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Crypto regulation, compliance, and enforcement were the hot topics in 2022.

The momentum to increase government oversight of crypto has never been stronger after the collapse of Terra-LUNA, Three Arrows Capital, many crypto lending platforms and now the spectacular disappearance of FTX and what appears to be a catastrophic fraud on the part of its founder, Sam Bankman-Fried. Specifically for the app, unprecedented penalties were imposed on smart contract addresses in the case of the cryptocurrency mixer Tornado Cash.

Meanwhile, many jurisdictions are making great strides in establishing regulatory frameworks. The Council of the European Union has reached a OK proposal on crypto-asset markets (MiCA). Like MiCA, the project Lummis-Gillibrand invoice in the United States outlines a comprehensive framework that encompasses key pillars, including centralized service provider oversight, consumer protection, and stablecoins.

During the draft stablecoin regulation began to merge, regulating the whole decentralized finance (DeFi) ecosystem is still in its infancy. DeFi regulation is mostly out of reach in European and US frameworks. As Deputy Governor of the Banque centrale de France Explain“MiCA regulation is not an end in itself but rather the beginning of a process.”

Given the current position and direction of the world’s leading central bankers and policymakers, the industry needs to take a more active role in shaping the future of DeFi regulation. Fighting regulation is no longer viable; instead, the industry needs to be more pragmatic, to stave off the dangers of over-regulation.

Where are we now?

Central bankers recognize the potential of blockchain technology to improve the financial system, although they are deeply concerned about the systemic risk implications and the level of risk taking by the average consumer. These concerns, along with earlier negative perceptions, have been further galvanized by the collapse of FTX and the damage it has caused to consumers.

Regulators are still formulating a game plan for DeFi; focus on a flexible framework and cast a wide net to respond to rapid technological advances. They plan to be blockchain ready and beyond. In addition, great attention is given to the key parameters of transparency, governance and accountability.

Industry needs to take a proactive approach and play a more active role in shaping outcomes. It is no longer viable to try to hold back regulation, instead the industry needs to be more collaborative. This is essential to avoid the apparent dangers of over-regulation which can become too subjective and too dependent on judgement.

How do regulators really feel?

In the introductory remarks from a recent round table hosted by the French Central Bank, EU Commissioner Mairead McGuinness called tokenization (and crypto more broadly) the Wild West and warned that “these lawless days are coming to an end.” These strong words and characterization set an ominous tone for the future of DeFi regulation.

US Federal Reserve Chairman Jerome Powell also struck a critical tone, warning: “Within the DeFi ecosystem, there are very significant structural issues related to lack of transparency.” Powell’s comment quickly drew the ire of industry players who are quick to tout blockchain’s transactional transparency. However, Powell is likely to be referring to DeFi’s opacities related to personal identity, legal entities, governance, operational risks, and money laundering issues.

These views reflect EU and US regulatory sentiments, with each respective government pursuing its own national policies but also organizing through supranational standard setters such as the Financial Stability Board (FSB) .

As key influencers, it is no surprise that European and American views have spilled over into FSB policy, as recently published advisory document for the international regulation of crypto-assets. The document echoes Powell’s views on transparency, accusing decentralized technology of opacity and lack of accountability.

Why is DeFi regulation so difficult?

Central bankers are not naive about the complexity and difficulty of regulating DeFi and are aware of the difficulties inherent in non-traditional legal entity structures, decentralized governance and the anonymity of those “in charge”.

Ravi Menon, Chief Executive of the Monetary Authority of Singapore, said that “it is extremely difficult to assign responsibility for governance and risk management to the (right) players in the DeFi world.” Menon then forcefully asserted that it would be difficult for DeFi to exist without proper regulation applied to the right people, calling it a “game stopper.”

The FSB advisory paper attempts to offer guidance, urging regulators to “establish ways to identify who exercises effective control over the protocol or provides access to the protocol, and to hold them accountable under existing or future regulation. “. However, these suggestions are difficult in practice and may suggest a certain level of naivety when it comes to the practical implementation of DeFi regulations.

