It’s not a matter of if, but when

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Cryp­to reg­u­la­tion, com­pli­ance and enforce­ment have been the top­ics du jour in 2022. 

Momen­tum for increas­ing gov­ern­ment over­sight of cryp­to has nev­er been stronger fol­low­ing the col­lapse of Ter­ra-LUNA, Three Arrows Cap­i­tal, many cryp­to lend­ing plat­forms and now the spec­tac­u­lar demise of FTX and what appears to be cat­a­stroph­ic fraud by its founder, Sam Bankman-Fried. Specif­i­cal­ly for enforce­ment, unprece­dent­ed sanc­tions have been levied against smart con­tract address­es in the case of cryp­tocur­ren­cy mix­er Tor­na­do Cash.

Many juris­dic­tions, in the mean­while, are mak­ing tremen­dous progress in estab­lish­ing reg­u­la­to­ry frame­works. The Coun­cil of the Euro­pean Union has reached an agree­ment on mar­kets in cryp­to-assets (MiCA) pro­pos­al. Like MiCA, the draft Lum­mis-Gilli­brand bill in the Unit­ed States out­lines a com­pre­hen­sive frame­work that encom­pass­es key pil­lars includ­ing over­sight of cen­tral­ized ser­vice providers, con­sumer pro­tec­tion and stablecoins.

While draft sta­ble­coin reg­u­la­tion has begun to coa­lesce, reg­u­la­tion of the broad­er decen­tral­ized finance (DeFi) ecosys­tem is still in its infan­cy. DeFi reg­u­la­tion is most­ly out of scope in both Euro­pean and Amer­i­can frame­works. As the French Cen­tral Bank deputy gov­er­nor explained, “MiCA reg­u­la­tion is not an end in itself but rather the start of a process.”

Giv­en the cur­rent stance and direc­tion of the world’s top cen­tral bankers and pol­i­cy­mak­ers, the indus­try needs to play a more active role in shap­ing the future of DeFi reg­u­la­tions. It is no longer viable to fight off reg­u­la­tion; instead, the indus­try needs to be more prag­mat­ic, to head off the dan­gers of overregulation.

Where are we at now?

Cen­tral bankers acknowl­edge the poten­tial for blockchain tech­nol­o­gy to improve the finan­cial sys­tem, though they are deeply con­cerned about sys­temic risk impli­ca­tions and the lev­el of risk-tak­ing by the aver­age con­sumer. These con­cerns, along with pre­vi­ous neg­a­tive per­cep­tions, were fur­ther gal­va­nized by the col­lapse of FTX and the con­sumer harm it caused. 

Reg­u­la­tors are still for­mu­lat­ing a game plan for DeFi; focus­ing on a flex­i­ble frame­work and cast­ing a wide net to meet rapid tech­no­log­i­cal progress. They plan to be ready for the blockchain and beyond. Addi­tion­al­ly, much atten­tion is being paid to key para­me­ters of trans­paren­cy, gov­er­nance and accountability.

The indus­try needs to take a proac­tive approach and take a more active role in shap­ing the out­come. It is no longer viable to try to hold back reg­u­la­tion, instead, the indus­try needs to be more col­lab­o­ra­tive. This is vital to head off the appar­ent dan­gers of over­reg­u­la­tion that can become too sub­jec­tive and too reliant on judgment.

How do regulators really feel? 

In the open­ing remarks from a recent round­table host­ed by the French Cen­tral Bank, E.U. Com­mis­sion­er Mairead McGuin­ness called tok­eniza­tion (and cryp­to more broad­ly) a Wild West and warned that “those law­less days are com­ing to a close.” These strong words and char­ac­ter­i­za­tion set an omi­nous tone for the future of DeFi regulation.

U.S. Fed­er­al Reserve Chair Jerome Pow­ell also struck a crit­i­cal tone, cau­tion­ing: “With­in the DeFi ecosys­tem, there are very sig­nif­i­cant struc­tur­al issues around lack of trans­paren­cy.” Powell’s com­ment quick­ly drew the ire of indus­try par­tic­i­pants who are quick to tout the trans­ac­tion­al trans­paren­cy of the blockchain. How­ev­er, it is like­ly that Pow­ell is allud­ing to the opac­i­ties in DeFi-relat­ed to per­son­al iden­ti­ty, legal enti­ty, gov­er­nance, exploit risks and mon­ey laun­der­ing concerns.

