Peer-to-face, face-to-face, face-to-face trading – this is the way transactions were done for millennia, before distance and lack of trust forced us to use middlemen such as banks and brokers to complete the transactions.
Now decentralized finance (DeFi) is taking us back to an oversized future. We can perform peer-to-peer transactions not only remotely, but also with confidence by interacting with a smart contract. This innovation laid the foundations for a financial renaissance that goes far beyond simply replacing intermediaries.
Until recently, regulators largely ignored this emerging shadow financial system. But with former blockchain professor Gary Gensler as chairman of the United States Securities and Exchange Commission, DC has woken up. The question is: how can authorities enforce regulations that do not rely on the presence of intermediaries? And how will the regulations protect users and the market?
DeFi protocols may seem out of regulatory scope. Copies of the blockchain’s transaction history are stored in nodes around the world, ready to reappear like the many-headed hydra should one ever be compromised.
Still, the story provides lessons for how regulators might think they can tackle DeFi.
Historically, regulators have only jurisdiction over legal entities under their jurisdiction. This changed with the extraterritorial Foreign Account Tax Compliance Act (FATCA) of 2010, which saw US authorities regulate beyond their currency and US nationals across the world and coordinate with other jurisdictions by signing intergovernmental agreements (IGA) for application.
The EU followed a similar approach with the General Data Protection Regulation (GDPR) in 2018, drafting regulations from their ivory tower to control the data of Europeans wherever they are in the world – well it is not clear how the authorities can enforce against organizations outside the EU. .
Going forward, we may see regulators rely on similar offshore methods to attempt to reach cyberspace and enforce regulation in DeFi.
Choke points and access ramps
However, even with an extraterritorial application, regulators should still identify bottlenecks that could be used to control otherwise decentralized protocols.
These centralization points are already appearing on the regulators’ radar. As Gensler pointed out: DeFi can be a misnomer, with platforms often being “decentralized in some ways but highly centralized in other ways.”
Individual protocols with known developers, or those controlled by corporate token holders, may be forced to obtain protocol changes. And for protocols as decentralized as they claim – run by distributed anonymous communities – regulators could make interaction with the protocol illegal. Or, more likely perhaps, hamper the flow of funds by targeting ramps or marking certain protocols as toxic.
These ramps could be fiat-to-crypto exchanges or stablecoins that could be forced to incorporate due diligence and know-your-customer procedures to ensure compliance with anti-money laundering efforts and terrorism (AML / CFT), etc. To be effective, these future controls will need to be built with DeFi in mind. This could see the sanctions list published as a Chainlink search or free API call from the Financial Action Task Force (FATF) or the Organization for Economic Co-operation and Development (OECD) directly.
At the same time, individual protocols seeking to integrate with the real economy are likely to make compromises that work in favor of regulators.
For example, your Aave customer-aware versions of liquidity pools provide limited DeFi access to institutions using ramps to KYC participants. They are able to mitigate risk by relying on organizations like Chainalysis to scan blockchains to know your transaction (KYT), although this comes at the expense of liquidity depth and does not add to the pie for all participants.
Other promising solutions include smart packaging contracts which allow verified entities to deposit funds and automatically issue “fully compliant assets” that can be used in any DeFi protocol without having to KYC every time. .
On the other hand, protocols can become more decentralized; as we have seen recently, MakerDAO has shut down legal entities and relies solely on DAO. But while these fully decentralized protocols can stay out of the reach of regulators, they could also be separated from the real economy to some extent.
With these scenarios in mind, the question is not how to enforce regulations but what the result regulation should aim to achieve.
How should DeFi be regulated?
As for the changes that should be pushed at the protocol level, we are now at a crossroads.
There is an opportunity for the right level of regulation to give DeFi enough room to make a difference: by strengthening transparency, increasing financial inclusion and enabling credit to 8 billion people who will see the world make a difference. considerable leap towards prosperity.
Yet there is also the potential for overshoot that would stifle innovation and growth and have unintended consequences. Unfortunately, we already seem to be well advanced in this direction.
What is needed is to realize that DeFi shares many of the same goals as financial regulators: to overhaul rigid processes and provide greater access, cheaper prices and more stability, while ensuring that these benefits are met. widely shared with all market participants.
For example, access to liquidity has long been a central concern not only for cryptocurrency and blockchain projects, but for financial markets in general. According to the Bank of England’s 2019 Run Lola Run speech, there is evidence that those further removed from liquidity are getting a deal worse and worse.
DeFi has the potential to create fairer, more transparent and more liquid markets through entirely new mechanisms, helping everyone reduce fraud and running, resolve fragmentation and create efficient, resilient markets, fair and equally accessible to everyone – not just participants with the right connections.
Defining the right regulation could make or break DeFi, and there are some big questions to answer: How do we set portfolio scores? How do we integrate decentralized identifiers (DID W3C)? And how can we make sure that no controls go against financial inclusion?
Given such an opportunity to rebuild finance from the ground up, we need to be bold: set clear goals and create regulation that eases the path to the new financial world – not just settling for a faster version of what we have today.