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September DeFi Roundup - Rethinking DeFi Regulation: Embedded Supervision and the Future of Decentralised Finance

The world of Decentralised Finance (DeFi) is rapidly evolving, pushing the boundaries of traditional finance and challenging existing regulatory frameworks. With the emergence of cryptocurrencies, stablecoins, and decentralised exchanges, regulators are grappling with how to oversee this new landscape effectively. Recent reports from the Bank for International Settlements (BIS) and other researchers shed light on this complex issue, proposing innovative approaches to DeFi regulation and highlighting critical considerations for regulators and firms.


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Embedded Supervision: Building Regulation into DeFi's DNA


One of the most intriguing concepts explored by the BIS is embedded supervision. This novel approach suggests leveraging the technology underpinning DeFi—Distributed Ledger Technology (DLT)—to streamline regulatory oversight. Imagine a system where compliance is automatically monitored by reading the market's ledger, eliminating firms' need to collect and deliver data actively. This could significantly reduce the administrative burden on firms, particularly smaller ones, and provide supervisors real-time access to transaction data for improved risk monitoring and decision-making.


Key Takeaways for Firms:


  • Reduced Compliance Costs: Embedded supervision could free up resources previously dedicated to regulatory reporting.

  • Improved Data Quality: Real-time data access could lead to more accurate risk assessments and better decision-making.

  • Enhanced Transparency: Increased transparency could foster trust and confidence in DeFi markets.

  • Technological Adaptation: Firms must adapt their systems to integrate with DLT-based market infrastructure and embedded supervision tools.

  • Regulatory Engagement: Active participation in developing embedded supervision frameworks is crucial to meet industry needs.


Information Asymmetry and the Role of Intermediaries


An NBER report delves into the role of private information in DeFi markets. The research highlights how intermediaries, such as block builders, can gain a larger share of profits by leveraging their access to private transaction data. This underscores the importance of transparency and information symmetry in fostering a fair and efficient DeFi ecosystem.



DAOs: Navigating the Legal and Regulatory Maze


Decentralised Autonomous Organizations (DAOs) present unique challenges for regulators. A third independent academic paper examines the legal and regulatory complexities surrounding DAOs, focusing on issues like knowledge attribution, transaction costs, security, and taxation.


Key Takeaways for Firms Involved with DAOs:


  • Legal Recognition and Regulation: Navigate the evolving legal landscape and ensure compliance with DAO-specific regulations.

  • Governance and Risk Management: Establish robust governance mechanisms and risk management strategies to mitigate vulnerabilities.

  • Taxation: Understand the potential tax implications and ensure compliance with relevant tax laws.

  • Collaboration and Transparency: Prioritize transparency and cooperation within the DAO community and with regulators.

  • Technological Innovation: Continue to invest in technology to enhance the security and efficiency of DAOs and DeFi protocols.



The Road Ahead


This research provides valuable insights into the evolving landscape of DeFi regulation. Embedded supervision, information symmetry, and transparent legal frameworks for DAOs are crucial for the responsible growth and development of the decentralised economy. By embracing innovation and collaboration, regulators and firms can work together to unlock DeFi's full potential while mitigating risks.


US Lawmakers Grapple with Defi: A Breakdown of the House Financial Services Committee Hearing


The US House Financial Services Committee recently held a hearing titled "Decoding DeFi: Breaking Down the Future of Decentralized Finance," marking a significant step in US efforts to regulate this burgeoning sector. The hearing featured testimony from key figures in the DeFi space, offering diverse perspectives on the challenges and opportunities this rapidly evolving technology presents. Here's a breakdown of the key takeaways:


Balancing Innovation and Consumer Protection


Brian Avello, Chief Legal Officer of Universal DeFi Holding Company, advocated for a balanced regulatory approach that fosters innovation while ensuring consumer protection. He highlighted the need for clear information disclosures and addressed the complexities surrounding the decentralised nature of DeFi protocols.


Defi: A New Paradigm for Finance


Rebecca Rettig, Chief Legal Officer of Polygon Labs, provided a comprehensive overview of DeFi, emphasising its unique characteristics, such as its non-custodial nature, user-directed transactions, and open-source foundation. She highlighted the potential benefits of DeFi, including increased transparency, operational resilience, and expanded access to financial services. Rettig proposed classifying DeFi as critical infrastructure, subject to oversight by the Cybersecurity and Infrastructure Security Agency, to ensure appropriate regulations that protect users.


