Crypto Regulation could hit the DeFi space

When Facebook announced Libra, its stablecoin project, regulators hit the panic button. Fast forward several years, and they’ve been working on crypto regulation for a while now. Regulators and legislators were not too spooked when FTX failed, because they have become increasingly blockchain literate.

Crypto regulation has been advanced at this point in some jurisdictions. It generally covers centralized crypto, which entails crypto companies like Coinbase, Circle, and FTX. For instance, the European Union’s Markets in Crypto-Assets (MiCA), upon which work started in 2018, is expected to be fully implemented by the end of 2024.

MiCA covers cryptocurrencies, security tokens, and especially stablecoins, but not Decentralized Finance (DeFi), which might most accurately refer to a network with a token that performs automated functions.

Bitcoin is debatably a true DeFi app. (In the U.S., however, it is categorized as a commodity) Nonetheless, the progress on the regulatory front allows regulators to begin locking their sights on DeFi.

This became clear in August 2022 when the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) sanctioned cryptocurrency mixer Tornado Cash for allegedly helping to launder more than $7 billion worth of cryptocurrency over three years. The U.S. Treasury made the ominous move to block the “notorious” decentralized mixing service from further U.S. activity.

The Treasury’s actions aren’t the only example of the executive branch setting its sights on DeFi. The White House released a Comprehensive Framework for Responsible Development of Digital Assets, a first of its kind. It asked the Treasury to complete illicit finance risk assessments in two areas —DeFi and NFTs.

The Treasury would need to complete the DeFi and NFT risk assessment by February and July 2023, respectively, with a goal of identifying gaps in the legal, regulatory, and supervisory regimes.

Still more action has been taken towards DeFi in the U.S. Senator Warren and three Democratic senators sent a letter to Treasury Secretary Janet Yellen about crypto compliance, and the possibility of tracking transactions to private wallets. In the aftermath of the FTX meltdown, Sen. Warren introduced a bill requiring the Treasury Secretary to create a rule barring financial institutions from transacting with self-custody wallets altogether.

Capitol Hill has been busy working on crypto regulation, including stablecoin legislation. For example, the Responsible Financial Innovation Act (RFIA) seeks to address cryptocurrency generally. While there might not be the political will to pass a broad and comprehensive framework like the E.U. has done with MICA, there have been detailed discussions and debate.

In Congress, unfortunately, the issues become political and partisan. In the meantime, executive branch agencies will regulate through enforcement, and career subject matter experts will drive policy.

Regulators Globally Looking At Crypto, As DeFi’s Future Comes Into View

Regulators are moving forward with crypto regulation all over the globe, and DeFi is next. The Financial Services Regulatory Authority (FSRA) of Abu Dhabi Global Market (ADGM) even released a discussion paper on DeFi in pursuit of comments on policy for DeFi.

“We expect to see significant developments in the DeFi space in the future,” the Authority wrote. “The medium-term trends that the FSRA has identified are subject to disruption and changes in the environment. Nonetheless, on balance we expect that DeFi’s composability and ability to create linked financial services will drive its adoption as part of mainstream financial services.”

The Authority noted that “appropriate regulatory frameworks” will need to be developed to mitigate potential DeFi risks.

“We therefore seek your input on our high-level policy positions so that we can better refine our understanding of the DeFi space and adjust our approach accordingly.”

Dubai’s Virtual Assets Regulatory Authority (VARA) and Singapore’s MAS have also been surveilling the industry. It ensured entities engaging in crypto activities secure a license and approval from a new regulator. Failure to comply entails heavy sanctions and fines. Every crypto and web3 project in the UAW would have to comply. The regulations would not, however, apply to the financial free zones of the UAE.

Dubai’s plans for DeFi remained entirely unclear until February 8, when reports poured in that the issuance of anonymity-enhancing cryptocurrencies like Monero (XMR) were prohibited there, suggesting perhaps a regulatory approach looking to attract easier-to-regulate and more profitable big business to its jurisdiction, not grassroots crypto projects.

Singapore regulation has been designed to attract well-funded blockchain companies, institutional and high net worth investors with its strict regulatory framework.

DeFi’s Fate Lies In The Balance

FTX’s fraud was not perpetrated on any blockchain. It occurred in those places where fraud traditionally occurs—an environment lacking corporate controls and governance. FTX is a story about classic fraud, like Enron or Lehman.

It’s a far cry from the novel frauds we’ve seen as of late in the cryptocurrency industry, such as hacks, to which regulation focused on decentralized technologies could apply. We have civil and criminal law in place today to protect consumers and investors from the FTXs of the world.

Regulators and law enforcement seek similar decentralized environments. Now that they’ve grown comfortable with blockchain technology, they’ll turn their attention to decentralized products and services, looking into those dApps where users truly transact peer-to-peer and entirely on blockchains, including the newly-popular staking, lending, on-chain financial services, etc.

Regulation will become progressively complicated where users transact entirely on blockchains rather than the popularly adopted dollar market onramps and offramps, such as Coinbase, Circle, and FTX. Compliance at the protocol layer, however, won’t be easy. Many regulatory questions have yet to be answered, such as those surrounding AML/KYC, anti-money laundering, and more.

From a regulator’s perspective, crypto regulation will only be as strong as its weakest link. While the world might have strong regulation in Singapore, the UK, and London, weak regulation elsewhere creates jurisdictional arbitrage and therefore opportunities for fraud. The same goes for centralized finance (CeFI) versus DeFi. Regulators will pursue DeFi regulation at least as robust as CeFI, so no arbitrage between the two exists.

Kadan Stadelmann 

Kadan Stadelmann is a blockchain developer, operations security expert and Komodo Platform’s chief technology officer. His experience ranges from working in operations security in the government sector and launching technology startups to application development and cryptography. Kadan started his journey into blockchain technology in 2011 and joined the Komodo team in 2016.