• J McGlynn and M Bacina

US Regulators Divided on Defi Regulation

Updated: Jun 15

The US has arrived at a crypto-crossroads. As a hot topic for many lawmakers, paths to our digital future are within political focus yet US Regulators can't seem to agree on what direction they should take. Should digital assets be shoehorned into the same boxes we do other financial assets, sticking it closed with red tape as some may suggest? Or should regulators be looking outside the legal industry's ordinary box to perhaps carve crypto its own regulatory - lets say, triangle?

Recently we've seen US regulators either pushing hard to update and increase America’s rules on engaging with cryptocurrencies, or expressing concern that using too much red tape will suffocate it's innovation. This difference of opinion is apparent across many financial regulators.

The internal debate in the US

Hester Peirce, one of the five commissioners at the Securities and Exchange Commission believes in honouring and accommodating the differences of the digital asset space to encourage its break with tradition.

In a recent interview with the Financial Times Peirce said:

I am concerned that the initial reaction of a regulator is always to say ‘I want to grab hold of this and make it like the markets I already regulate...I am not sure that’s going to be great for innovation.

These comments mirror the words of our own Financial Services Minister Jane Hume who recently recognised the profound opportunity posed by digital currencies and the Australian Government's need to reject the calls undue restrictions on digital asset marketplaces. Yet they are in stark contrast to another member of the US SEC, Gary Gensler who reportedly " spearheads an effort to bring the fast-growing cryptocurrency market more in line with other types of financial assets."

Gensler has told Congress members there are “gaps” in the regulatory system and a need for lawmakers to clarify which regulator should oversee digital asset exchanges in particular. He has also touted his desire for crypto investors to be offered similar protections to those consumers would have at the New York Stock Exchange or Nasdaq.

This split of opinion is further highlighted in recent comments of Commissioner Dan Berkovitz of the CFTC (Commodity Futures Trading Commission). In his keynote address at the FIA and SIFMA AMG, Asset Management Derivatives Forum 2021, Commissioner Berkovitz ballyhooed that "unlicensed decentralized finance (DeFi) markets may be illegal", urging other regulators to focus more attention to DeFi derivatives as a growing area of concern and to address regulatory violations appropriately.

In summary, the main bone Berkovitz had to pick was with the 'counterparty risk' involved in Defi. Similar could be said of Gensler who seemed to paint digital asset holders as defenceless without the protection of increased regulation overseen by clearly elected supervisors.

Berkovitz commented:

In a pure “peer-to-peer” DeFi system, none of the benefits or protections (in traditional finance) exist. There is no intermediary to monitor markets for fraud and manipulation, prevent money laundering, safeguard deposited funds, ensure counterparty performance, or make customers whole when processes fail.

He continued:

A system without intermediaries is a Hobbesian marketplace with each person looking out for themselves. Caveat emptor—“let the buyer beware."

Reframing matters

Any financial transaction carries risk, the concern expressed by Gensler and Berkovitz appear to mis-apply what is traditionally considered as counterparty risk.

In a traditional transaction, intermediaries are required because of the opaque nature of a marketplace where certain parties can have information advantages over others, and where the risk of counter-party risk (that is one party defaulting on their promises) poses a real and systemic threat to confidence in the entire marketplace.

A significant part of existing financial services laws are designed to deal with counterparty risk and the safety of deposited funds given the incentives to bad actors to take risks or cheat customers.

The entirely open nature of blockchain based systems, upon which DeFi is built (in this case principally the Ethereum blockchain) by design has radical transparency so that parties can transact on a peer-to-peer basis with trust in the computerised system, rather than in a person, to complete a transaction. This is of course only possible by smart contract code being open source and visible, so that users can see (or more realistically rely upon auditors who have reviewed) the code of those contracts.

A smart contract can never do something the code doesn't permit, and so can provide mechanisms previously at risk of bad actors mishandling or stealing funds. Escrow smart contracts with release only upon performance by a counterparty in many cases today entirely eliminate the counterparty risk and the permanent nature of blockchain transactions with tracking of the transactions publicly available renders money laundering a foolish endeavour.

The biggest risks which have crystalised to date in DeFi projects are either "rug pulls", where a project is a scam and the price of the tokens in the project have been hyped up by bad actors, something just as illegal in DeFi as it is in regular commerce or indeed in a financial market, and in hacks or smart contracts being manipulated due to a bug in the code or exploit not previously unocovered.

The Hobbesian nature of DeFi which Berkovitz referred to is viewed by some as a strength, as smart contracts with poor code will be exploited and weeded out over time and only the strongest and most reliable code should survive. That is, of course, cold comfort to those who have lost funds in such exploits.

There remain many centralised parties involved in DeFi who may well be sensible targets for light touch regulatory treatment (we're looking at you CeFi lenders and centralised chains like Binance Smart Chain), but it seems to these writers that Berkovitz and Gessler need to improve their understanding of Blockchain, Crypto and DeFi considerably before making such sweeping misstatements as to the risks posted by DeFi generally. Blockchain and crypto have a hard enough time with myths abound without new myths being spread and leaders of regulators should ensure they are informed and speak accurately and with nuance about new technologies. In the meantime, Commissioner Peirce continues to lead the way.