DeFi poses a challenge for regulators

DeFi protocols are for trading or lending crypto tokens and derivatives. They exist across a throng of validating and coordinating nodes, rather than as a single portal run by an incorporated legal entity. Furthermore, they exist without the formal leadership that regulators would normally interact. 

This lack of an identifiable leadership, plus the fact that the systems are designed without any requirement for users to reveal their identities, poses a challenge for regulators. They feel more comfortable with entities like Coinbase and Kraken, because at least they have comprehensive ‘know your customer’ (KYC) processes.

Regulators see DeFi as “a potential vector for all three of the key risks that financial regulators are tasked with controlling,”

David Z Morris writes. These are basically criminal activities, such as money laundering, tax evasion and terrorist financing, as well as fraud. Their biggest fear though is systemic risk. As Morris says, “DeFi and crypto still probably aren’t large or influential enough to trigger broader financial contagion in the event of a major market collapse or system failure, but you no longer have to engage in wild speculation to foresee that level of influence in the future.”

Regulators traditionally rely on the people managing trading services to control these risks by monitoring their customers and suspicious activity on their platforms, but this simply doesn’t exist with DeFi, which is much harder to regulate than crypto. Katherine Kirkpatrick, co-chair of the financial services practice at King & Spalding said in regard to this, “The ultimate question, beyond how to regulate, is how do you enforce the rules? How do you make someone accountable for breaking the rules? It doesn’t make sense to regulate if you have no enforcement mechanism.”

Don’t stifle DeFi

On the other side of the argument, “premature or misguided” regulations could stifle DeFi innovation and growth. But despite the risk of misguided overreach, there are good reasons to want a regulatory framework for DeFi. It would for a start, “make the fundamental advantages of the technology accessible to many more participants,” as Morris suggests, including making it more appealing to public companies and regulated institutions. At the moment they aren’t participating in DeFi because, “using DeFi in its current state could expose banks like JPMorgan to money laundering or fraud risk,” says Michael Shaulov, CEO and cofounder of Fireblocks, a DeFi custody and infrastructure provider.

The future DeFi landscape

There is little doubt that regulators will pursue DeFi if they find it has become a “powerful entity floating beyond their oversight.” Morris warns, “The modern state’s monopoly on violence as the endpoint of law enforcement will likely find some way to control your access to protocols living in the cloud.” Still, there will always be jurisdictions without strict regulations, where DeFi users who take sufficient privacy precautions will continue to take the risk of using them. It may also be the case that DeFi protocols will become testing grounds for new forms of digital statelessness. However, if we want DeFi to have a role in improving the financial system, there will have to be some compromises made with the regulators.

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