These view­points reflect the E.U. and U.S. reg­u­la­to­ry sen­ti­ments, with each respec­tive gov­ern­ment pur­su­ing its own nation­al poli­cies but also orga­niz­ing through supra­na­tion­al stan­dard-set­ting bod­ies such as the Finan­cial Sta­bil­i­ty Board (FSB). 

As key influ­encers, it is no sur­prise that the Euro­pean and Amer­i­can view­points have rever­ber­at­ed in FSB pol­i­cy, such as the recent­ly pub­lished con­sul­ta­tive doc­u­ment for the inter­na­tion­al reg­u­la­tion of cryp­to assets. The doc­u­ment echoes Powell’s views on trans­paren­cy, accus­ing decen­tral­ized tech­nol­o­gy of opaque­ness and a lack of accountability. 

Why is regulating DeFi so difficult?

Cen­tral bankers are not naive about the com­plex­i­ty and dif­fi­cul­ty of reg­u­lat­ing DeFi and are aware of the dif­fi­cul­ties inher­ent with non-tra­di­tion­al legal enti­ty struc­tures, decen­tral­ized gov­er­nance, and the anonymi­ty of per­sons “in charge.”

Ravi Menon, man­ag­ing direc­tor of the Mon­e­tary Author­i­ty of Sin­ga­pore, com­ment­ed that “pin­ning gov­er­nance and risk man­age­ment respon­si­bil­i­ty on the (right) play­ers in the DeFi world is exceed­ing­ly dif­fi­cult.” Menon then made the pow­er­ful claim that it would be hard for DeFi to exist with­out prop­er reg­u­la­tion applied to the prop­er per­sons, call­ing it a “game stopper.”

The FSB con­sul­ta­tive doc­u­ment attempts to offer guid­ance, urg­ing reg­u­la­tors to “estab­lish ways to iden­ti­fy who exer­cis­es effec­tive con­trol on the pro­to­col or pro­vides access to the pro­to­col, and to make them account­able under exist­ing or future reg­u­la­tion.” How­ev­er, these sug­ges­tions are dif­fi­cult in prac­tice and may sug­gest some lev­el of naivete with regards to the prac­ti­cal imple­men­ta­tion of DeFi regulation.

How does the industry deal with regulatory pressure?

Cen­tral author­i­ties’ desire to con­trol and reg­u­late DeFi is dia­met­ri­cal­ly opposed to the decen­tral­ized and pseu­do­ny­mous nature of DeFi. 

Per­haps the indus­try founder that most clear­ly antic­i­pat­ed this con­flict is none oth­er than Andre Cron­je, a key fig­ure­head of the yearn.finance (YFI) pro­to­col and one of the most influ­en­tial devel­op­ers in the DeFi world. 

In an inter­view with Del­phi Dig­i­tal, Cron­je addressed the reg­u­la­to­ry con­cern of account­abil­i­ty, stat­ing, “Who’s the per­son [the reg­u­la­tors] tar­get? It’s the founders, the devs, the lead roles in the com­mu­ni­ty, even­tu­al­ly, it will be mem­bers on a DAO multi-sig.” 

His pre­scient com­ment comes months before recent events such as the arrest of Tor­na­do Cash devel­op­er Alex­ey Pert­sev and the Com­mod­i­ty Futures Trad­ing Com­mis­sion (CFTC) charg­ing a decen­tral­ized autonomous orga­ni­za­tion (DAO) for offer­ing ille­gal trad­ing of dig­i­tal assets.

Oth­er indus­try founders have also hot­ly debat­ed the top­ic of reg­u­la­tion, most notably Sam Bankman-Fried’s pro­pos­al of self-reg­u­la­to­ry stan­dards and Erik Voorhees’ sharp response and crit­i­cism of those pro­pos­als. Bankman-Fried also lob­bied for the DCCPA bill, wide­ly seen as anti-com­pet­i­tive for the ben­e­fit of FTX and poten­tial­ly detri­men­tal to DeFi.

