Regulatory Challenges to Decentralized Derivative Protocols: Reviewing CTFC’s Polymarket OrderPosted on Feb 15, 2022
Decentralized finance (“DeFi”) generally refers to the “decentralized provision of financial services through a mix of infrastructure, markets, technology, methods, and applications.” Though DeFi lacks a clear legal or technical definition, it typically comprises applications which provide services such as payments, lending, trading, investing, insurance, and asset management using the blockchain. In contrast to traditional finance, DeFi seeks to replace intermediaries in financial transactions with decentralized software protocols.
A growing number of decentralized platforms offer derivatives without traditional intermediaries such as brokers or clearinghouses. Specifically, in the context of DeFi, a derivative protocol facilitates the peer-to-peer trading of derivate contracts, such as synthetic tokens that track fiat currency or digital assets, using automated smart contracts recorded on the blockchain.
This presents a novel dilemma for the regulation of decentralized entities: how does a regulator effectively reach a platform designed to operate outside of regulation?
I. CFTC’s Polymarket Order
The Commodities Future Trading Commission (“CFTC”) has indicated that it believes decentralized derivative protocols fall under its regulatory purview. In June 2021, Commissioner Dan M. Berkovitz stated that he “d[id] not see how [DeFi markets for derivative instruments] are legal under the [Commodity Exchange Act]” which “does not contain any exception from registration for digital currencies, blockchains, or ‘smart contracts.’” In particular, Berkovitz expressed concern with the development of derivatives markets without regulated intermediaries, indicating that their absence could lead to fraud, counterparty failure, and money laundering. However, beyond asserting that the Commodity Exchange Act (“CEA”) likely applies, Berkovitz failed to explain how the CFTC planned to regulate DeFi entities.
On January 3, 2022, CFTC regulators settled their first enforcement action against a purportedly decentralized platform for derivatives contracts. The CFTC charged Blockratize Inc. (“Blockratize”), a Delaware corporation that owns and operates the Polymarket website, for offering off-exchange commodity options and operating as a facility for trading options without registering under the CEA. Polymarket is a “decentralized information markets platform” that allows individuals trade on event-based binary options contracts, a type of prediction market. Polymarket uses an automated market maker to determine the premiums for each contract based on demand for each position. For example, a popular contract on the platform permitted users to place bids on whether a celebrity couple would be engaged by a certain date. According to the CFTC, these binary options for event markets—wagering “yes” or “no”—constitute swaps under the CEA. In its order, the CFTC notes that Blockratize settled for a $1.4 million civil monetary policy, ended non-compliant options markets, and agreed on a “cease and desist” from further violating the CEA.
While this action implicated a self-described “decentralized” platform, the CFTC emphasized certain centralized features of Polymarket’s platform in their drafting charges. For example, the CFTC highlighted that Polymarket defined “market resolution conditions,” or how to determine the winner of a contract if there was a dispute about the outcome, using a “Market Integrity Committee” that only contained Polymarket personnel. Additionally, Polymarket appeared to retain control over liquidity protocols: the CFTC emphasized that, not only did Polymarket and its employees supply liquidity alongside investors, they “set the conditions” for participation and “changed the relevant policies over time.” Moreover, while the CFTC stated that Blockratize did not claim any profits from Polymarket—a note that further distinguished this entity from traditional centralized entities—the presence of an operating entity suggests a degree of centralization despite the self-executing nature of the individual event contracts. Ex post, the fact that Blockratize retained the ability to unilaterally cease the offer of certain contracts and “wind down” non-complaint trading market provides strong evidence that Polymarket was subject to control by a central entity.
The CFTC’s Polymarket order suggests that the commission seeks to bring more enforcement actions against decentralized derivative programs. However, it is still not clear how the CFTC will reach entities with comparatively greater levels of “decentralization,” as these protocol’s intentional ousting of intermediaries removes the traditional hook by which the CFTC typically targets derivatives markets. Further, the decentralized nature of these protocols mean that developers and token holders may lack the ability to halt transactions or modify DeFi platforms in response to regulatory action: even if these individuals are subject to liability, a system of self-executing smart contracts cannot be unilaterally halted if fully decentralized. The CFTC’s order may instead provide a warning to platforms that simply branding oneself as “decentralized” does not provide regulatory cover for the entity’s centralized activities.
