that there exist a variety of activities that people engage in through DAOs. He stated that DAOs enable these people to organize easily. He further discussed how DAOs take on various forms, including LLCs, overseas foundations, and groups that operate without legal entities. He lastly stated that the flexibility offered through DAOs has contributed to the popularity of these organizations.
• Rep. Rose then mentioned how the IRS had proposed a 2023 rule that would require broker reporting of sales and exchanges of digital assets. He commented that this rulemaking appeared to be contingent on the assumption that broker businesses are in the position to know a person’s potential tax obligation. He asked Ms. Tuminelli to indicate whether the IRS’s proposed rule is workable.
  • Ms. Tuminelli remarked that the IRS’s 2023 proposed rule requiring brokers to report sales and exchanges of digital assets is not workable. She called the proposed rule’s definition of the term “broker” extremely broad and commented that it would subject a broad class of Americans to reporting requirements. She stated that this proposed rule would require commissioners of fantasy football leagues to report the winnings or losses of all of the participants in their fantasy football leagues. She commented that fantasy football commissioners would fall under the definition of a broker as part of the IRS’s proposed rule.
• Rep. Rose asked Ms. Tuminelli to indicate the status of the IRS’s 2023 proposed rule requiring brokers to report sales and exchanges of digital assets.
  • Ms. Tuminelli noted how the IRS has finalized the part of the proposed rule that applies to parties outside of DeFi. She applauded the IRS for working to learn more about the DeFi space before finalizing their proposal to apply to the DeFi space.
• Rep. Rose then stated that Congressional Democrats and the Biden administration are falsely claiming that the digital assets are tools for avoiding tax liability. He asked Ms. Tuminelli to address how the DeFi industry could support tax compliance.
  • Ms. Tuminelli noted how individuals are responsible for addressing their own tax liability. She stated that there exist software and technology solutions that make it easier for a person to assess their own tax liability and pay that tax liability. She emphasized however that individuals are ultimately responsible for paying their own taxes.
• Rep. Rose then mentioned how FinCEN under the Trump administration had released 2019 guidance to provide legal clarity for DeFi developers and businesses. He stated however that the DoJ under the Biden administration has subsequently pursued more aggressive enforcement activities against DeFi developers and businesses. He asked Ms. Tuminelli to discuss the impact of the DoJ’s current enforcement approach on the DeFi industry.
  • Ms. Tuminelli mentioned how FinCEN had finalized guidance in 2019 that had been “very helpful” to the DeFi industry. She noted how this guidance had explained what a money service business was in the context of providing and publishing software. She indicated that the DeFi industry had relied upon this guidance for years. She stated however that the DoJ had recently decided that the guidance did not have the force of law and that it would therefore not comply with the guidance. She lamented how FinCEN and the DoJ have expressed disagreement as to how federal law applies to DeFi developers and businesses. She commented that this disagreement harms these developers and businesses.
• Rep. Rose indicated that his question period time had expired.

Full Committee Ranking Member Maxine Waters (D-CA):