How does the industry deal with regulatory pressure?

The desire of central authorities to control and regulate DeFi is diametrically opposed to the decentralized and pseudonymous nature of DeFi.

Perhaps the industry founder who most clearly anticipated this conflict was none other than Andre Cronje, a leading figure in the yearn.finance (YFI) protocol and one of the most influential developers in the DeFi world. .

In a interview with Delphi Digital, Cronje addressed the regulatory issue of liability stating, “Who is the person [the regulators] target? These are the founders, the developers, the main roles in the community, eventually they will be the members of a multi-sig DAO.

His prescient comment comes months before recent events such as the Stop from Tornado Cash developer Alexey Pertsev and the Commodity Futures Trading Commission (CFTC) loading a decentralized autonomous organization (DAO) for proposing the illegal trading of digital assets.

Other industry founders were also hot debated the subject of regulations, in particular that of Sam Bankman-Fried proposal self-regulatory standards and the cutting edge of Erik Voorhees answer and criticism of these proposals. Bankman-Fried also lobbied for the ACCPD invoice, largely seen as anti-competitive in favor of FTX and potentially harmful to DeFi.

The debate shows that two poles of DeFi could emerge: one being fully compliant and regulated DeFi, the other being permissionless DeFi beyond the reach of central authorities. The silver lining to this scenario is that they may not be mutually exclusive and could eventually co-exist and thrive. Users will ultimately decide where to play, each influenced by their national jurisdiction.

How might regulators approach DeFi regulation?

It’s too early to speculate what a DeFi regulatory framework might look like, but there’s a lot to be learned from the discussions and comments from the world’s leading central bankers.

Powell, the chairman of the US Fed, has laid out the fundamental principle of a technology-neutral approach that addresses inherent risks and activities no matter where they reside, blockchain or otherwise. He says, “Some of these crypto activities are similar to traditional financial activities and they need the ‘same risk, same regulation’ wherever they take place.”

The FSB echoes a similar principle in its advisory paper, promoting a regulatory framework that is “technology-neutral and focused on underlying activities and risks.” In fact, the concept of “same risk, same regulation” refers to a speech by US Treasury Secretary Janet Yellen in April 2022, shortly after President Joe Biden signed the historic executive decree on digital assets.

It looks like regulators are planning to cast a wide net to chain all financial activities under one regulatory umbrella, no matter where they occur. Beyond blockchain, there may also be broader implications for fintech companies that offer financial services that may suddenly find themselves in the regulatory perimeter.

One of the biggest challenges for regulators will be reconciling the dissonance between the principles of transparency, accountability, and robust governance against the decentralized and pseudonymous nature of many DeFi systems, some of which are governed by DAOs without lines of accountability. clear accountability to a particular person(s).

Conclusion

Crypto, including stablecoins and DeFi, has enormous potential to enable a parallel universe of financial services beyond the control of conventional authorities such as central banks and regulatory agencies. There is no doubt that crypto is now getting the full attention of these institutions as well as governments around the world.

Blockchain technology has helped expand access to financial services and redefine what they mean. Consequently, the regulatory perimeter of financial services and activity will also have to widen and redefine itself.

There is an apparent danger that regulation becomes too subjective and judgmental. The future of supervision will need to move away from entity-based regulation and towards risk- and activity-based regulation. Whether it is a person or a company or a DAO, the intent of the services rendered will be a determining factor in whether they are inside or outside the regulatory perimeter.

The crypto industry would be well served by taking a proactive approach and using all avenues and opportunities to shape the outcome of DeFi regulation. The industry may also benefit from embracing the sentiment expressed by Ethereum co-founder Vitalik Buterin, who declared“It is up to members of the crypto community to anticipate more contentious situations, I am hopeful that we can have more collaborative conversations between regulators and industry.”





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