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09-12-2021|Technology

How should we regulate DeFi?

Peer-to-peer trading, face to face, eye to eye — it's the way deals had been done for millennia, before distance and lack of confidence forced us to use go-betweens such as banks and brokers to transact.

Now decentralised finance (DeFi) has taken us back to an over-collateralized future. By interacting with a smart contract, we can transact peer to peer not only remotely but also securely. This breakthrough has laid the foundation for a financial renaissance that goes far beyond the replacement of intermediaries.

Regulators have largely disregarded the emergence of a parallel financial system until lately. D.C. has awoken with the nomination of former blockchain professor Gary Gensler as chair of the US Securities and Exchange Commission. How can authorities enforce legislation that do not rely on the presence of intermediaries? And how will the regulation protect users and the market?

Deterritorialization > decentralisation

DeFi protocols may appear to be beyond the grasp of regulatory oversight. Copies of blockchain transaction histories are maintained at nodes throughout the world, ready to reemerge if one is compromised, like the many-headed hydra.

However, history teaches us how regulators can assume they can deal with DeFi.

Regulators have traditionally only had jurisdiction over legal entities within their jurisdiction. With the extraterritorial Foreign Account Tax Compliance Act (FATCA) of 2010, U.S. authorities began to regulate outside its currency and U.S. citizens around the world, coordinating with other jurisdictions through the signing of intergovernmental agreements (IGAs).

With the General Data Protection Regulation (GDPR) in 2018, the EU used a similar strategy, creating regulations from their ivory tower to govern Europeans' data wherever they are in the globe — but it's unclear how authorities will enforce against firms outside the EU.

In the future, we may see authorities use similar extraterritorial ways to reach into cyberspace and implement DeFi regulations.

Regulators would still need to discover choke spots that could be utilised to control otherwise decentralised protocols, even if they used extraterritorial enforcement.

These points of centralization already appear to be on the radar of regulators. As Gensler remarked: DeFi can be a misnomer, with platforms often being "decentralized in some aspects but highly centralized in other aspects.”

Individual protocols with well-known developers, as well as those controlled by corporate token holders, may face pressure to make changes. Regulators may make engagement with protocols that are as decentralised as they claim — run by distributed anonymous communities — illegal. Alternatively, stifle the flow of funding by focusing on on-ramps or labelling specific methods as hazardous.

These on-ramps might be fiat-to-crypto exchanges or stablecoins that are required to use due diligence and know-your-client procedures to comply with anti-money laundering and counter-terrorism (AML/CFT) initiatives, among other things. Future controls will need to be designed with DeFi in mind in order to be effective. The punishment list could be made available via a Chainlink lookup or a free API call straight from the Financial Action Task Force (FATF) or Organisation for Economic Co-operation and Development (OECD).

Individual protocols attempting to integrate with the actual economy, on the other hand, are likely to make trade-offs that work in favor of regulators.

By leveraging on-ramps to KYC participants, Aave's know-your-client versions of liquidity pools, for example, provide limited DeFi access to institutions. They can reduce risk by depending on companies like Chainalysis to examine blockchains for know-your-transaction (KYT), but this comes at the cost of liquidity depth and does not increase the pie for all participants.

Other promising solutions include smart wrapping contracts that allow verified entities to deposit funds and automatically mint "fully compliant assets" that can be utilised in any DeFi protocol without having to KYC each time.

On the other hand, protocols may decentralise further; for example, MakerDAO recently shut down legal entities and relies exclusively on the DAO. However, while fully decentralised protocols may remain outside the grasp of authorities, they may also be separated from the real economy to some level.

With these circumstances in mind, the question becomes not so much how to implement regulation as it is what conclusion the regulations should be aiming achieve.

How should DeFi be regulated?

As to what changes should be pushed to protocol level, we now stand at a crossroads.

There is a chance for the appropriate degree of regulation to provide DeFi enough breathing room to make a difference: raising transparency, increasing financial inclusion, and enabling credit to 8 billion people, allowing the world to take a giant leap toward prosperity.

Overreach, on the other hand, has the ability to hinder innovation and progress while also having unintended consequences. Regrettably, we appear to be well down this path already.

What's needed is an understanding that DeFi has many of the same goals as financial regulators: reforming archaic systems and delivering broader access, lower pricing, and greater stability - all while ensuring that these gains are fairly shared among all market participants.

Access to liquidity, for example, has long been a major challenge for cryptocurrency and blockchain initiatives, as well as financial markets in general. According to the Bank of England's 2019 Run Lola Run speech, individuals who are further from liquidity get a poorer and worse bargain.

Through completely new mechanisms, DeFi has the potential to create fairer, more transparent, and liquid markets, assisting everyone in reducing fraud and front-running, resolving fragmentation, and creating markets that are efficient, resilient, fair, and equally accessible to all — not just those with the right connections.

The appropriate legislation could make or break DeFi, and there are a lot of questions that need to be answered: What method do we use to estimate wallet scores? What is the best way to implement decentralised identifiers (W3C DIDs)? And how can we be sure that any regulations we put in place aren't working against financial inclusion?

Given the chance to rebuild finance from the bottom up, we must be bold: set clear objectives and design regulation that smooths the way to the new financial world — rather than settling for a quicker version of what we have today.

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