• Ranking Member Waters remarked that while DeFi aims to create greater efficiencies and transparency, she also asserted that DeFi can pose heightened risks of hacks, scams, information asymmetries, and conflicts of interest that can harm consumers and investors. She stated that these risks are present in the new DeFi venture World Liberty Financial (which is being run by Donald Trump Jr. and Eric Trump). She discussed how bad actors had taken advantage of World Liberty Financial to scam World Liberty Financial’s potential users. She mentioned how bad actors had hacked the X accounts of Lara Trump and Tiffany Trump and had used these X accounts to announce links to a coin falsely claiming to represent World Liberty Financial. She indicated that at least 200,000 people had viewed these fraudulent announcements and that approximately 2,000 people had purchased $1.8 million in fake tokens as a result of these fraudulent announcements. She remarked that lawmakers have a responsibility to consider strong protections to prevent similar types of scams moving forward. She then stated that opaque DeFi platforms with unclear governance and control mechanisms may impede regulators in establishing responsibility and accountability for compliance. She noted how various regulators (including the SEC and the CFTC) have needed to navigate complex legal issues. She indicated that these legal issues have played out in litigation involving DAOs and virtual currency mixers. She asked Mr. Hays to discuss how regulators can address mass non-compliance from entities claiming that decentralization exempts them from regulatory compliance. She also asked Mr. Hays to provide recommendations for ensuring that there exist robust consumer and investor protections within the DeFi industry.
  • Mr. Hays remarked that regulators could continue to follow their current courses of actions to address regulatory non-compliance within the DeFi industry. He noted how the Securities Exchange Act of 1934 had intended for the definition of the term “exchange” to be expansive to cover many different scenarios. He mentioned how Congress has previously decided against narrowing this law’s definition of the term “exchange.” He remarked that the SEC’s rulemaking regarding the definition of “exchange” would provide clarity based on the functional nature of how exchanges operate. He stated that this rulemaking indicates that a party that matches a buyer and a seller should be considered an exchange. He elaborated that such a party could be a regulated exchange under the Securities Exchange Act of 1934, an alternative trading system (ATS), or a designated contract market (DCM) under the CFTC’s jurisdiction. He stated that the SEC is continuing to work this rulemaking to provide further clarification. He expressed support for the SEC’s current work on this rulemaking. He also mentioned how the CFTC’s case against Ooki DAO has demonstrated that there exist times and places where DAOs meet the facts and circumstances similar to an unincorporated association. He commented that persons have responsibility in these types of situations. He remarked that legislation that undermines the ability of regulators to pursue non-compliance within the DeFi industry would be misguided.

Rep. Bryan Steil (R-WI):

• Rep. Steil remarked that DeFi technology shows both promises and risks. He mentioned how DeFi hacks had cost more than $3.6 billion in 2022 and commented that this figure has likely increased in subsequent years. He asked Ms. Rettig to discuss how DeFi protocols and the broader DeFi community have worked to address these risks. He also asked Ms. Rettig to identify additional actions that can be taken to address existing vulnerabilities within the DeFi system.
  • Ms. Rettig remarked that any hacks, scams, or risks facing the DeFi system should be mitigated as thoroughly as possible. She stated that the three primary risks in DeFi are cyber risks, system management risks, and usage risks. She indicated that there are current efforts to address these risks. She highlighted how the Security Alliance is looking into these risks from an illicit finance perspective and is training developers to build safer DeFi ecosystems. She also mentioned how the Security Alliance is training developers to implement system management controls to ensure that there do not exist centralized places of data or other areas of vulnerabilities. She further discussed how there exist “significant” public-private partnerships between the DeFi industry and law enforcement agencies to address these risks.
• Rep. Steil then noted how Mr. Avello’s written testimony had discussed how many DeFi participants experience challenges navigating the jargon and code associated with DeFi projects. He also noted how Mr. Avello had stated that many DeFi projects fail to present fulsome information. He asked Mr. Avello to identify actions that DeFi market participants can take to ensure that counterparty communications and disclosures are better understood.
  • Mr. Avello remarked that many of the most notable DeFi projects disclose large amounts of information. He stated that these disclosures include granular-level information and plain English explanations of the projects (such as how the project’s smart contracts function).
• Rep. Steil interjected to ask Mr. Avello to provide recommendations for how regulators should develop rules governing disclosures and other forms of communications for DeFi projects.
  • Mr. Avello remarked that regulators must engage with the DeFi industry. He also stated that regulators should ensure that DeFi project information is simple and clear to understand for users.
• Rep. Steil then mentioned how Polygon Labs maintains a database of DeFi use cases. He noted how SEC Commissioner Hester Peirce had asserted that the SEC’s approach to exchange regulation is too rigid to allow for new technologies or new ways of conducting business. He remarked that laws and regulations must evolve to accommodate innovation safely. He asked Ms. Rettig to discuss current DeFi use cases that would benefit U.S. workers and families.
  • Ms. Rettig noted how DeFi has both financial and non-financial use cases. She highlighted how DeFi can enable faster payments and mentioned how DeFi has supported humanitarian aid transfers from the U.S. to Venezuelan health workers and to Ukraine’s war efforts involving Russia.

