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 have been working on crypto regulation for a while now. Regulators and lawmakers weren’t too alarmed when FTX failed because they have become increasingly blockchain savvy.

Crypto regulation has been advanced at this point in some jurisdictions. It generally covers centralized crypto, which involves crypto companies like Coinbase, Circle and FTX. For example, the EU’s Markets in Crypto-Assets (MiCA), on which work began 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 perhaps most accurately refers to a network with a token that performs automated functions.

Bitcoin is without a doubt a true DeFi app. (In the US, however, it is categorized as a commodity) Nevertheless, progress on the regulatory front is allowing regulators to start locking sights on DeFi.

This became clear in August 2022 when the US 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 US Treasury Department made the ominous move to block the “infamous” decentralized hashing service from further US activity.

The Treasury Department’s actions aren’t the only example of the executive branch turning its sights on DeFi. The White House released a comprehensive framework for the responsible development of digital assets, the first of its kind. It asked the Treasury to complete illicit finance risk assessments in two areas – DeFi and NFT.

The Ministry of Finance must complete the DeFi and NFT risk assessment by February and July 2023 respectively, with the aim of identifying gaps in legal, regulatory and supervisory regimes.

Even more measures have been taken against DeFi in US 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 wake of the FTX meltdown, Senator Warren introduced a bill requiring the Treasury Secretary to create a rule preventing financial institutions from trading self-custodial wallets.

Capitol Hill has been busy with crypto regulation, including stablecoin legislation. For example, the Responsible Financial Innovation Act (RFIA) seeks to address cryptocurrency in general. Although there may not be the political will to adopt a broad and comprehensive framework as the EU has done with MICA, there have been detailed discussions and debates.

In Congress, the problems unfortunately become political and partisan. Meanwhile, executive agencies will regulate through enforcement, and career experts will drive policy.

Regulators are looking globally at crypto, as DeFi’s future comes into view

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

“We expect to see significant developments in the DeFi space in the future,” the authority wrote. “The medium-term trends identified by the FSRA are subject to disruption and changes in the environment. Nevertheless, we expect DeFi’s compositional capabilities and ability to create connected financial services to drive its adoption as part of mainstream financial services.”

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

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

Dubai’s Virtual Assets Regulatory Authority (VARA) and Singapore’s MAS have also monitored the industry. It ensured that entities engaged in crypto activities secured a license and approval from a new regulator. Non-compliance entails heavy sanctions and fines. Every crypto and web3 project in the UAW must comply. However, the rules will not apply to the economic free zones in the UAE.

Dubai’s plans for DeFi remained entirely unclear until February 8, when reports poured in that the issuance of anonymity-promoting cryptocurrencies such as Monero (XMR) had been banned there, perhaps hinting at a regulatory approach that seeks to attract easier-to-regulate and more profitable big business to its jurisdiction, not grassroots crypto projects.

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

DeFi’s fate hangs in the balance

FTX’s fraud was not committed on any blockchain. It happened in the places where fraud traditionally occurs – an environment that lacks corporate control and governance. FTX is a story of classic fraud, like Enron or Lehman.

It’s a far cry from the new scams we’ve seen lately in the cryptocurrency industry, such as hacks, to which regulation focused on decentralized technologies may apply. We have civil and criminal laws 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 have become comfortable with blockchain technology, they will turn their attention to decentralized products and services, looking more closely at those dApps where users truly transact peer-to-peer and solely on blockchains, including the recently popular betting, lending, financial services in the chain, etc.

Regulation will become progressively more complicated where users trade exclusively on blockchains instead of the popularly adopted dollar market onramps and offramps, such as Coinbase, Circle and FTX. Compliance with the protocol layer will not be easy, however. Many regulatory questions have yet to be answered, such as those around 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 may have strong regulation in Singapore, the UK and London, weak regulation elsewhere creates jurisdictional arbitrage and thus opportunities for fraud. The same applies to centralized finance (CeFI) versus DeFi. Regulators will pursue DeFi regulation at least as robustly as CeFI, so no arbitrage exists between the two.

Kadan Stadelmann

Kadan Stadelmann is a blockchain developer, operational security expert and Komodo Platform’s Chief Technology Officer. His experience ranges from working with operational security in the public 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.