The Situation: Decentralized finance ("DeFi") is a rapidly growing sector that, by definition, eschews centralized financial institutions altogether. Misconduct that has accompanied that growth has drawn the attention of the Commodity Futures Trading Commission ("CFTC"), which has brought three DeFi cases in the last 12 months.
The Result: The latest subject of this scrutiny allegedly artificially affected prices through "oracle manipulation" on three digital asset exchanges to benefit his "perpetual futures" contract positions on a DeFi market. In response, the CFTC recently brought a civil enforcement action, its first for a fraudulent or manipulative DeFi scheme, charging an individual with wash trading and with unlawfully obtaining more than $110 million in digital assets through this manipulative scheme.
Looking Ahead: The CFTC, U.S. Securities and Exchange Commission ("SEC"), U.S. Department of Justice ("DOJ"), and other federal agencies will continue to bring cases involving issues of first impression to apply their jurisdiction in new markets, including DeFi markets, in response to new methods of perceived violations of the statutes they administer.
On January 9, 2023, the CFTC initiated a civil enforcement action against the defendant, who came under scrutiny in October 2022 when he allegedly employed a manipulative strategy across three digital asset exchanges, and Mango Markets, a DeFi protocol, that yielded over $110 million in digital assets. The DOJ and SEC also brought parallel charges. In its complaint, the CFTC alleges that on October 11, 2022, the defendant misappropriated more than $110 million in digital assets from Mango Markets through oracle manipulation. An oracle is a data feed that moves data on and off a blockchain. Oracle manipulation can consist of artificially influencing the data feed to the oracle and/or into the blockchain—in this case, the Mango Markets blockchain. This is the type of oracle manipulation the CFTC alleged in its complaint.
The defendant allegedly executed his improper scheme by creating two anonymous accounts on Mango Markets, which he used to establish long and short perpetual futures contracts in the different accounts based upon the relative prices of MNGO, the native Mango Markets token; and USDC, a stablecoin. According to the complaint, the defendant then began purchasing substantial quantities of MNGO on three digital asset exchanges that were the inputs for the Mango Markets oracle. The complaint alleges that these high quantity, large-scale transactions severely inflated the price of MNGO on those exchanges, in turn significantly increasing the value of the defendant's long perpetual futures position on Mango Markets. He then purportedly cashed out his position by taking a loan he did not intend to repay, which was collateralized by the value of the long position, effectively completely draining Mango Markets's liquidity, and requiring it to suspend operations. Although the value of the defendant's short position decreased dramatically, the defendant needed to establish the short position so that he would have a counterparty for his long position in his other account, according to the complaint. The CFTC charged the defendant with wash trading for executing this offsetting trade.
The complaint states that the defendant then contacted the Mango Decentralized Autonomous Organization ("DAO")—the Mango Markets blockchain operator—to negotiate his return of some of the digital assets that he had "borrowed," conditioned on Mango Markets agreeing, among other things, to not pursue any criminal investigations or freeze the defendant's funds. The defendant agreed to return approximately $67 million in digital assets but retained about $47 million, according to the complaint.
This case represents the first CFTC enforcement action involving DeFi manipulation and fraud and the third CFTC DeFi action overall in a relatively short span of time, since January 2022. The first two were actions against Polymarket in January 2022 and Ooki DAO in September 2022. This trend suggests that the CFTC is attuned to DeFi developments and focused on this space. Two CFTC commissioners released statements concurrent with the announcement of the complaint suggesting that the CFTC is just getting started. For instance, Commissioner Kristen Johnson noted that she supports the CFTC using its "existing authority to vigorously pursue misconduct ... in novel venues like a decentralized digital asset exchange." Commissioner Caroline Pham noted that this enforcement action makes clear that perpetual futures can constitute a swap, which brings such a scheme within the CFTC's jurisdiction.
As to perpetual futures, it is interesting that, although the product is called a perpetual "futures," a product over which the CFTC also has jurisdiction, the CFTC characterized it as a swap. This may be because the CFTC has lost several cases (e.g., CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004); CFTC v. Erskine, 512 F.3d 309 (6th Cir. 2008)) in which it sought to characterize products as futures; and the definition of "swap" in the Commodity Exchange Act ("CEA"), the statute the CFTC administers, is quite broad and possibly easier to apply to particular new products. The CFTC has also stated in the past that the name given to a product does not dictate its legal treatment.
The case is also a notable example of cooperation and coordination among the CFTC, DOJ, and SEC in the DeFi enforcement space. In that regard, the CFTC's Division of Enforcement has an Office of Cooperative Enforcement, which "provides expert help and technical assistance with case development and trials to U.S. Attorneys' Offices, other federal and state ... agencies, and international authorities." The CFTC's Mango Markets enforcement press release makes clear that it is working closely with the DOJ and the SEC (which charged the defendant with manipulating MNGO, "a so-called governance token that was offered and sold as a security"), to crack down on various fraudulent schemes involving digital assets. Relatedly, DOJ's criminal complaint against the defendant was unsealed on December 27, 2022.
Two Key Takeaways
- The CFTC and other federal agencies are focused on DeFi misconduct.
- Though DeFi is new, the statutes cited in enforcement actions administered by the CFTC, DOJ, and SEC (including the CEA, securities laws, or wire fraud) are not new. Therefore, DeFi innovators wishing to avoid a federal enforcement action would be well advised to become familiar with the applicable federal regulatory scheme.
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