How to use crypto: DeFi meets CeFi: Compliance and Regulations

DeFi meets CeFi: Compliance and Regulations

  • The EU's Digital Markets Act entered into force in November 2022. Tech companies that meet certain thresholds are known as 'gatekeepers' and subjected to special obligations on the EU internal market.
  • The lines between CeFi and DeFi started to blur when big banks in the United States started investing in DeFi.  

The starting point of regulatory principles

This is not another 'what if' article; while we have discussed several times in the past whether DeFi projects or the world of cryptocurrency trading in general will be regulated and how, in this series of articles we are committed to explaining the main terms and principles regarding the territory where centralised finance (CeFi) and decentralised finance (DeFi) come together.

If you are interested in whether DeFi will be regulated in general, we suggest reading this article: 'How DeFi can comply with old school compliance'.

Both centralised and decentralised finance present a global financial system that, by using the perks of modern technology, crosses borders with ease. They both constitute a huge market. All markets, including traditional finance markets, are made of certain rules that regulate the conduct of their participants.

Before moving on to the competition and how it might affect DeFi, you can gain more insights by reading this comparative analysis: 'CeFi vs DeFi: A Centralised and Decentralised Finance Comparison'.

It's known as competition law and antitrust - we'll explain the difference. Basically, everyone who steps on the market is subjected to these rules of conduct. Even though DeFi is not yet under competition-related scrutiny due to being exposed more by SEC's activities, we want to teach you how the market regulations are shaped and what it means to comply with competition norms.

Competition compliance running the financial system

The term market competition has frequently been used in relation to markets subjected to centralised control. That is true simply because regulators impose rules on businesses regarding their behaviour in any market.

Competition policies are not a new thing in the digital sector. In the past few years, it has often been associated with big tech companies due to their large impact on the economy. Big Tech raises concerns on multiple fronts, ranging from data protection to competition law. Competition concerns are usually related to the general tendency of digital markets to form monopolies. 

Numerous competition law proceedings have been conducted against major tech companies such as Meta, Amazon, Apple, Google, Apple and others in multiple jurisdictions. 

For example, the European Commission in its Google Shopping decision required the company to redesign Google Search in order to equally treat Google Shopping and its competitors in search results. A similar outcome was received by Apple by depriving consumers of cheaper streaming choices in its App store.

What is the difference between competition law and antitrust?

Competition law and antitrust are frequently used interchangeably, but they are not synonyms. There is a subtle difference between them. 

Competition law can be defined as a set of legal norms and regulations with the purpose of promoting fair competition and preventing anticompetitive activities in the market.  

The reason behind having competition rules set in place is to make sure that market participants are competing on a level playing field, enabling consumers to enjoy lower prices, more options and better products, along with fostering innovation and investments. When you look at the bigger picture, everything is linked to the same foundation - a healthy market.

On the other hand, antitrust is a specific branch of competition law that explicitly deals with the formation of monopolies or cartels on the market that can harm consumers and deter competition. It explicitly deals with anti-competitive activities such as price-fixing or market allocation. 

Why is competition compliance important for the market?

We often perceive competition as something negative, such as a threat or an enemy ready for a battle. The truth is, if there wasn’t competition, there would be no incentive for us to become better. The same thing applies to market competition. 

Competition is a fuel that drives innovation, provides more value to customers and keeps the market going. Think of it as a race; the main objective of any business is to cross the finish line by providing reliability, best products, services and consumer satisfaction. 

Sometimes businesses want to take a shortcut to the finish line by forming cartels, fixing prices, engaging in predatory pricing or conducting restrictive agreements. By doing that, they harm competition and impose barriers to entry, harming consumers in the long run. Regulatory oversight entities jump in here to punish them and keep the market safe and sound. 

Therefore, we can define the main upper-hands of competition in three categories.

a. Improved quality

When many companies with the same product or services are facing the same target audience, they are forced to step up their game by providing higher quality and customer experience. 

Competition makes products and services more durable and safer, along with enhanced performance. All those perks benefit consumers directly. For example, automotive companies are in constant competition, trying to provide more value to consumers. As a result, consumers can choose between a wide range of options, depending on their preferences, needs and budget. 

b. Improving transparency

A highly competitive market encourages businesses to be more straightforward with their communication in pricing and performance. Customers benefit from clear and concise information due to knowing what they are paying for or investing in. 

When it comes to CeFi examples of markets that provide financial services and products, transparency and users’ confidence are key factors that drive innovation and investment. 

In centralised finance, the financial sector is run by banks as intermediaries. Banks are a central authority when it comes to conducting financial transactions. The link between banks, users and payment systems is important to the functioning of financial markets. The loss of trust in one financial institution can snowball into a loss of trust in the entire market, making the whole system quite vulnerable. 

 If one bank isn’t working well, the financial system becomes risky. That is the reason behind governments imposing significant oversight and regulation to ensure smooth operations on the financial market. 

c. Fostering innovation

There is no industry that doesn't rely on innovative solutions and improvements. To achieve that, both CeFi companies and DeFi systems need incentives.

Highly competitive markets spark the emergence of new technologies and solutions making all businesses work harder to gain more attention from their target audience.  

The interplay between innovation and competition is evident within the tech industry. For example, competition has driven down prices for smartphones over the years. A few years ago, a smartphone was worth a lot more than today. It resulted in massive adoption of technology and consumer welfare. 

This isn’t a bad thing for businesses though; even though competition can drive prices down, businesses are not denied their share of profits. In fact, while customers benefit from more options and lower prices, companies increase their productivity through economies of scale enabling greater profits after expenses. 

