The challenges involved in regulating DeFi

While there has never been a shortage of regulation when it comes to traditional financial institutions and practices, the rise of digital assets has presented new issues that need to be addressed.

In the context of traditional finance, typical intermediaries would include for example brokers, money lenders, insurers, bankers and other regulated entities. These intermediaries have obligations such as complying with Know Your Client (KYC) requirements and anti-money laundering obligations. This is very different to what is expected from virtual asset service providers (VASPs).

The role of VASPs is one area where the need for regulation has become a serious consideration for the authorities. A VASP is the intermediary that offers trading, exchange and custodial services for cryptocurrency and other digital assets. It should have come as little surprise, therefore, that some authorities have begun imposing anti-money laundering and counter-terrorist financing  (AML/CFT) obligations on VASPs, especially as this was something that the multinational Financial Action Task Force wanted to see carried out.

But while such action has a clear effect on VASPs, the issue of decentralised finance (DeFi) has gone largely ignored when it comes to regulation. DeFi are networks that use consensus-based systems that are not reliant on financial intermediaries. These networks can be subject to the same overall regulations that apply to digital assets, but their own, unique activities have not – so far, at least – attracted the attention of the regulators. It would be a surprise, however, if the rate of expansion in the digital assets market did not lead to DeFi becoming the next most obvious target for regulation.

Explaining DeFi

DeFi involves the use of smart contracts to automate the completion of financial agreements. As this tends to involve the use of blockchain technology, there will be no intermediary at the heart of the deal unlike in the context of traditional finance. In traditional finance, you would have an intermediary who has legal obligations. The intermediary will be capable of complying with regulatory requirements. With DeFi, the smart contract is executed on the blockchain without the need for a third party. In such cases, however, there can be a “sponsor” or “promoter” – the person who devised the original code and placed the DeFi protocol on a crypto platform. This protocol can be a self-governing Decentralised Autonomous Organisation (DAO) or those involved with it can be given a degree of control regarding its development.

The challenges facing those who would want to regulate DeFi are, therefore, numerous. While DeFi can involve financial services similar to those provided by existing licensed financial intermediaries, it has little in common with the frameworks that are currently covered by regulation. As a result, drawing up the blueprint for regulating DeFi is far from simple. It is a conundrum facing both those who would be regulating it and those who are involved in the markets affected by DeFi.

The Issues

While regulation of DeFi is far from impossible, it does require a number of issues to be addressed.

It needs to be decided whether the services provided by DeFi can be covered by the regulatory regimes currently in place. There is also the question of if and when any licensing or regulatory obligations are activated, who should be triggering them and who should be subject to them? And some sense of consensus needs to be reached on whether DeFi should be regulated even if no licensing or regulatory obligations are triggered.  

While existing regulatory frameworks were devised and introduced before DeFi was even a consideration, there have been some changes made to the regulation landscape in response to the arrival of digital assets. But while this has largely involved classing digital assets as an investment product that can be traded (and conducting checks on those who trade in them), it has not covered how such networks operate.

While a regulator could, in theory, decide that a network was within its regulatory scope, there is still much to be determined.

Whereas more traditional forms of finance involve an organisation or individual providing a service, the situation is not so clear-cut with DeFi. The traditional service provider is bound by legal and regulatory obligations and is often subject to a licensing regime. But with DeFi functioning on smart contracts, it is difficult to establish the person or organisation that is providing the services, as well as the precise legal relationship between the parties involved. 

Adding to the uncertainty is the fact that the jurisdictional reach of regulators is often limited by borders. With DeFi operating in a way that has no real regard for geographical boundaries, there could be difficulties in establishing which body should take responsibility for regulation of activities on a particular platform. Regulation can be viewed as an even harder challenge when the potential for anonymous investors to act on a DeFi platform is factored in.

While there is an argument that says the DeFi sponsor or promoter would be the most likely subject for regulation, this may not always be appropriate. As many of them give control rights to investors after the launch of the platform, their subsequent lack of authority may make them unsuitable targets for regulation.

Conclusion

For now at least, regulation of DeFi poses problems for the authorities. But while they may be reluctant to take on the challenge because of the difficulties detailed here, they will be aware that they cannot afford to turn a blind eye to such a rapidly-developing trading concept.