Tailored Regulations for a Unique Technology


Amanda Tuminelli, Chief Legal Officer at the DeFi Education Fund, stressed the need for tailored regulations recognising DeFi's distinct characteristics. She argued against applying existing regulations designed for traditional finance to DeFi, highlighting the potential to stifle innovation. Tuminelli emphasised the benefits of DeFi, including increased transparency, equitable access, and lower costs, urging lawmakers to understand the technology before crafting regulations.


Protecting Individual Rights and Fostering Innovation


Peter Van Valkenburgh, Research Director of Coin Center, focused on individual rights and fostering innovation in the DeFi space. He criticised various agencies' current regulatory approach, arguing that they are overstepping their authority and hindering innovation. Van Valkenburgh advocated for a regulatory approach focusing on addressing fraud and protecting individual rights rather than overly restrictive measures that stifle development.


Addressing Risks and Centralization Concerns


Mark Hays, Senior Policy Analyst at Americans for Financial Reform, raised concerns about the risks associated with DeFi, particularly regarding investor protection and market manipulation. He argued that despite claims of decentralisation, DeFi exhibits significant centralisation in various aspects and, therefore, should be subject to existing financial market regulations.


The Tornado Cash Case Study: Challenges in Regulating Decentralized Systems


The hearing also discussed the challenges of regulating decentralised systems, referencing the research paper "Regulating Decentralized Systems: Evidence from Sanctions on Tornado Cash." The paper highlights the complexities of regulating DeFi protocols and the limitations of traditional regulatory tools in controlling activities on decentralised platforms.


The Path Forward


The House Financial Services Committee hearing provided valuable insights into the complexities of regulating DeFi.The testimony highlighted the need for a nuanced approach that balances innovation and consumer protection, recognises DeFi's unique characteristics, and addresses the challenges of regulating decentralised systems. This hearing marks a crucial step in the ongoing dialogue between lawmakers, regulators, and industry participants as the US seeks to establish a clear regulatory framework for DeFi.



Tornado Cash Sanctions: A Wake-Up Call for DAO Regulation


The US Treasury's sanctions on Tornado Cash, a decentralised protocol to enhance transaction privacy, have sent ripples throughout the crypto world. A recent research paper from the Federal Reserve Bank of New York, "Regulating Decentralized Systems: Evidence from Sanctions on Tornado Cash," sheds light on the complexities of regulating decentralised systems like DAOs and the implications for the future of DeFi.


Key Takeaways from the Tornado Cash Case:


  • Limited Effectiveness of Traditional Regulatory Tools: Despite the sanctions, Tornado Cash was partially shut down. This highlights the limitations of traditional regulatory approaches in controlling decentralised protocols.

  • Fragile Censorship Resistance: Ethereum is often touted as censorship-resistant, but the sanctions revealed vulnerabilities. The reliance on a few key players to process transactions post-sanctions underscores this fragility.

  • Non-Economic Motivations: Some actors' decision to continue processing Tornado Cash transactions despite being less profitable suggests that ideological or philosophical beliefs play a significant role in the decentralised space.


Implications for DAOs:


The Tornado Cash case is a valuable lesson for DAOs, highlighting the need for proactive measures to address regulatory challenges and mitigate risks.


  • Compliance is Not Optional: DAOs, even if genuinely decentralised, are not immune to regulatory scrutiny. Ensuring compliance with AML and other relevant regulations is crucial to avoid legal repercussions.

  • Balancing Privacy and Security: DAOs must balance user privacy and the need to prevent illicit activities. Investing in technological solutions that enhance privacy while mitigating risks is essential.

  • Transparency and Accountability: Promoting transparency in DAO operations and establishing precise accountability mechanisms can help build trust with regulators and users.

  • Proactive Engagement with Regulators: DAOs should actively engage with regulators to contribute to developing clear and balanced regulatory frameworks that foster innovation while addressing concerns related to illicit finance.



eToro Settlement with SEC: A Wake-Up Call for DAOs Navigating the Crypto Regulatory Landscape


The recent settlement between eToro USA LLC and the Securities and Exchange Commission (SEC) highlights the increasing regulatory scrutiny of cryptocurrency platforms and the potential implications for DAOs. While eToro operates a centralised platform, the SEC's actions underscore the importance of compliance with securities laws, a lesson that DAOs should heed as they navigate this evolving landscape.


eToro's Regulatory Troubles:


The SEC charged eToro with operating as an unregistered broker and clearing agency, facilitating the trading of crypto assets that the SEC considers securities. As part of the settlement, eToro agreed to pay a $1.5 million penalty and significantly reduce the number of cryptocurrencies available for trading on its U.S. platform.