 Dirk A. Zetzsche et al., Decentralized Finance, 6 J. Fin. Regul. 172, 173–4 (2020).
 Id. at 173.
 David Gogel et. al, DeFi Beyond the Hype: The Emerging World of Decentralized Finance, Wharton Blockchain and Digital Asset Project, 2(May 2021). The “blockchain” here refers to “[d]istributed ledgers serving as the settlement layer for transactions” which also serve to generate a public record of transactions. Id. Blockchain protocol includes storage of transaction data in bundles—often referred to as blocks—in which “a strict time-related series with each block linked to the previous and subsequent blocks through a time stamp as well as a number of protocols providing evidence of a user’s authority to amend the data stored.” Zetzsche et al., Decentralized Finance, supra note 1, at 180.
 Yan Chen & Cristiano Bellavitis, Blockchain Disruption and Decentralized Finance: The Rise of Decentralized Business Models, 13 J. Bus. Venturing Insights e00230, e00231 (2020).
 The Protocols Bringing Derivatives to DeFi, Quantstamp Labs (May 25, 2021), https://quantstamp.com/blog/the-protocols-bringing-derivatives-to-defi
 Decentralized Derivatives Exchange Platform Development, Antier, (last accessed on Feb. 12, 2022), https://www.antiersolutions.com/decentralized-derivatives-exchange-platform-development/.
 Keynote Address of Commissioner Dan M. Berkovitz Before FIA and SIFMA-AMG, Asset Management Derivatives Forum 2021 (Jun. 8, 2021), https://www.cftc.gov/PressRoom/SpeechesTestimony/opaberkovitz7.
 CFTC Orders Event-Based Binary Options Markets Operator to Pay $1.4 Million Penalty, CFTC Press Release No. 8478-22 (Jan. 3, 2022), https://www.cftc.gov/PressRoom/PressReleases/8478-22.
 In the Matter of: Blockratize, Inc. d/b/a Polymarket.com, CFTC Docket No. 22-09 at 7.
 How it Works, Polymarket (last accessed Feb. 12, 2022), https://polymarket.com/blog/how-it-works.
 In the Matter of: Blockratize, Inc. d/b/a Polymarket.com, CFTC Docket No. 22-09 at 3.
 Will J.Lo and Ben Affleck get engaged by Thanksgiving?, Polymarket Market Position, (last accessed Feb. 12, 2022), https://polymarket.com/market/will-jlo-and-ben-affleck-get-engaged-by-thanksgiving-1.
 In the Matter of: Blockratize, Inc. d/b/a Polymarket.com, CFTC Docket No. 22-09 at 5–7 (“Binary options are swaps as defined under Section 1a(47) the Act, 7 U.S.C. § 1a(47)(A)(ii), which covers any agreement, contract, or transaction: that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.”).
 CFTC Orders Event-Based Binary Options Markets Operator to Pay $1.4 Million Penalty, CFTC Press Release No. 8478-22 (Jan. 3, 2022), https://www.cftc.gov/PressRoom/PressReleases/8478-22 (“All derivatives markets must operate within the bounds of the law regardless of the technology used, and particularly including those in the so-called decentralized finance or ‘DeFi’ space”).
 In the Matter of: Blockratize, Inc. d/b/a Polymarket.com, CFTC Docket No. 22-09 at 4.
 Id. at 3.
 Id. at 5.
 7 U.S.C. § 2(h); 7 U.S.C. 7b-3. See also Heath P Tarber, The Enduring Legacy of the Dodd-Frank Act’s Derivatives Reforms, 6 J. Fin Reg. 159, 164–65 (2020).
 Decentralized Finance (DeFi) Policy-Maker Toolkit, World Economic Forum 22 (June 2021).