What are the main issues of competition within the digital sector?

Governments worldwide have been very proactive in trying to deal with big tech companies and their monopoly tendencies. When we say proactive, we mean that enforcement entities have been more into using positive remedies, such as obliging companies to act in a particular way, as opposed to reactive remedies that imply that something shouldn’t be done and enforcing fines. 

Even though a proactive approach sounds like an excellent way to go, other issues appeared; for example, technology has to be looked at from divergent aspects. In fact, it requires constant monitoring, an in-depth understanding of each technology, and a wider interpretation of intellectual property rights, and that is where competition watchdogs failed a few times.  

For example, we mentioned the Google Shopping decision; while the European Commission told Google to redesign its search engine, Google’s competitors are still arguing that Google Search fails to comply with the Commission’s decision. 

Decentralised finance meeting competition law

We may think of DeFi and the whole crypto industry as a pioneering sector that is too different to become subjected to the same rules. Competition experts would probably just smile away at that notion since it is often claimed that any emerging industry will describe itself as special, different, and not suitable for the application of competition law.  

Let's step a bit away from the CeFi vs DeFi debate and simplify things. In the world of decentralised finance, we have a market, users, and businesses that provide new products and services. Smart contracts remove the need for intermediaries, but DeFi examples still sound a lot like competition. Decentralised exchanges, firms looking for investments, and all kinds of digital platforms are fighting for their target audience.

It is still a new form of trading, but imagine things going a bit south. For example, companies could start colluding to push away other DeFi protocols from the crypto market. Even in centralised finance (CeFi) colluding cannot be illustrated anymore as a few important businessmen in a dark room shaking hands. We're way past that.

On one side we have blockchain technology that is permissionless, trustless, transparent, and immutable. On the other side, we still have human actors that strive for profits. The current 'buyer beware' approach is not an adequate foundation on which reimagined financial services can be built. When lacking a common set of conduct expectations, markets tend toward self-dealing, cartel-like activities, fraud, and information asymmetries.

What are the issues of introducing competition law within DeFi systems?

The sole nature of blockchain technology and the crypto space provides a barrier to entry to competition law and enforcement activities as seen in CeFi. On the other hand, exchanges and wallet providers are frequently organised as traditional businesses, making them more suitable for competition and antitrust policy.  

DeFi being a movement that puts an emphasis on transparency and shareability is based on pro-competition grounds. When there is insufficient competition, dominant competitors can use their power to block potential rivals from entering the market. A permissionless setup is not in line with imposing barriers to entry. 

Even though DeFi isn’t called out for a lack of competition policy, it is good to know the implications of introducing these norms into its space. It is often discussed that, even though we use the same terminology and concepts in CeFi and DeFi, DeFi needs a tailored competition policy that could honour the decentralised feature of blockchain technology and introduce a set of conduct expectations for companies and human actors behind the technology. 

What do DAOs have in common with antitrust?

Decentralised autonomous organisations (DAOs) are entities governed by code. They can promote competition by enhancing governing efficiencies and lowering costs for DAO members and users. While the DAO design sounds like being pro-competition, it presents antitrust challenges at the same time.  

Remember how we said that competition law and antitrust are not synonyms? Now we’ll focus on certain antitrust aspects of DeFi.  

It has been claimed by competition professionals that DAOs have the ability, through automated decision-making, to divide markets, fix prices or exchange sensitive information. Further, it is thought that such a setting has the potential to enable competitors to collude when deciding which products to sell or which pricing methods to implement. 

Usually, anti-competitive behaviour is linked to humans; yet, they could be much harder to detect on platforms that are decentralised, autonomous, and probably anonymous. This is not quite a game changer if you are aware that CeFi has been dealing with algorithmic collusion for a while now.  

What are securities and how are they linked to DeFi projects and competition law?

When talking about the U.S. Securities and Exchange Commission, we always end up talking about whether digital assets in the crypto space are securities or not. Somehow it is a part of every discussion involving crypto and governments. The problem is that most aspects of regulation come down to that exact question.

We have explained in the past whether non-fungible tokens can be securities. If you're interested in finding out more, we suggest reading this article: 'Can NFTs Be Securities?'.

A basic definition of a security says that it is a fungible, negotiable financial instrument that has a monetary value. It can represent ownership rights in a corporation in the form of a stock, a creditor relationship with a government, or a corporation represented by owning that entity’s bond. Sales of securities are regulated by the SEC in the United States. 

Many DeFi products and services closely resemble their CeFi counterparts. There are decentralised applications (Dapps) for all sorts of financing, running on blockchains, that allows users to obtain digital assets or loans upon posting of collateral, much like traditional collateralized loans. Some other Dapps provide the possibility of depositing a crypto asset and receiving a return.

Whether cryptocurrencies are securities is relevant from a competition law perspective. If they were, they would be subjected to severe disclosure obligations on the market from issuers. An initiative that stems from the EU aims to subject crypto companies to requirements of securing licences and banning social media posts that deter market incentives and harm competition. 

Crypto companies are aiming to build decentralised platforms in which a token serves as a means of exchange or provides access to the network’s functions. If they want to succeed, these tokens need to get into the hands of the users. 

 If cryptocurrencies are deemed as securities, they would fall under the regulatory oversight of the SEC and similar commissions around the globe. Being subjected to stringent requirements on financial markets, issuers would consequently have to comply with more severe competition law obligations as well. This is the point where securities, DeFi and competition law meet.

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