Will DeFi be regulated? How DeFi can comply with old school compliance

The US SEC announced in 2022 the allocation of 20 additional positions to the unit responsible for protecting investors in crypto markets and from cyber-related threats.

SEC reopens comment period for new DeFi rules

The US Securities and Exchange Commission (SEC) met on 14 April 2023 and voted in favour of reopening the comments period for proposed amendments to the Exchange Act for an extra period of 30 days. Reopening the comments came after crypto companies publicly criticised the plan as unclear and aiming to centralise decentralised finance (DeFi). 

The changes that are deemed controversial in the crypto community were initially proposed in January 2022. The proposal in question wants to expand the definition of an ‘exchange’ by adding that existing rules on traditional finance and exchanges apply to DeFi platforms as well. 

The US Securities and Exchange Commission defines the rules for centralised financial institutions. Within traditional finance, consumers rely on intermediaries such as banks and brokerages to access financial services and capital. On the other hand, DeFi challenges the whole centralised system by providing direct financial services to individuals through peer-to-peer digital exchanges. 

The crypto community fears that such legislative changes could force centralization and rope in the DeFi ecosystem within the centralised financial system. Essentially, it would force many digital asset platforms to register with the Commission. 

If you are a frequent reader, you probably remember that we already examined the importance of decentralisation within contemporary finance in this piece: 'What is decentralisation & why is it important'.

What makes up decentralised finance (DeFi)?

Decentralised finance is an umbrella term for financial services that sit on public blockchain networks, such as Ethereum. In its basic form, DeFi provides you with access to a variety of financial services. These services include simple financial transactions that are provided by every bank to complex financial instruments usually used by investment bankers and hedge funds. 

DeFi enables you to do most of the things supported by traditional finance, yet it is faster and removes the need for an intermediary and paperwork. As peer-to-peer networks, DeFi platforms are open and transparent. Transactions are conducted directly between users and not routed through a centralised financial system as the middleman. 

DeFi is often linked to Ethereum, one of the largest blockchain networks worldwide. Even though most DeFi applications run on the Ethereum blockchain, there are many other ecosystems that provide decentralised financial services such as Polkadot and Tron. Despite the specific blockchain that is used to support decentralised finance, it operates in the same manner. 

A. How does DeFi work?

Decentralised finance uses blockchain technology similar to cryptocurrencies. Blockchain technology, as a distributed ledger technology, is essentially a new way to store data. Instead of centralising information via middlemen that take control over it, blockchain technology stores data across a network where nobody has the authority to control or mess with it. In fact, this sums up the whole point of decentralisation. 

If you want to learn more about blockchain basics, we suggest reading this article: ‘Crypto Basics: What is a Blockchain’.

Applications known as decentralised applications or Dapps are used to handle financial transactions and run on the blockchain. Transactions are recorded in blocks and subsequently verified by other users on the blockchain. If those users as verifiers agree on a particular transaction, that block is closed and encrypted, and another block is created that holds the information about the previous block. 

DeFi platforms don't rely on any centralised financial institutions and are not subject to bankruptcy or any form of adversity. The decentralised nature of DeFi protocols mitigates much of this risk.

Furthermore, DeFi uses so-called smart contracts. A smart contract can be defined as a legal agreement written in code. Similar to traditional agreements, smart contracts contain terms that have to be fulfilled.  

Unlike traditional contracts, smart contracts use a programming language to express the financial side of the agreement such as payment terms and interest. The blockchain it runs on then executes the smart contract.  

Due to blockchain technology’s main perks, smart contracts cannot be altered in any way. Instead of using people as intermediaries and going through formal procedures, smart contract technology is based on code. 

If you want to find out more about how DeFi works, why not read this article: ‘How to use crypto: Getting started with DEFI’. 

B. Use cases of DeFi

Being a new financial ecosystem, DeFi provides a non-exhaustive list of use cases. While it is made up of some new financial concepts that are not familiar to centralised finance such as synthetic assets, most use cases are similar to traditional finance and financial products.

1. Asset Management

Asset management is one of decentralised finance’s main advantages as it provides end-users with complete control over their digital assets. DeFi users can fully manage their assets in terms of trading, transferring, and earning interest without the involvement of any intermediary. 

Contrary to the traditional financial structure, DeFi enables end-users to maintain the privacy of their sensitive data. Users exercise full control over the privacy of their assets. Sensitive information such as passwords for financial accounts or private keys that had to be shared with relevant financial institutions earlier, are reserved only for the user in question. 

