The existing traditional vs. progressive approaches to DeFi regulation

Introduction

Is decentralised finance (DeFi) the frontier of a new financial system or a thinly veiled attempt to conduct financial services in an unregulated manner? Currently, there is a broad gap between prevailing regulatory views on the nature of DeFi systems and those of market participants in the DeFi industry. This article aims to clarify these polarised views in a manner that allows regulators and DeFi market participants to understand each other’s motivations and beliefs, fostering a more collaborative approach to DeFi regulation.

The traditional regulatory view: DeFi as an illusion

The traditionalist regulatory view is that DeFi projects should be regulated in the same manner as any financial service provider offering similar products or services. This approach is supported by a widespread distrust of decentralised systems best illustrated by the following passage from the International Organisation of Securities Commissions (IOSCO) Final Report with Policy Recommendations for Decentralized Finance (IOSCO DeFi Report):

A common misperception is that DeFi products and services are materially different from those found in traditional financial markets. Another common misperception is that DeFi products and services are offered in a fully automated manner using smart contracts, with no human involvement. However, these are not accurate descriptions of how the DeFi market currently operates in practice.^[1]

From the traditional regulatory perspective, “same activities, same risks, same regulation/regulatory outcomes” means applying existing securities, derivatives or crypto legislation to DeFi. From this perspective, there is little incentive for regulators to modify their approach for a business model they feel is risky^[2] and often designed to circumvent applicable rules. Generally, there is little appetite or incentive for traditionally focused regulators to develop regulatory approaches that may result in the exclusion of financial services from the regulatory perimeter.

Although an unmodified approach to regulation may threaten the feasibility of DeFi ecosystems or force DeFi projects into the shadows where bad actors thrive, a significant proportion of the regulatory community would rather see DeFi conform to a more traditional financial market business model with accountable intermediaries.

The industry view: DeFi as a panacea

The DeFi industry’s views on regulation stand in sharp contrast to those of traditional regulators, with many believing the DeFi should either not be regulated or be subject to an entirely new regulatory paradigm. From their perspective, attempting to regulate DeFi through existing financial market frameworks represents the proverbial “square peg in a round hole” scenario.

At its essence, DeFi exists to replace traditional centralised systems of finance that rely on chains of intermediaries with open and transparent systems based on immutable code where users can engage in financial market activities directly with one another. This new financial paradigm has the potential to significantly reduce costs, increase financial inclusion and transparency and revolutionise ageing financial market infrastructures that do not effectively leverage new technologies. Further, DeFi systems allow users to maintain control of their own assets and not rely on centralised actors, some of whom have created a crisis of trust in crypto markets.

From the DeFi industry point of view, applying traditional regulation would effectively attempt to impose the very market infrastructure that DeFi is seeking to replace. For example, the approach taken in the IOSCO DeFi Report of identifying responsible persons at the enterprise level would, in essence, require individuals to exercise control over DeFi systems and re-introduce the risks and inefficiencies that DeFi ecosystems were designed to replace.

The progressive regulatory view: DeFi as a possibility

Although the prevailing narratives on DeFi ecosystems appear worlds apart, they will not always be. As with most new technologies, we will see a slow convergence between industry and regulatory views and approaches. Some jurisdictions have considered DeFi’s unique attributes and contemplated more nuanced approaches to regulation.

For example, a discussion paper published in April 2023 by the Autorité de contrôle prudential et de resolution (ACPR) of the Banque de France explained that “the regulation of disintermediated finance cannot simply replicate the systems that currently govern traditional finance.”^[3] This paper considers hybrid approaches to the regulation of DeFi ecosystems where centralised intermediation services fall under traditional regulation, but truly decentralised financial services (tDeFi) could be subject to novel and progressive new approaches. For example, the paper considers approaches leveraging certification systems for smart contracts, minimum standards for the computer code design of public blockchain infrastructure and applying governance rules and standards to validators that verify new blocks and earn rewards.

A critical precondition to the broader acceptance of new approaches to regulation will be the development of regulators’ expertise and understanding of DeFi systems so they feel comfortable diverging from longstanding regulatory approaches.

Conclusion

The DeFi industry is currently characterised by a high degree of regulatory uncertainty supported by polarised views regarding the appropriate role of regulation over DeFi systems. However, this will not always be the case. As the popularity of DeFi systems grows and the merits of this new financial technology become more well-accepted, we will likely see regulators adopt or at least experiment with new, more tailored approaches to regulation. However, it will be critical for the DeFi industry to continue expanding its outreach and educational efforts with the public sector and, crucially, accept that fundamental regulatory imperatives still must be solved.

‍

This article is the second in XReg Consulting’s series on DeFi. Click here to read the first article in the series covering a high-level overview of what DeFi is and its key components.

^{[1] IOSCO's Final Report with Policy Recommendations for Decentralized Finance (DeFi)}

^{[2] For example, see the Financial Stability Board’s The Financial Stability Risks of Decentralized Finance which outlines an extensive list of risks and perceived deficiencies of DeFi systems.}

^{[3] EU commission report: “Decentralised” or“disintermediated” finance: what regulatory response?}

‍