Rep. Sean Casten (D-IL):

• Rep. Casten raised concerns that the potential beneficial uses of DeFi technology are being to justify the non-application of AML rules to DeFi technology. He mentioned how Ooki DAO had advertised itself as a means for evading AML laws and noted how the CFTC had pursued Ooki DAO for enabling illegal activities. He asked Mr. Van Valkenburgh and Ms. Tuminelli to indicate whether a DeFi protocol’s creators and operators should face legal accountability if the protocol is found to be violating AML rules.
  • Mr. Van Valkenburgh noted how custodial parties are subject to AML laws and stated that AML laws should be enforced against these parties.
• Rep. Casten interjected to ask Mr. Van Valkenburgh to indicate whether AML rules should be applied to DeFi protocols.
  • Mr. Van Valkenburgh remarked that an American transacting with an immutable smart contract using their own funds should not be subject to the BSA.
• Rep. Casten asked Ms. Tuminelli to indicate whether a DeFi protocol’s creators and operators should face legal accountability if the protocol is found to be violating AML rules.
  • Ms. Tuminelli remarked that bad actors should be held liable for the bad conduct that they engage in. She stated however that developers should not be held liable when bad actors use their software or protocols to engage in bad conduct.
• Rep. Casten asked Ms. Tuminelli to indicate whether the parties that had created the DeFi protocols should face any liability for illegal conduct involving their protocols.
  • Ms. Tuminelli stated that a party that creates a neutral tool should not be held responsible when another party uses the neutral tool to commit a crime.
• Rep. Casten described Ms. Tuminelli’s response as “bizarre” and stated that DeFi protocols can aid and abet in the commission of felonies. He asked Mr. Hayes to indicate who should have liability in cases where DeFi protocols are used to enable illegal activities.
  • Mr. Hayes discussed how developers and administrators will intervene in DAO platforms facilitating transactions on a fairly regular basis. He indicated that this intervention can occur directly or indirectly through the functions of the DAO. He noted that these developers and administrators can update the code, issue assets, and alter validation processes. He added that these interventions can involve people both inside of the developer team and people outside of the developer team. He remarked that these interveners should be held accountable when the transactions that they are helping to facilitate result in support for illicit finance activities. He argued that the U.S. must develop a means for providing these developers with some degree of accountability for the activities on their protocols.
• Rep. Casten then noted security transactions on traditional stock exchanges have clear custody titles and commented that a party cannot participate in securities transactions as an anonymous actor. He asked Ms. Rettig to indicate whether similar identity requirements should be applied to DeFi protocols.
  • Ms. Rettig stated that adopting identity requirements for DeFi protocols would import intermediaries into disintermediated systems. She warned that this approach would disadvantage the U.S. from a global competitiveness perspective.
• Rep. Casten acknowledged that his question period time had expired. He asserted that the U.S. economy would not be harmed if the U.S. refuses to protect the interests of child traffickers, money launderers, and the North Korean nuclear system.

Rep. Mike Flood (R-NE):

