Polygon Labs' Bold Strategy to Combat Illicit Finance in DeFi

The proposed solution from Polygon Labs comes at the perfect time as the crypto community is pestered by a resurgence in crypto exchange listing scams.

Polygon Labs and Arktouros law firm have proposed a new regulatory framework that is specifically aimed at fighting against illicit finance activities in decentralized finance (DeFi). Authored by experts from both firms, the paper suggests classifying truly decentralized DeFi protocols as “critical infrastructure” under the oversight of the U.S. Treasury’s Office of Cybersecurity and Critical Infrastructure Protection.

This possible solution came during a new rise in crypto exchange listing scams. Concurrently, the U.S. Securities and Exchange Commission (SEC) has charged Xue Lee and Brenda “Bitcoin Beautee” Chunga with conducting a $1.7 billion fraud scheme involving HyperFund, HyperVerse, and HyperTech.

Polygon Labs’ Plan to Combat Illicit Activities in DeFi

Legal experts from Polygon Labs and Arktouros law firm have proposed a new regulatory framework that could completely redefine how decentralized finance (DeFi) protocols are overseen in the United States. Rebecca Rettig and Katja Gilman of Polygon Labs, along with Michael Mosier of Arktouros, co-authored a 45-page paper titled “A Conceptual Framework for Combating Illicit Finance Activity in Decentralized Finance,” published on Jan. 29.

The paper suggests a pretty novel approach to the regulation of DeFi protocols by referring to them as “critical infrastructure.” This classification would place truly decentralized DeFi protocols under the oversight of the U.S. Treasury’s Office of Cybersecurity and Critical Infrastructure Protection (OCCIP). The OCCIP, while not a traditional financial regulator, still plays a crucial role in enhancing the security and resilience of the financial services sector’s infrastructure, especially in the context of cybersecurity.

The proposed framework did acknowledge that not all DeFi protocols are entirely decentralized, with some exhibiting centralization points. These protocols, the authors argue, should remain subject to existing financial regulations. Conversely, the framework introduces a new category of entities, which are called “critical communications transmitters,” which are deeply intertwined with DeFi systems. These entities would have to adhere to certain obligations tailored to protect U.S. national and economic security, without being classified as “financial institutions” under the Bank Secrecy Act (BSA).

Furthermore, the framework distinguishes between DeFi and centralized finance (CeFi) or traditional finance (TradFi), recommending independent regulatory controls based on guidance from FinCEN (the Treasury’s Financial Crimes Enforcement Network).

Jake Chervinsky, a crypto industry lawyer, also emphasized the importance of this framework, noting that while public discussions often focus on securities and commodities laws, policymakers in Washington, DC, are more concerned about illicit finance in the digital asset industry. He suggests that this new framework could be a real solution to these concerns.

The authors of the paper stress that while combating illicit activities is crucial, it is just as important to encourage legitimate activities in the DeFi space. They believe that their proposed framework aligns with the Treasury’s overarching mandate of promoting economic prosperity and ensuring the financial security of the United States. This proposal marks a potential turning point in how DeFi is regulated, aiming to balance the need for security with the innovative potential of decentralized financial systems.

Rise in Crypto Exchange Listing Scams

Polygon Labs’ solution comes at just the right time as Yi He, the co-founder of Binance, alerted the public about the increase of crypto exchange listing scams. These scams, which have seen a comeback during the broader market recovery, involve impersonators using well known names and positions to deceive people. Yi He emphasized to the crypto community that she does not handle token listings and warned people not to believe anyone claiming to be close to her and discussing investments or listings.

Blockchain author Anndy Lian exposed a similar scam, where individuals pretending to be Binance staff offered free money through cryptocurrency discussion groups on WhatsApp.

Binance's customer support team advised users to verify identities using links from the official Binance website. They also emphasized the importance of confirming the legitimacy of anyone offering unsolicited services related to the platform, and advised people against contacting unverified sources or sharing personal account details.

These scams are not new and were quite popular during the last bull market. Scammers often target project developers and co-founders, using professionally crafted LinkedIn profiles that appear to be from credible exchanges. The scammers typically ask for a very large initial deposit, sometimes more than 250,000 USDT, to begin the token listing process. However, once the deposit is paid, the token is never listed, and the victims are left defrauded.

Massive Crypto Scam Uncovered

The need for better security in the DeFi sector is also evident in the HyperVerse case. The U.S. Securities and Exchange Commission (SEC) has filed charges against two people, Xue Lee (also known as Sam Lee) and Brenda “Bitcoin Beautee” Chunga, in connection with a $1.7 billion fraud scheme involving several crypto ventures, including HyperFund, HyperVerse, and HyperTech. The scheme, which ran from June 2020 to May 2022, involved false promises of high returns from crypto mining operations and plans to list on the Hong Kong Stock Exchange.

The SEC's filing on Jan. 29 revealed that the duo offered various membership packages to investors, guaranteeing high returns. However, these funds were allegedly used for personal luxuries like luxury cars, condos, and crypto wallets. Chunga has agreed to settle the charges with the SEC and faces civil penalties. Additionally, both Chunga and Lee face charges from the U.S. Attorney’s Office for the District of Maryland for conspiracy to commit securities fraud and wire fraud. Chunga has pleaded guilty to these criminal charges. A third individual, promoter Rodney Burton, has also been charged by prosecutors.

According to the SEC, Lee falsely claimed that HyperTech would list on the Hong Kong Stock Exchange by 2022 and used fabricated media appearances and a hired actor to pose as the CEO to enhance the firm's credibility. This fake CEO, who was actually a Thai actor, was part of the elaborate scheme to deceive investors.

The SEC also pointed out a pyramid scheme-like referral system set up by Lee to attract even more investors, promising them participation in initial coin offerings at much lower market prices. Chunga is accused of personally taking $3.7 million, which she spent on luxury items and properties, while Lee directed around $140,000 in cryptocurrencies to his own wallet.

Lee is also under investigation by the Australian Securities Investment Commission after the collapse of another of his cryptocurrency businesses, Blockchain Global, which left $58 million in debts.