2. Compliance & Protection Against Financial Irregularities

Finance, whether centralised or decentralised, is always on the hunt for new ways to solve money laundering, terrorism financing, fraud and similar financial irregularities. Traditional financial services relied heavily on Know-Your-Customer (KYC) protocols.  

KYC protocols are not suitable for DeFi because their nature directly contradicts enhanced privacy settings provided by DeFi. That is why DeFi had to come up with the Know-Your-Transaction (KYT) scheme. Instead of focusing on the customer, KYT focuses on the nature of transactions, digital addresses, and financial transactions behaviour.

3. Decentralised Autonomous Organisations (DAOs)

Decentralised Autonomous Organisations (DAOs) are entities that bring to the table a new way of making decisions within an organisational structure. Instead of putting one person or a small group of people in charge as a central authority, governance is based on technology and financial stake. 

If you are interested in DAOs, we recommend reading this article: ‘What’s a DAO?’. 

In terms of DeFi, such entities are used mainly for fundraising, managing financial operations, and decentralised governance. For example, UkraineDAO was successfully used for fundraising as it managed to raise $7 million in only five days. You can read more about it here: ‘UkraineDAO: How a DAO is funding the Ukraine defence’. 

4. Borrowing & Lending

Borrowing and lending are terms usually associated with traditional finance. We made it already clear that DeFi shares many similarities and use cases with centralised finance. 

DeFi platforms became popular since they made borrowing and lending quite simple. They provide platform users with digital loans in a trustless way as they utilise blockchain technology to provide a transparent and straightforward system for such financial services. 

5. Decentralised Exchanges

A decentralised exchange (DEX) refers to a type of decentralised application that enables users to conduct trading and similar activities such as borrowing, lending, acquiring insurance against potential risks, and earning interest from savings.

While DEXs are frequently associated with crypto trading, this is not their only use. These platforms include many use cases – essentially anything from asset to derivative trading. 

The absence of a central authority, or any other type of intermediary that sits on top of the hierarchy, amounts to more safety for market participants since there is no risk for market or asset manipulation.  

Understanding DEXs is significant because that is the item the US SEC wants to regulate. This article explains how DEX works in detail: ‘Crypto Basics: What are Decentralised Crypto Exchanges? DEX Explained.’. 

C. DeFi risks

Even though the DeFi market has many promises to deliver and ambitions to live up to its full potential, it is still an infant market with emerging challenges. It is true that DeFi encompasses many advantages that amount to it being a decent alternative to centralised financial institutions.

Financial systems need to be reliable. DeFi cannot provide that at the moment.  The philosophy behind the word decentralisation is a bit utopian. In a traditional setting plagued with central authorities exercising a high degree of control and a low level of privacy and data protection, an environment based on a community approach lacking rules imposed by traditional financial institutions and governments seems like a good idea. 

The problem emerges when personal finance and savings are involved. If we proceed with decentralisation too rapidly, it might result in anarchy. The tricky part of DeFi is linked to a lack of compliance and the beforehand mentioned Know-Your-Customer and Anti-Money Laundering guidelines. While Know-Your-Transaction procedures are a great innovation, it still has to prove its worth in practice.  

For example, there is a high risk of money laundering via liquidity pools. Additionally, there are still many scammers in the crypto ecosystem. We have examined these occurrences in this article: ‘The most common crypto scams & how to avoid them’.

Furthermore, DeFi operates within a highly volatile and generally unpredictable market. Many users are still not quite familiar with new terms such as crypto wallets and smart contracts. At its current state, DeFi is not consumer-friendly since it doesn’t provide a substantial level of consumer protection. 

What does the US Securities and Exchange Commission think of DeFi?

The plan to regulate DeFi was proposed back in January 2022. The initial proposal aims to expand the definition of an exchange to include digital platforms that use so-called communication protocols such as request-for-quote systems.  

The proposal’s main objective is to capture many more digital financial services for regulation beyond the current definition of exchanges as platforms that directly bring together buyers and sellers. 

The problem emerged when it became evident that many crypto brokers functioned smoothly as exchanges without registering them as such. The legislative plan is going through an extended comments period since it caused growing tensions within the crypto community. A lot of crypto companies pushed back on the plain claiming that the SEC needs to freshen up its securities regulations. 

While decentralised finance presents a variety of opportunities, it also poses significant risks and regulatory challenges. In the midst of the extended comments period, the U.S. SEC has defined a number of problems associated with DeFi that should be addressed and acknowledged by the regulators, the crypto industry, and the community as a whole.

a. Structural limitations of unregulated markets

As noted by the SEC, DeFi currently uses a ‘buyer beware’ approach which is not a suitable foundation to build a firm financial market. Without a common set of conduct guidelines and a functional system to execute such principles, markets can become plagued with corruption, fraud, and cartel activities. Over time this adds up to decreased confidence and participation. 