• Rep. Flood remarked that the largest implications of DeFi are unrelated to its financial applications and commented that smart contracts have applications beyond asset speculation and currencies. He expressed specific interest in Web3 technology and how this technology would disempower large technology companies that currently yield significant influence. He discussed how video creators are currently beholden to YouTube’s rules governing the sharing of advertising revenue. He stated that Web3 technology would eliminate intermediaries (such as YouTube) and enable video creators to keep more of the revenues produced by their content. He explained that the infrastructure of Web3 platforms would guarantee that the video creators are compensated directly for the value that they provide. He noted how Polygon Labs is involved with some Web3 technology projects. He asked Ms. Rettig to discuss these projects and the potential for a decentralized internet.
  • Ms. Rettig noted how Polygon Labs builds the networks upon which Web3 applications are built. She indicated that these Web3 applications include both financial applications and non-financial applications. She highlighted how Web3 could enable users to hold their own intellectual property (IP), as well as their own assets and own data. She commented that these ownership capabilities would be especially beneficial within the context of social media.
• Rep. Flood asked Ms. Rettig to discuss the status of web decentralization efforts. He also asked Ms. Rettig to predict when decentralized web solutions will be more broadly offered to consumers.
  • Ms. Rettig remarked that Web3 technology has likely not even reached 25 percent of its full potential. She stated however that progress regarding Web3 technology is “very far along” and asserted that this progress is moving at an “exponentially rapid pace.”
• Rep. Flood mentioned how he had worked professionally in the media industry prior to entering Congress. He expressed interest in how a decentralized internet could impact traditional print media, traditional broadcast media, and overall news consumption patterns. He noted how many newspapers are going out of business, which is resulting in fewer government watchdogs. He asked Ms. Rettig to opine on Web3 technology’s impact on the media space.
  • Ms. Rettig remarked that Web3 applications are changing how the U.S. consumes information. She noted how Web3 applications enable individuals to transmit news stories online in an immutable fashion and crowdsource information in novel ways.
• Rep. Flood acknowledged that it can be challenging to forecast future innovations and remarked that the U.S. should be the global leader in blockchain technology. He stated that the proper harnessing of blockchain technology would provide significant opportunities for U.S. innovation. He commented that these blockchain technology promotion efforts must involve protections for U.S. citizens and vulnerable populations. He raised concerns that Congress could impede domestic blockchain technology innovation and allow for foreign countries to lead this innovation.

Rep. Wiley Nickel (D-NC):

• Rep. Nickels remarked that DeFi has “transformative potential” and commented that DeFi can make the financial system more accessible, transparent, efficient, innovative, and inclusive. He expressed interest in working to mitigate the risks associated with DeFi. He called it important for DeFi to remain a bipartisan issue and expressed interest in working to support both domestic DeFi innovation and DeFi consumer protections. He asserted that these goals of domestic innovation and consumer protection are not mutually exclusive. He asked Ms. Rettig to discuss the risks associated with DeFi and how the Committee could address these risks.
  • Ms. Rettig remarked that policymakers and industry stakeholders agree regarding the need to address illicit finance problems within the DeFi sector. She mentioned how she had published a January 2024 paper that had proposed a three-part framework for addressing illicit finance within the DeFi space. She first proposed expanding the definition of independent control found in FinCEN’s 2019 guidance. She commented that this definition should seek to identify existing intermediaries that possess regulatory obligations. She secondly proposed treating pure technology protocols as critical infrastructure (similar to electronic clearing systems and financial messaging systems). She lastly proposed creating a new category of entities that will have additional risk mitigation obligations within the financial integrity space. She stated that the creation of this new category of entities would support the U.S. in meeting the BSA’s goals of document detection and deterrence of bad actors.
• Rep. Nickel then asked Ms. Rettig to discuss how other jurisdictions are approaching the regulation of DeFi. He also asked Ms. Rettig to indicate whether the U.S.’s regulation of DeFi lags other countries (such as China).
  • Ms. Rettig lamented that the U.S. is lagging “far behind” the rest of the world in regulating DeFi. She noted how foreign regulators have been engaging with the DeFi industry over the previous five or six years and described these foreign regulatory approaches as “collaborative.” She mentioned how the EU, the UK, and various Asian countries (including Japan and Singapore) have expressed interest in further exploring DeFi regulations. She highlighted how French prudential regulators have proposed to regulate DeFi in a manner similar to cyber infrastructure. She indicated that this French proposal would entail imposing cybersecurity standards and audits on DeFi protocols. She asserted that foreign regulators are approaching DeFi very differently than U.S. regulators are approaching DeFi. She recommended that the U.S. further study DeFi.
• Rep. Nickel remarked that foreign countries are actively courting DeFi companies and seeking to take DeFi jobs away from the U.S. He called it important for the U.S.’s regulatory approach to DeFi to keep pace with foreign regulatory approaches to DeFi. He expressed hope that Congress can develop a regulatory framework for the DeFi space. He noted how there are reports that innovators and capital are leaving the U.S. due to the U.S.’s lack of regulatory clarity for DeFi. He asked Mr. Avello to discuss the human capital and financing trends that he is observing as the U.S. DeFi and Web3 technology sector becomes less globally competitive.
  • Mr. Avello testified that he had observed many promising DeFi companies with talented developer teams being forced to move abroad. He stated that while these DeFi companies often want to remain in the U.S., he asserted that the U.S.’s current regulatory uncertainty surrounding DeFi makes it too challenging for these companies to remain in the U.S. He commented that these companies must move abroad to effectuate their businesses.