The debate shows two poles of DeFi that may emerge: one being ful­ly com­pli­ant and reg­u­lat­ed DeFi, the oth­er being per­mis­sion­less DeFi out­side the reach of cen­tral author­i­ties. The sil­ver lin­ing of this sce­nario is that they may not be mutu­al­ly exclu­sive and could pos­si­bly co-exist and thrive. Users will ulti­mate­ly decide where to play, each influ­enced by their nation­al jurisdictions.

How might regulators approach DeFi regulation?

It is too soon to spec­u­late on what a DeFi reg­u­la­to­ry frame­work may look like, but there is much to be gleaned from dis­cus­sions and com­ments from the world’s top cen­tral bankers.

Pow­ell, the U.S. Fed chair, laid out the fun­da­men­tal prin­ci­ple of a tech­nol­o­gy-neu­tral approach that address­es inher­ent risks and activ­i­ties no mat­ter where they reside, blockchain or oth­er­wise. He states: “Some of these cryp­to activ­i­ties resem­ble tra­di­tion­al finan­cial activ­i­ties and they need ‘same risk, same reg­u­la­tion’ wher­ev­er they take place.” 

The FSB echoes a sim­i­lar prin­ci­ple in its con­sul­ta­tive doc­u­ment, pro­mot­ing a reg­u­la­to­ry frame­work that is “tech­nol­o­gy-neu­tral and focus­es on under­ly­ing activ­i­ties and risks.” In fact, the con­cept of “same risk, same reg­u­la­tion” harks back to a speech by U.S. Trea­sury Sec­re­tary Janet Yellen in April 2022, short­ly after Pres­i­dent Joe Biden signed the his­toric dig­i­tal assets exec­u­tive order

It appears that reg­u­la­tors are plan­ning to cast a wide net to rope in all finan­cial activ­i­ties under a reg­u­la­to­ry umbrel­la no mat­ter where they occur. Beyond blockchain, there may also be broad­er impli­ca­tions for fin­tech com­pa­nies that offer finan­cial ser­vices that may sud­den­ly find them­selves with­in the reg­u­la­to­ry perimeter.

One of the biggest chal­lenges for reg­u­la­tors will be rec­on­cil­ing the dis­so­nance between prin­ci­ples of trans­paren­cy, account­abil­i­ty and robust gov­er­nance ver­sus the decen­tral­ized and pseu­do­ny­mous nature of many DeFi sys­tems, some of which are gov­erned through DAOs with­out clear lines of respon­si­bil­i­ty to any par­tic­u­lar person(s). 

Conclusion

Cryp­to, inclu­sive of sta­ble­coins and DeFi, has tremen­dous poten­tial to enable a par­al­lel uni­verse of finan­cial ser­vices beyond the con­trol of con­ven­tion­al author­i­ties such as cen­tral banks and reg­u­la­to­ry agen­cies. It is with­out a doubt that cryp­to now has the full atten­tion of these insti­tu­tions as well as gov­ern­ments around the world. 

Blockchain tech­nol­o­gy has helped to broad­en access to and rede­fine the mean­ing of finan­cial ser­vices. Con­se­quent­ly, the reg­u­la­to­ry perime­ter of finan­cial ser­vices and activ­i­ty will also have to broad­en and be redefined. 

There is an appar­ent dan­ger that reg­u­la­tion could become over­ly sub­jec­tive and rely too heav­i­ly on judg­ment. The future of over­sight will need to move away from enti­ty-based reg­u­la­tion and move toward risk and activ­i­ty-based reg­u­la­tion. Whether a per­son or cor­po­ra­tion or DAO, the inten­tion of the ser­vices being ren­dered will be a deter­min­ing fac­tor of whether they are inside or out­side the reg­u­la­to­ry perimeter.

The cryp­to indus­try would be served well by tak­ing a proac­tive approach and using all avenues and oppor­tu­ni­ties to shape the out­come of DeFi reg­u­la­tion. The indus­try can also ben­e­fit from adopt­ing the sen­ti­ment expressed by Ethereum co-founder Vita­lik Buterin who stat­ed, “It is up to peo­ple in the cryp­to com­mu­ni­ty to pre-empt more adver­sar­i­al sit­u­a­tions, I am very hope­ful that we can have more col­lab­o­ra­tive con­ver­sa­tions between reg­u­la­tors and the industry.”



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