Lessons for DAOs:


  • Token Classification Matters: The eToro case emphasises the importance of determining whether tokens offered or traded on a DAO platform are classified as securities. If they are, compliance with securities laws is crucial, even in a decentralised context.

  • Decentralisation is Not a Shield: While DAOs operate with a decentralised structure, this does not exempt them from regulatory obligations. The SEC's focus on eToro demonstrates that regulators are willing to hold platforms accountable, regardless of their level of decentralisation.

  • Compliance is Key: DAOs must prioritise compliance with applicable securities laws and regulations to avoid potential enforcement actions and penalties.

  • Transparency and Disclosure: Clear and comprehensive disclosure of information related to token offerings, trading activities, and governance processes is essential for building trust and ensuring compliance.


Navigating the Regulatory Maze:


The eToro settlement reminds us that the regulatory landscape for cryptocurrencies is complex and evolving.DAOs must be proactive in understanding and complying with relevant laws and regulations.



SEC's Action Against Galois Capital: A Cautionary Tale for DAOs and Custody of Crypto Assets


The SEC's recent charges against Galois Capital, a crypto-focused investment advisory firm, for custody failures are a stark reminder of the regulatory scrutiny facing the digital asset space, including DAOs. While DAOs operate with a decentralised structure, this case highlights the importance of proper custody arrangements and compliance with existing regulations, even without traditional intermediaries.


Galois Capital's Missteps:


The SEC found Galois Capital violated the Investment Advisers Act's Custody Rule for failing to ensure that a qualified custodian held certain crypto assets. This led to significant losses for investors during the FTX collapse. Additionally, the firm misled some investors about its redemption policies.


Lessons for DAOs:


  • Custody is Critical: Even though DAOs may not have a centralised management structure, the secure custody of digital assets remains crucial. DAOs must ensure that their assets are held in a manner that complies with relevant regulations and safeguards the interests of token holders.

  • Transparency and Accountability: Clear communication and transparency regarding asset management and redemption policies are essential for building trust and confidence among DAO participants.

  • Regulatory Compliance: DAOs must recognise existing regulations, even if they operate decentralizedly. Understanding and complying with applicable rules, including those related to custody, is crucial to avoid regulatory scrutiny and potential penalties.

  • Due Diligence: When engaging with third-party custodians or service providers, DAOs must conduct thorough due diligence to ensure they meet regulatory requirements and have robust security measures.


Navigating the Regulatory Landscape:


The Galois Capital case underscores the SEC's commitment to regulating the crypto industry and protecting investors.DAOs must proactively navigate the evolving regulatory landscape and prioritise compliance to ensure long-term sustainability.



CFTC Takes Aim at Uniswap: A Clear Signal for DAOs and DeFi Regulation


The Commodity Futures Trading Commission (CFTC) has significantly regulated the decentralised finance (DeFi) space by issuing an order against Uniswap Labs for offering illegal digital asset derivatives trading. This action sends a clear message to DAOs and all DeFi operators: regulatory compliance is not optional, even in a decentralised environment.


C FTC's Order Against Uniswap Labs:


The CFTC found Uniswap Labs violating the Commodity Exchange Act (CEA) for providing leveraged or margined retail commodity transactions in digital assets without being a designated or registered contract market. This means that Uniswap was facilitating complex financial products without regulatory oversight.


Implications for DAOs:


While Uniswap Labs is not a DAO, this case has significant implications for DAOs operating in the DeFi space, particularly those involved in derivatives trading or offering leveraged products.


  • Regulatory Scrutiny is Increasing: The CFTC's action demonstrates its commitment to actively enforcing regulations in the DeFi space, including DAOs.

  • Compliance is Crucial: DAOs must ensure their platforms and activities comply with all applicable laws and regulations, including the CEA and other relevant legislation.

  • Understanding Jurisdiction: DAOs need to be aware of the jurisdictional reach of regulatory bodies like the CFTC, especially when offering services or products that may fall under their purview.

