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Tuesday, 13 July 2021

Regulators scratching their heads: DeFi – Part II

We took a look at the emerging decentralized finance space angling to disrupt the finance system in yesterday’s issue of EnterprisePM. But with its rendering of brokerages and middlemen unnecessary, and in the absence of specific legislation targeting transactions, how are regulators proposing to set a framework for this relatively new space?

A quick refresher: DeFi is an umbrella term for a raft of financial applications in cryptocurrency (mainly stablecoins), geared towards disrupting financial intermediaries and facilitating peer-to-peer transactions. DeFi transactions use blockchain, mainly Ethereum — to create “smart contracts” through which users can manage financial transactions outside the purview of traditional financial institutions. DeFi differs from regular crypto trading in that it does not require an exchange, and in that it can facilitate the tokenization of real world assets such as commodities and shares into tradeable tokens.

If this sounds like a nightmare for regulators, that’s because it is. Regulations that govern cryptocurrency projects currently also govern DeFi, though present regulation is inadequate as it assumes the presence of intermediaries in trades, which does not apply to decentralized DeFi digital asset classes. So what are regulators planning on doing about it?

The World Economic Forum published this month a policy toolkit (pdf) for DeFi, in a bid to help shape the regulation of digital asset marketplaces between countries and drive policy-making decisions. The report raised a number of issues that could prevent regulators from getting a clear handle on the sector.

#1- Governance tokens: Many DeFi projects include governance tokens that allow voting rights on certain governance decisions. As deregulated autonomous organizations (DAOs) DeFi projects do not have a centralized management that runs operations on a day to day basis. While conferring limited management rights, the tokens are also tradeable on exchanges. Regulators will need to decide whether to treat such tokens as investment vehicles, or governance tools, and how to tax and manage them accordingly.

#2- Decentralized creators: DeFi services are created through a collaborative process, typically involving a group of protocol developers, or an open source development community, who build on one another’s code base. The operation of the service is then largely automated through the protocol and smart contracts. This poses the question, at what point do regulators impose restrictions? And on whom? Developers have also argued against the regulation of source code, which some say amounts to censorship, as they consider open source projects a form of “protected speech.”

#3- The scope of trading: DeFi makes possible far more varied services than traditional crypto, including derivatives trading, insurance, credit, and savings accounts. Regulators could be more inclined to move against DeFi if it begins drawing users away from the traditional financial system and competing with conventional exchanges.

DeFi apps are also keen to resist classification as virtual asset service providers: Recent draft guidance by the Financial Action Task Force, an intergovernmental organisation that develops anti-money laundering standards, suggested expanding the definition of virtual asset service providers to include decentralized software programs. This would encompass DeFi apps, and could oblige them to begin complying with know your customer (KYC) procedures required of banks. The FATF has said it will postpone issuing its guidance until October.

Some countries have already turned their regulatory sights towards DeFi: Thailand’s SEC announced earlier this month that any activities related to DeFi may require a license from the financial regulator “in the near future.” The latest regulatory push came on the heels of the launch of the country’s first DeFi yield farming platform, Tuktuk Finance, operated by Thai crypto exchange Bitkub. At that time, the platform’s native token, TUK, immediately saw “ a several hundred dollar spike,” then plummeted just shy of USD 1 within minutes, illustrating the volatility of DeFi tokens that has both tempted investors and alarmed regulators.

And this is taking place as regulators worldwide gather speed to clamp down on crypto: Countries including Turkey and Ghana have joined Egypt, Bolivia, Nepal, Algeria and Vietnam in banning cryptocurrencies or severely restricting their use. India could soon follow suit, and is drafting legislation that aims to crack down on its crypto market later this year. In China, the government is getting serious about its anti-crypto crackdown, recently banning financial institutions and payment companies from providing services in the crypto business, and shuttering at least half of the world’s mines — located within China’s borders.

So what does all this mean for DeFi? Governments can deploy a range of regulatory actions to manage DeFi, including designing new license types, issuing guidance or expectations, or imposing prohibitive measures in the sector. Regulators can also consider an “opt in” model, where DeFi projects can voluntarily decide to comply with regulations in return for certain protections. What DeFi creators don’t want is for governments to decide to apply the same rules used to regulate crypto onto DeFi apps, thereby forcing them to comply with untailored measures that would strip DeFi of what makes it different from crypto brokerages to begin with.

Ultimately, the relative newness of the space means policy recommendations must remain adaptable: “There were no decentralized digital currency assets before 2009, and no general purpose smart contract platforms before 2015, so any recommendations about the proper treatment of an offshoot such as DeFi must consider potential and unpredictable developments in a space that is evolving rapidly,” the WEF forum report concludes.

Enterprise is a daily publication of Enterprise Ventures LLC, an Egyptian limited liability company (commercial register 83594), and a subsidiary of Inktank Communications. Summaries are intended for guidance only and are provided on an as-is basis; kindly refer to the source article in its original language prior to undertaking any action. Neither Enterprise Ventures nor its staff assume any responsibility or liability for the accuracy of the information contained in this publication, whether in the form of summaries or analysis. © 2021 Enterprise Ventures LLC.