DeFi, Law and Regulation
Rafael Padilla
Professor of Law, San Beda Alabang School of Law
Co-Founder & Trustee, BlockDevs Asia
https://www.blockdevs.asia/
[email protected]
ABSTRACT: The application of blockchain and smart contracts in finance compels financial regulators to revisit existing rules and assess their relevance in the world of decentralized finance (DeFi), open finance, and distributed financial market infrastructures (dFMI). New rules and policies may need to be established to address the unique risks created by DeFi. The emergence of decentralized autonomous organizations (DAO) administered via decentralized governance could reduce the relevance—if not bypass—traditional regulated intermediaries. Because authorities partly depend on licensed entities to police financial transactions and enforce rules, DeFi could undermine the potency of financial regulators to supervise activities in banking, lending, payments, and other regulated financial activities. On the flip side, the rise of DeFi could offer authorities the impetus to discover new regulatory approaches and realize that they can likewise harness blockchain and smart contracts to optimize their regulatory functions, without necessarily relying on intermediaries as chokepoints for enforcement.
Introduction
Decentralized Finance or DeFi broadly refers to blockchain-based networks, protocols or applications that enable their users to access diverse categories of financial services in a peer-to-peer paradigm, rather than through the facility of a traditional central intermediary. Also referred to as open finance, DeFi leverages blockchain and distributed ledger technology (DLT) to reinvent finance by employing smart contracts to automate delivery. This transforms conventional financial products or services into natively digital artifacts that can be accessed without involving trusted institutions such as banks, insurers, and payment service providers.
Smart contracts enable the processing of basic business logic (“if this, then that” statements) which can be used to generate and transfer digital assets (including “tokenized” physical assets and financial instruments, and “wrapped” tokens that are not native to a particular blockchain, e.g. WBTC), verify signatures reliably and with integrity (i.e., tamper-proof), develop unorthodox, complex, modular, ”composable” financial applications, and implement new blockchain-based governance systems. (De Filippi & Wright, 2018) Indeed, DeFi and decentralized governance are some of the early use cases for smart contracts.
The role of stablecoin in DeFi
Stablecoins, especially decentralized primitives like DAI, play a critical role in the decentralization of financial services and in the DeFi ecosystem. Because they are designed to stabilize the value of a digital asset, many DeFi projects encourage the use of stablecoins in their platform due to their viability as a medium of exchange and unit of account within the DeFi ecosystem, as compared to other volatile cryptocurrency alternatives. That said, stablecoins present a set of challenges to regulators who are already grappling with general issues concerning cryptocurrencies (Furlonger & Uzureau, 2019) and “the category-defying changes that cryptocurrency poses”. (Casey & Vigna, 2018)
Insurance and DeFi
There are also DeFi projects that take advantage of blockchain to revitalize the cooperative ethos in mutual insurance—creating aligned incentives through digital assets and smart contract code. By introducing membership tokens, blockchain is employed to achieve the original goals of the mutual where all contributions are entirely for the benefit of members. The technology enables members to efficiently transact directly among each other, resulting in the disintermediation of the core insurance entity. This allows peer-to-peer mutual insurance to be recreated in a cost effective and scalable way, encouraging cooperation while preserving the benefits of diversification. (Karp & Melbardis, 2018) DeFi platforms such as Nexus Mutual and Opyn offer essential tools to enable participants to effectively manage risks within the DeFi ecosystem.
Decentralization and the regulability of DeFi
The autonomous nature of blockchain-based networks and applications does not absolutely insulate DeFi and decentralized applications (dApps) from the so-called “long arm of the law”. Because most financial regulations are “activity-based”, the services or features activated by dApps and DeFi projects remain subject to regulation IF the substance of those activities suggest that they fall within any of the existing categories of regulated financial services.
The fact that a protocol or application is decentralized and autonomous, BY ITSELF, does not mean that it is excluded from the material scope of the existing regulatory regime. In one case, the U.S. Securities and Exchange Commission—based on the underlying facts and circumstances—treated an initial coin offering (ICO) by a decentralized autonomous organization (DAO), The DAO, as a public offering of securities, an activity which requires prior registration with the securities regulator. (Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO [2017])
In another case involving EtherDelta, the U.S. SEC took the view that even a decentralized exchange could fall within the scope of the Exchange Act and be required to register as a “national securities exchange” or as an alternative trading system (ATS), unless it can find some other ground for exemption. That same case also demonstrated the practical feasibility of enforcing rules against identified actors behind decentralized applications and other blockchain projects, especially if they maintain significant control over the project. (In the matter of Zachary Coburn, U.S. SEC, Administrative Proceeding File No. 3-18888 [2018])
DeFi projects integrate blockchain and DLT to quintessentially decentralize access to financial services. DeFi enables the disintermediation of trusted third parties that perform a central role in brick-and-mortar and brick-and-click financial services. Because of its ability to disintermediate, the Financial Stability Board (FSB) examined the regulatory implications of DeFi especially as it relates to governance and financial stability:
“The application of decentralized financial technologies – and the more decentralized financial system to which they may give rise – could benefit financial stability. It may also lead to greater competition and diversity in the financial system and reduce the systemic importance of some existing entities. At the same time, the use of decentralized technologies may entail risks to financial stability. These include the emergence of concentrations in the ownership and operation of key infrastructure and technology, as well as a possible greater degree of procyclicality in decentralized risk-taking. New uncertainties concerning the determination of legal liability and consumer protection may also affect public trust in the financial system. Recovery and resolution of decentralized structures may be more difficult.
