June 4, 2023

Decentralized finance (DeFi) is one of the fastest growing ecosystems in the cryptocurrency market and has long been a dilemma for regulators given the decentralized nature of the space.

In 2022, U.S. regulators have a particular focus on the nascent field, with a particular focus on ending the anonymous nature of the ecosystem.

DeFi protocols allow users to trade, borrow and lend digital assets without going through an intermediary. The DeFi ecosystem is decentralized in nature, with most projects run by automated smart contracts and Decentralized Autonomous Organizations (DAOs). Most DeFi protocols do not require strict know-your-customer (KYC) requirements, making way for traders to trade anonymously.

A leaked copy of the U.S. draft bill in June showed some key areas of concern for regulators, including DeFi stablecoins, DAOs and cryptocurrency exchanges. The draft bill pays particular attention to user protection and aims to eliminate any anonymous projects. The act requires any crypto platform or service provider to be legally registered in the United States, be it a DAO or a DeFi protocol.

Sebastien Davies, head of institutional infrastructure and liquidity provider Aquanow, blamed regulators’ lack of understanding of the technology as the reason behind the regression approach. He told Cointelegraph that incidents such as sanctioning Tornado Cash users after the app was added to a list of specially designated nationals produced by the Office of Foreign Assets Control showed a lack of technical understanding. He explained:

“I think the point that policymakers are trying to make is that they will make it very difficult for developers/users of a protocol that completely obfuscate transaction history, and they are willing to act quickly. Officials may eventually backtrack, but precedent will be tough Seriously. Participants in the digital economy should continue to engage with regulators as much as possible to maintain a voice at the negotiating table to avoid such shocks and/or engage in balancing conversations after the fact.”

A separate discussion paper released by the U.S. Federal Reserve in August said that despite their small share of the global financial system, DeFi products could still pose risks to financial stability. The report states that DeFi’s resistance to censorship is overstated and that transparency can become a competitive disadvantage for institutional investors and invite wrongdoing.

Mandatory legislation will weed out budding projects

Regulators’ concerns about user protection are understandable, but experts believe this should not come at the expense of innovation and progress. If the focus is only on collecting data and putting up roadblocks that hinder innovation, the United States will fall behind in the innovation race.

Hugo Volz Oliveira, secretary of the New Economics Institute, a nonprofit focused on developing policy recommendations for the digital economy, explained to Cointelegraph why the regulator’s current approach and focus on de-anonymizing projects will not bear fruit. He says:

“Considering the fact that policymakers and regulators continue to insist on eliminating anonymous crypto projects and teams, effectively trying to kill the industry by targeting its builders. But this is not feasible in the more complex projects that are being developed in the spirit of community of.”

He further added that there is a real danger that lawmakers will succeed in driving most of the cryptocurrency industry out of North America. “This is also a problem, as the rest of the world still needs large nation-states to defend against bullying from the FATF and other undemocratic institutions that seem more interested in maintaining a monopoly on power than promoting a risk-based approach,” he said. Innovation.”

On Aug. 30, the FBI issued a new warning to investors in DeFi platforms that are targeting $1.6 billion in 2022. Law enforcement agencies have warned that cybercriminals are exploiting “investors in cryptocurrencies” and “the sophistication of cross-chain functionality and the open-source nature of Defi platforms.”

While decentralization is a key aspect of the DeFi ecosystem, criminals can take advantage of it to deal with their illicit transactions. However, it is important to note that money laundering via crypto has historically proven riskier as they can be traced and blocked. Even after years of theft, criminals are still laundering money.

DeFi regulation requires a mindset shift

Encryption regulation itself is an important discussion point for the mainstream industry, as there is no general rulebook for crypto operators in the U.S. other than a few states with niche crypto-centric laws. Thus, regulating a niche ecosystem can be a complex task in the absence of fairness and clarity across the crypto market.

Jackson Mueller, director of policy and government relations at Securrency, a developer of blockchain-based financial and regulatory technology, told Cointelegraph that policymakers are increasingly interested in the DeFi space.

However, they are currently torn between whether to apply the existing long-standing but potentially inappropriate regulatory regime or consider stepping out of the regulatory framework to develop an appropriate and accountable framework. He explained:

“Policy makers will never be satisfied with a system based on complete anonymity, thus driving the application of anti-money laundering and KYC regulations. While this obviously raises concerns in the areas of privacy and fair play, the advanced technologies that can be deployed today can greatly improve the Protect the privacy of individuals without significantly limiting the potential of DeFi services or driving opaque markets. Regulated DeFi is not a contradiction. The two can and must coexist.”

A new proposal released by the U.S. Securities and Exchange Commission (SEC) in early February highlighted the SEC’s lack of understanding of the space. The proposal seeks to revise the definition of “exchange” in the Securities Exchange Act of 1934. The amendment will require all platforms with a certain threshold trading volume to register as exchanges.

The proposal threatens many DeFi projects as most of them are not centrally operated and having to register as an exchange would likely spell doom for the industry. U.S. Securities and Exchange Commission commissioner and prominent cryptocurrency advocate Hester Peirce was one of the first to come up with the flawed proposal, saying it could involve more types of “transaction mechanisms, including potential DeFi protocols.”

Multiple proposals and warnings from U.S. federal agencies suggest a hard-line approach that many experts believe won’t necessarily work. Gabriella Kusz, CEO of a self-regulatory group called the Global Digital Assets and Cryptocurrency Association (Global DCA), told Cointelegraph:

“DeFi regulation requires a shift in mindset – from a ‘police on the beat’ concept to a ‘community governance’ concept. In a DeFi world where interactions and entities are decentralized in nature, the relationship between regulators and regulated The whole nature must change. As opposed to reactionary, regulation must be reimagined to move towards preventive measures that support the constructive development of the industry.”

She added that Global DCA is researching this topic specifically to design and create a self-regulatory organization that forms a broad dialogue with different stakeholder groups in the digital asset ecosystem. These insights and views will be “reflected in a self-regulatory framework that may help promote market integrity and consumer protection”.

Eric Chen, CEO and co-founder of DeFi R&D firm Injective Labs, told Cointelegraph that ecosystem stakeholders should be involved in regulatory discussions:

“I personally think that regulators should have a more open dialogue with Web3 companies and founders. I think this dialogue will help both parties reach clear regulatory clarity faster. Many may not remember, but the early Web2 The space also benefits from an opaque regulatory structure. This has of course been corrected over time as regulators and founders begin to work together to develop appropriate guidelines.”

Any new technology that gets the attention of the masses will be in the spotlight of regulators. However, their approach is key to determining whether the technology can be put to good use or banned simply because of some bad actor. Industry experts believe that the current approach to regulating the DeFi market under existing financial laws could be devastating for the nascent industry, and that dialogue is the right way forward for now.