Peer-to-peer, face-to-face trading: It's the way deals have been done for millennia, before distance and lack of trust forced us to use intermediaries like banks and brokers to transact.
Now, decentralized finance (DeFi) has brought us back to a future with many guarantees. We can perform peer-to-peer transactions not only remotely, but also trustlessly by interacting with a smart contract. This innovation has laid the groundwork for a financial renaissance that goes far beyond simply replacing intermediaries.
Until recently, regulators have largely ignored this emerging parallel financial system. But with former blockchain professor Gary Gensler as chairman of the US Securities and Exchange Commission, he has raised the question: How can authorities enforce regulations that don't rely on the presence of intermediaries? And how will regulation protect users and the market?
From decentralization to deterritorialization
DeFi protocols appear to be out of regulatory reach. Copies of blockchain transaction history are stored on nodes around the world, ready to resurface if one is compromised.
However, history shows how regulators could approach DeFi.
Regulators have historically only had jurisdiction over legal entities within their jurisdiction. This changed with the Foreign Account Tax Compliance Act (FATCA) of 2010, which saw US authorities regulate beyond their currency and US persons around the world and coordinate with other jurisdictions by signing intergovernmental agreements. (IGA) for compliance.
The EU followed a similar approach with the General Data Protection Regulation (GDPR) in 2018, drafting regulations to control the data of Europeans anywhere in the world, although they do not make it clear how authorities can enforce the regulations against outside organizations. from the EU.
Going forward, these examples could be used offshore to reach the virtual environment and enforce regulation for DeFi.
Control points: Locks and Accesses
However, even at the offshore level, regulators still need to identify local issues that block otherwise fully decentralized operations.
These centralization points already seem to be on the radar of regulators. As Gensler remarked: DeFi may be a misnomer, as platforms are often "decentralized in some ways but very centralized in other ways."
Individual protocols with known developers, or those controlled by corporate token holders, could come under pressure for protocol changes. And for protocols that are as decentralized as they claim, managed by distributed anonymous communities, regulators could make interaction with the protocol illegal. Or, more likely, hinder the flow of funds by targeting access operations or marking certain protocols as toxic.
These access operations could be fiat-to-crypto or stablecoin exchanges that could be required to incorporate due diligence procedures and Know Your Customer (KYC) processes. customer knowledge) to ensure compliance with anti-money laundering and terrorist financing (AML/CFT) regulations, etc.
To be effective, these future checks must be built with DeFi in mind. This could result in the sanctions list being published as a Chainlink search or a free API call from the Financial Action Task Force (offend) or the Organization for Economic Co-operation and Development (OECD) directly.
At the same time, individual protocols that want to integrate with the real economy are likely to make adaptations in order to operate within regulation.
For example, Aave provides limited DeFi access to institutions through the use of access operations based on the KYC process. In this way, they mitigate the risk by trusting organizations such as Chainalysis to analyze blockchains for the “know your transaction” (KYT) process. This generates a liquidity cost and does not increase the opportunity for all participants, but it does produce a safer and better regulated environment.
Other promising solutions include smart contracts that allow verified entities to deposit funds and automatically mint “fully compliant assets” that can be used on any DeFi protocol without having to use KYC each time.
On the other hand, protocols can be further decentralized; as we have seen recently, MakerDAO based solely on a model DAO. But while these fully decentralized protocols may remain beyond the reach of regulators, they could also be divorced from the real economy.
With these scenarios in mind, the question is not how to enforce regulation but What purpose should regulations have?.
How should DeFi be regulated?
There is an opportunity for an appropriate level of regulation to give DeFi enough leeway to make a difference: driving transparency, increasing financial inclusion, and enabling credit to 8 billion people who will see the world given new options to prosperity.
However, there is also the possibility that overreach would stifle innovation and growth and have unintended consequences.
Unfortunately, it seems that we are already on this path.
Regulators need to understand that DeFi shares many of the same goals: overhauling inflexible processes and providing broader access, cheaper prices, and more stability, all while ensuring these benefits are widely shared with all market participants.
For example, access to liquidity has long been a central concern not only for cryptocurrency and blockchain projects, but for financial markets in general. According to the Bank of England, Run Lola Run Andrew Hauser's 2019 speech, there is evidence that those furthest from liquidity are getting worse and worse treatment.
DeFi has the potential to create fairer, more transparent, and more liquid markets through entirely new mechanisms, helping everyone reduce fraud and early execution, resolving fragmentation, and creating markets that are efficient, resilient, fair, and equally accessible to everyone, not just participants with the right contacts.
Defining the right regulation could make or break DeFi, and there are big questions to answer: how are new ratings established? how do we build decentralized identifiers (W3C DIDs)?, how can we make sure that the controls do not work against financial inclusion?, etc.
There is an opportunity to rebuild the financial market in another way, but clear objectives must be established and regulations must be created to pave the way to achieve this.