These issues may pose challenges for financial regulatory and supervisory frameworks, particularly those that currently focus on centralized financial institutions. A more decentralized financial system may reinforce the importance of an activity-based approach to regulation, particularly where it delivers financial services that are difficult to link to specific entities and/or jurisdictions. Certain technologies may also challenge the technology-neutral approach to regulation taken by some authorities. These concerns could continue to be the subject of further consideration by authorities. Regulators may also wish to engage in further dialogue with a wider group of stakeholders, including in the technology sector, that have had limited interaction with financial regulators to date. This should help avoid the emergence of unforeseen complications in the design of decentralized financial technologies at a later stage.” (FSB, Decentralized Financial Technologies: Report on Financial Stability, Regulatory and Governance Implications [2019])
Prof. Dirk Zetzsche, Prof. Douglas Arner, and Prof. Ross Buckley, all professors of law, grappled with the legal and practical issues concerning the enforcement of financial regulation vis-à-vis DeFi:
“Enforcement becomes problematic in the context of DeFi. For instance, financial regulation on outsourcing and delegation, as a general principle, seeks to ensure that one entity is in charge and liable for compliance with all laws and regulations applicable to that entity even where that entity relies on external service providers, and require entities to manage legal, concentration and reputation risks relating to outsourcing. In short, these rules create a hierarchy of liability and accountability, based on contractual rather than technical or financial relationships, where the supervised entity needs to ensure compliance from all service providers connected to it. How, in the world of DeFi, could a supervised entity enforce its oversight requirements vis-a-vis multiple, dispersed network participants that are spread around the world and subject to entirely different rules, ethics and reputational concerns? The core concern is not that the network participants reside in different countries, but that they are dispersed and decentralized.” (Zetzsche, Arner & Buckley, 2020).
In view of the novelty of DeFi as a specific use case for blockchain and smart contracts, a number of challenges would need to be addressed both by authorities in charge of enforcing financial regulations, and by the entrepreneurs and technologists who are experimenting with decentralized delivery channels for financial services. (Chen & Bellavitis, 2019)
DeFi’s impact on the enforcement of financial regulations
But how do DeFi and dApps fit in the existing regulatory schema that assumes the existence of a chartered (i.e., licensed) financial intermediary or middleman that is required to aid the regulator in enforcing financial services rules? Is there an approach by which we could design a framework for financial regulation that does not count on the middleman to ensure and enforce compliance?
As this new category of finance gains wider traction, DeFi could gradually reshape the financial services sector. This could in turn compel authorities to modernize their regulatory approach by coming up with innovative supervisory technologies (suptech), enhancing their potency to enforce rules without necessarily relying on regulated institutions to police financial transactions.
Conclusion: is there a need to set new rules for Defi?
It is generally ideal for law and regulation to be technology-agnostic. Hence, legal and regulatory developments should target the actors or intermediaries who offer services that are substantially similar to traditionally regulated financial services, regardless of the technology employed by said actors. Even so, the nature of blockchain and smart contracts are forcing financial regulators to revisit existing rules and assess their relevance in the world of DeFi, open finance, and distributed financial market infrastructures (dFMI).
In some instances, new rules and policies need to be established to address the unique risks created by DeFi. The emergence of DeFi and decentralized governance through decentralized autonomous organizations (DAO) could reduce the relevance—if not bypass (i.e., disintermediate)—traditional regulated intermediaries. Having in mind the conventional regulatory approach where authorities partly depend on regulated entities to police financial transactions and enforce rules, DeFi or open finance could undermine the potency of financial regulators to supervise activities in banking, lending, payments, and other regulated financial activities.
On the flip side, the rise of DeFi could offer regulators the impetus to discover new ways to fulfill their mandate and realize that they can likewise harness blockchain and smart contracts to enhance their regulatory functions, without necessarily relying on intermediaries as chokepoints for enforcement.
In the advent of smart contracts, blockchains and other distributed ledgers, new legal paradigms and regulatory strategies should be explored to discourage illicit and improper use of the technology, while reaping the benefits of the technology as a catalyst of economic growth, decentralization and competition. If done correctly, dynamic policies could enable blockchains to flourish, like the internet, and encourage DeFi to evolve as a free-market solution that will optimize financial inclusion in the long term.
18 September 2020