Regulating for a decentralised future

DeFi is moving very fast and the innovation is exponential.  We keep hearing comments like:

“You can’t regulate it, it’s decentralised”

“It’s entirely code governed and operated”

Let’s find out what experts think. I recently moderated a panel at the AIBC Summit in Dubai, and thought that it was timely to write an update on some of the latest regulatory thinking – especially on the fast moving world of DeFi.

The  panel comprised Dr Marwan Al Zarouni, Head of the Dubai Blockchain Center, Loretta Joseph, global blockchain regulatory adviser, and Rico Pang, VC. We first covered why regulation is important and then moved to discuss some of the regulatory issues with DeFi, DAOs and Metaverse, from government, regulator and industry perspectives.

Regulatory concerns tend to be around the volatility of crypto markets, the nature of their use in connection with illicit or illegal activities, the unregulated nature of crypto exchanges and the absence of legal recourse in the event of any financial loss incurred.

A key challenge for regulators is the decentralisation of the financial system and the ability to manage economic stability and protect consumer interests in the event of this occurrence. Decentralising the provision of financial assets, services, decision-making and record-keeping poses unknown risks for regulators and international bodies.

Loretta Joseph, who has worked on digital asset regulation in Bermuda, Mauritius, Vanuatu, Nigeria, Serbia, India, Antigua and St Lucia, was on my panel,  made the point: “It’s not one bucket. regulations are made by industry segment. Central Banks monitor financial stability;  securities regulators  protect investors and consumers  and tend to be principal based; and FATF  overseas anti money laundering and terrorist financing using a risk based approach.”

A more decentralised 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 or jurisdictions. Regulators may employ a ‘buy time’ strategy until terminology unifies and stabilises or use “activities-based regulation”, whereby the focus is on the underlying activity that is conducted, such as processing stock trades, rather than on the technology used to conduct the activity  to promote a sustainable regulatory environment. This approach would treat blockchain technology no differently from other technologies, and essentially fit it into existing regulations about financial practices.

A recent review of 16 leading exchange platforms by LSE found that only four were subject to a significant level of regulation related to trading, so there is a clear gap. Getting listed on any major exchange now requires a project to have passed auditing, but meaningful security doesn’t end there. Smart contracts can be attacked. Even if they are audited, it does not give you a guarantee that it will be exploit-free. It is expected that exchanges and wallet providers will be a focus for regulators.

Decentralised exchanges (DEXs) allow users to trade directly from their wallets in a P2P manner without intermediaries.  Global money-laundering watchdog the Financial Action Task Force (FATF) has exchanges in their sights, and their guidelines suggest that dApps will need to comply with country-specific laws enforcing FATF, AML, and Counter-Terrorism Financing (CTF) requirements.

DeFi DAOs are popular as a means of transferring cryptocurrencies across different blockchains and in a DAO IT governance and corporate governance are one and the same.  The organisation is governed and operated by smart contracts, which are monitored and enforced by  algorithms. The code both governs and executes. Should the algorithms fail, who then is responsible? When a smart contract fails to work as expected, which party would be liable?

Legal accountability and liability is often shared in partnership entities and in many types of governance mechanisms. Regulators may conclude that it seems reasonable that members of DAO communities should be held jointly liable for losses, as they are jointly awarded for gains. Loretta Joseph pointed out: “Don’t be surprised if you see the regulator actually participating as a node.”

With NFTs, two big issues threaten to undermine the whole industry – washtrading and money laundering. Wash trading is a series of trading activities involving the same trader buying and selling the same NFT, creating an artificially high trading volume and a manipulated market price for the NFT. Loretta Joseph pointed said: “Securities regulators are looking at NFTs, if they behave like commodities, they will be regulated like commodities.” The U.S. The Department of the Treasury highlighted the risk that NFTs can be used to launder funds. 

The development of international standards are also  required regarding terminology  and to enable interoperability of blockchains with legacy systems and the facilitation of productive conversation between all stakeholders.

The absence of an agreed terminology affects how regulators understand, discuss, and ultimately regulate the technology (or not), as well as how any regulation or regulatory guidance will be interpreted by courts in the future.

Lawyers are deeply concerned with achieving accuracy and precision in the use of language, with ambiguous and fluid terminology, there are likely interpretive problems to follow, as regulators, companies, lawyers, and the courts decipher actions (regulation or guidance, for example) taken by regulators in regards to blockchain technology.

While regulation and consumer protection is vital, regulation should not quell the greatest innovations. Conventional regulatory approaches are insufficient for the new digital world. New and powerful technologies demand a new approach and one that is co-developed with industry. In an open-source environment where projects are developing at an average compound growth rate of 20% per year, finding just the right moment to regulate is the classic problem to solve, whereby people are protected from risk but innovation is not constrained.

Who, what and how to regulate in this global 24/7, borderless market?  This is a whole new ball game.

Loretta Joseph shared her vision… “In a perfect world we need a sensible balance of regulation that protects people and does not allow innovation to be stifled. Someone has to figure out together  how to cover off this new asset class which  is  not fully defined yet. But we know the rules we write now will affect the future of the industry.”