  • Transparency and Disclosure: Clear and comprehensive disclosure of risks and terms associated with DeFi products is essential for protecting users and complying with regulations.


The Path Forward:


The CFTC's action against Uniswap Labs serves as a wake-up call for the DeFi space, including DAOs. By prioritising compliance, engaging with regulators, and adopting responsible practices, DAOs can contribute to the sustainable growth and development of the decentralised economy while mitigating regulatory risks.



UK Takes a Step Forward in Digital Asset Regulation: Implications for DAOs


The UK is making strides in establishing a clear legal framework for digital assets, with implications that extend to the burgeoning world of Decentralized Autonomous Organizations (DAOs). Recent developments, including the Property (Digital Assets, etc) Bill [HL] and the FCA's enforcement action against unregistered crypto ATM operations, provide valuable insights into the evolving regulatory landscape.


The Property (Digital Assets, etc) Bill [HL]: A Foundation for DAOs?


This bill aims to clarify the legal status of digital assets under English and Welsh law, recognising them as objects of personal property rights. This is a significant step, laying the groundwork for legally recognising DAOs and their assets.


Key Implications for DAOs:


  • Legal Certainty: By clarifying the property status of digital assets, the bill could provide greater legal certainty for DAOs, which often rely on digital tokens for governance and operations.

  • Ownership and Transfer Rights: Clearer ownership and transfer rights for digital assets could simplify DAO governance processes and facilitate the transfer of assets within the DAO.

  • Enhanced Security: Recognizing digital assets as property could strengthen legal protections for DAOs against theft or unauthorised use of their assets.

  • New Business Models: The bill could facilitate the development of new DAO-based business models, fostering innovation in the decentralised economy.



FCA Enforcement Action: A Warning for DAOs


The FCA's recent action against unregistered crypto ATM operations reminds us that regulatory compliance is crucial, even in the decentralised space. While DAOs operate without traditional intermediaries, they are subject to anti-money laundering (AML) and other relevant regulations.


Key Takeaways for DAOs:


  • Compliance is Key: DAOs must comply with all applicable regulations, including AML requirements, to avoid legal repercussions.

  • Transparency and Due Diligence: DAOs should prioritise transparency in their operations and conduct thorough due diligence on participants to mitigate risks associated with illicit activities.

  • Collaboration with Regulators: Engaging with regulators and developing clear regulatory frameworks for DAOs is crucial for the long-term sustainability of the decentralised ecosystem.



Navigating the Evolving Landscape


The UK's approach to digital asset regulation is evolving rapidly. The Property (Digital Assets, etc) Bill [HL] and the FCA's enforcement action signal a move towards greater clarity and regulatory oversight in the digital asset space. DAOs, with their unique structure and operational models, must navigate this evolving landscape carefully, ensuring compliance with existing regulations while actively contributing to the development of future frameworks. By embracing transparency, engaging with regulators, and prioritising legal certainty, DAOs can contribute to the responsible growth and development of the decentralised economy in the UK.


Overall


The DeFi space is at a critical juncture, facing increasing regulatory scrutiny while simultaneously demonstrating its potential to revolutionise finance. This September roundup highlights a clear theme:  compliance, transparency, and collaboration are essential for the sustainable growth and development of the decentralised economy.


Key Takeaways for DAOs:


  • Regulation is Coming: Regulators worldwide are actively working to establish frameworks for DeFi, including DAOs. Ignoring these developments is not an option.

  • Decentralisation is Not a Defense: While DAOs operate with a decentralised structure, they are not exempt from regulatory obligations.

  • Compliance is Key: DAOs must understand and comply with applicable laws and regulations, including those related to securities, custody, and derivatives trading, to avoid penalties and legal challenges.

  • Transparency Builds Trust: Maintaining transparency in DAO operations, token offerings, and governance processes is essential for building trust with regulators and users.

  • Collaboration is Crucial: DAOs should actively engage with regulators and policymakers to contribute to developing clear, balanced, and effective regulatory frameworks.


The Path Forward:


The future of finance is decentralised but also regulated. DAOs that recognise this reality and adapt accordingly will be best positioned to thrive in this exciting new era.



 
 

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The posts listed on the 'What we think' webpages are our interpretation of regulatory developments we have been reading about. They should not be considered legal, regulatory or other advice. Contact us if you want to understand the impact of public policy, regulation and governance changes for you.

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