Subcommittee Vice Chairman Warren Davidson (R-OH):

• Vice Chairman Davidson called DeFi an “essential component” for a vibrant U.S. financial sector and warned that the U.S.’s failure to pursue DeFi would jeopardize U.S. global leadership in financial markets. He criticized certain Subcommittee Democrats for asserting that DeFi protocols should be liable for enabling illegal activities. He commented that this treatment is not provided to traditional technology companies when their platforms enable illegal activities. He also asserted that many proposed DeFi restrictions would infringe on rights to speech and privacy. He asked Mr. Van Valkenburgh to elaborate on how DeFi restrictions would infringe on the freedom of speech.
  • Mr. Van Valkenburgh remarked that the U.S. will likely not achieve total identification of and control over DeFi transactions. He stated that the U.S. will instead have robust anonymity within the DeFi space and commented that this anonymity is an American constitutional right. He elaborated that Americans have a constitutional right to make anonymous transactions that support organizations and causes that defend against discrimination and violations of U.S. constitutional rights. He recounted how former U.S. Supreme Court Associate Justice Thurgood Marshall had argued in a dissenting opinion that the BSA should not apply to custodial intermediaries because the law enforcement benefits of this application does not outweigh the need to protect First Amendment rights.
• Vice Chairman Davidson remarked that privacy is key to DeFi’s appeal and functioning. He discussed how companies currently charge fees to users to surveille their transactions. He elaborated that credit card companies verify consumer transactions and provide consumers with protections if invalid transactions are made. He raised concerns however that the U.S. government can force credit card companies to provide transaction data on consumers without a warrant or a subpoena. He also noted how he can transact anonymously as a consumer through using cash. He highlighted how cash transactions are non-intermediated and that people are less able to reclaim cash post-transaction. He asked Ms. Rettig to indicate how DeFi could function without privacy.
  • Ms. Rettig indicated that DeFi transactions would have pseudonymity, which would conceal consumer identities and certain types of consumer information. She also stated that all Americans should be able to access the U.S. financial and payments systems without needing credit cards and large banks. She commented that DeFi and the Web3 movement is meant to democratize access to the U.S. financial and payments systems.
• Vice Chairman Davidson expressed hope that the U.S. DeFi industry will be successful.

Rep. Brad Sherman (D-CA):

• Rep. Sherman remarked that cryptocurrencies facilitate tax evasion, drug trafficking, human trafficking, and sanctions evasion. He commented that Russia and Iran have embraced cryptocurrencies and unhosted wallets because these technologies enable these illicit activities. He asserted that tax evasion remains the key market for cryptocurrencies. He noted how the U.S. has $1 trillion in uncollected taxes annually, which amounts to $3 trillion in unreported income annually. He then expressed interest in exploring whether DeFi systems constitute securities. He posited a hypothetical system where an individual gives their money to another individual for management and lending. He indicated that the individual providing the money in this hypothetical system receives a return based on the other individual’s management and lending of their money. He asked Mr. Hays to indicate whether this hypothetical system would constitute a security.
  • Mr. Hays stated that the test under the U.S. Supreme Court’s SEC v. W.J. Howey Co. decision (known as the Howey test) for determining whether an asset constitutes a security is designed to consider a broad range of facts and circumstances. He stated that there exist many circumstances where cryptocurrencies (whether issued on CeFi platforms or DeFi platforms) should be classified as securities under the Howey test. He also stated that a platform does not need to be exclusively issuing or facilitating the transfer of securities for the platform to trigger the terms and conditions obligations to become a securities exchange. He concluded that the Howey test can help determine whether a given investment arrangement meets the definition of a security.
• Rep. Sherman remarked that DeFi proponents that emphasize the privacy characteristics of DeFi systems for tax evaders are “waging a war against economic democracy.” He also asserted that DeFi would create an economic system that discourages the payment of taxes. He stated that while only a small number of wealthy people may initially use DeFi to evade paying their taxes, he warned that the legitimization of DeFi would eventually cause a larger number of wealthy people to evade paying their taxes. He commented that his warning of widespread tax evasion is based on his assessment of tax enforcement trends in other countries where small numbers of wealthy individuals are able to evade paying their taxes.