The Commission acknowledged that DeFi managed to produce impressive alternative methods of processing transactions, but markets need to fulfil additional regulatory requirements to prosper. Further, it laid down U.S. capital markets as examples of good practice. Reliable markets share a number of similarities, such as adherence to minimum standards of disclosure.  

While it is true that investments are usually associated with risks and potential losses, details should be provided to investors so that they could assess risk likelihood and severity.  

Even though the Commission makes a good point about the need to introduce a set of minimum standards and regulatory requirements, it would be wrong to assume that the crypto community is against compliance. As noted by the Blockchain Association and the DeFi Education Fund in a 2022 letter, the Commission’s legislative proposal fails to acknowledge that DeFi presents a fundamentally new way for individuals conducting asset exchanges that cannot be treated under regulations designed for intermediating exchanges. 

b. DeFi is transparent, unless you take a second look.

Blockchain technology itself is transparent for sure. On the other hand, SEC claims that DeFi projects, investments, and its unregulated market lack transparency. DeFi itself provides a high degree of transparency because its activity is based on code that is publicly available. 

The Commission pointed out that only a relatively small group of people can actually read and understand that code, and that even experts may miss some flaws or perils. Further, if DeFi wants to reach a broad investing pool, it is not likely that investors are expert interpreters of complex code at the same time. 

A similar conclusion was reached within the provisions of the European recently adopted regulation on Markets in Crypto Assets (MiCA). Even though DeFi itself does not fall yet within MiCA’s scope of application yet, the new Act set out requirements regarding white papers. White papers need to have a minimum set of obligatory information, written in plain and generally understandable language. 

If you want to find out more about the new EU crypto regulation and how it might affect you as a consumer, we suggest reading this article: ‘What is Markets in Crypto Assets (MiCA)? Europe’s Crypto Law’.  

Let’s lay down an example. Professional investors have access to and can afford, technical and economic experts before making an investment decision. On the other hand, if a small investor has only $3,000 to invest, it is not cost-effective to hire a bunch of experts to audit the code. Instead, such investors have to rely on information available through marketing, word of mouth, and social media. If that area is totally unregulated, there is no protection. 

Investors in highly regulated markets, such as that in the United States, have long been comfortable with a compromise in which they give up some limited degree of privacy by sharing their identity with the entity through which they trade securities. In return, they benefit from a highly regulated market that provides less manipulation and fraud. 

In theory, DeFi is highly transparent. Rules are imposed through smart contract codes and transactions are publicly available; an advantage over the traditional financial system that used to scatter data across various proprietary databases. The problem is that theoretical transparency doesn’t necessarily correspond to actual transparency in practice.  

What does the DeFi community think of SEC's proposal?

DeFi industry players and the crypto community spoke against the new proposal. Their main argument is that too many legal requirements could hinder innovation. As the saying goes, where there is fire, there is smoke – even Hester Peirce, the SEC commissioner, criticised the proposal as being too broad, claiming that it could stifle innovation and competition in financial markets. 

The DeFi community sees the current proposal as a tool to destroy DeFi. For instance, imposing liability as an exchange despite instances in which you no longer control the smart contract is legally ambiguous. The question of whether a DeFi protocol could comply with existing requirements for regulated exchanges arises, and the answer seems to be negative at the moment. 

If such a proposal is adopted, DeFi protocols such as Uniswap, which uses smart contracts to execute transactions, could fall under the proposed amended definition of an exchange and suffer from an over-the-top standard for registration.  

It seems that the DeFi community is not against compliance, yet it opposes SEC’s main standing. Gary Gensler, the chairman of the US SEC, claims that there is no need to write new rules as financial rules already on the books are clear enough to cover novel technologies.  

Will DeFi be regulated?

DeFi is regulated.

At the moment, the SEC has an efficient enforcement mechanism for non-compliant projects within the US jurisdiction. For example, back in 2021, the Commission settled an enforcement action with a DeFi platform operated by the company Blockchain Credit Partners. The company failed to register its offering that raised $30 million and misled its investors.

The question here isn't whether DeFi will be regulated, yet how it will be regulated. Current legal regimes have the power to fight non-compliant DeFi projects, but the crypto community made a good point when it opposed Gensler's statement that there is no need to introduce new rules.

It is possible to obtain the right amount of regulation to enable DeFi some breathing room. While DeFi at its current state encompasses a number of disadvantages that could deter investor and consumer protection, the possibility of a regulatory overreach could lead to unexpected effects and hinder innovation.