Rep. William Timmons (R-SC):

• Rep. Timmons called DeFi an “incredible advancement” in financial technology. He stated that DeFi leverages blockchain technology and smart contracts to create an open, transparent, and accessible financial ecosystem. He commented that DeFi enables anybody located anywhere in the world to access services (including lending and trading) without relying upon centralized authorities. He stated however that Congress has not yet fully acknowledged, understood, and addressed DeFi technology, which has impeded U.S. innovation within the DeFi space. He remarked that incorporating DeFi into the U.S. regulatory perimeter constitutes a “complex endeavor” given the innovative nature of DeFi protocols. He asked Mr. Van Valkenburgh to identify whether there exist additional challenges facing the U.S.’s oversight mechanisms and regulatory structures as DeFi systems become more popular.
  • Mr. Van Valkenburgh remarked that tax evasion is a crime that should be aggressively policed. He asserted however that the existence of tax evasion warrants a fully surveilled and controlled financial system. He discussed how the cryptocurrency industry has faced challenges obtaining clear guidance from the IRS regarding how Americans can pay their taxes when they earn capital gains or wages on cryptocurrency networks.
• Rep. Timmons noted how blockchain networks are open ledgers that are publicly accessible. He asked Mr. Van Valkenburgh to explain how one could evade taxes using an open ledger system.
  • Mr. Van Valkenburgh remarked that open blockchain networks make it more difficult for people to evade taxes. He stated that the legacy financial system enables users to open shell accounts globally to evade taxes. He also remarked that the IRS has been very late to offer clear guidance to cryptocurrency users. He blamed the IRS for current tax collection issues within the cryptocurrency space. He stated that the IRS should have offered guidance on brokers who need to file third-party tax documentation and reports long ago using existing authority from Congress. He noted how Coinbase is a custodial broker of cryptocurrency for tax purposes and asserted that Coinbase should be engaging in third-party tax reporting to ensure sufficient tax compliance. He stated that legislation should not have been needed to designate Coinbase as a broker and commented that the IRS could have designated Coinbase as a broker under its existing authorities. He applauded Congress for directing the IRS to provide third-party tax reporters in the cryptocurrency space with guidance as part of the IIJA. He criticized the IRS for subsequently seeking to apply third-party tax reporting rules to non-custodial intermediaries. He asserted that the IRS’s proposed rules will not work and will trample constitutional rights.
• Rep. Timmons interjected to comment that the U.S. government is not helping cryptocurrency tax reporting efforts. He then remarked that the Biden administration (through the U.S. Department of the Treasury and the SEC) have pursued a “regulation by enforcement” approach to DeFi. He stated that some foreign jurisdictions (such as the EU) have taken a different regulatory approach to the DeFi space. He asked Ms. Rettig to identify lessons from foreign regulatory frameworks for DeFi that could positively influence the U.S.’s development of its own regulatory framework for DeFi.
  • Ms. Rettig remarked that foreign jurisdictions have moved forward with centralized cryptocurrency regulation and have provided clear guidance to centralized actors within the cryptocurrency space. She also stated that governments throughout the world have decided to further study DeFi. She mentioned how some foreign regulators have conducted their own experiments with DeFi. She also noted how some foreign regulators have looked at DeFi protocols as technology that should be reviewed from a cyber perspective to accomplish policy goals.
• Rep. Timmons remarked that DeFi will play a key role in the future of technology and will result in disruption. He stated that the U.S. must be the global leader within the DeFi space.