Regulators begin to grapple with DeFi

On private video calls last week, some of the world’s fastest-growing cryptocurrency start-ups educated global financial regulators on a corner of the market that has largely evaded oversight: the booming world of decentralised finance.

The event featured presentations by the decentralised exchange Uniswap and derivatives trading venue dYdX, among other popular so-called DeFi programs, according to people familiar with the conference. 

Representatives from the Commodity Futures Trading Commission and the Securities and Exchange Commission also attended the event, which was hosted by the International Organization of Securities Commissions, the people said.

The gathering, which has not been previously reported, shows how financial regulators have begun paying greater attention to DeFi, a collection of cryptocurrency projects that aims to cut out the middleman and provide financial services such as lending and trading using automated software programs.

Lawyers and cryptocurrency advocates said the rapid growth of DeFi in the past year had caught authorities off guard, while also raising unprecedented questions about the nature of financial regulation. 

Bitcoin is the most high-profile effort to bypass traditional financial systems but the so-called DeFi sector extends far beyond cryptocurrencies into insurance, derivatives trading and even savings accounts.

In the US, CFTC commissioner Dan Berkovitz has suggested that many DeFi apps could be illegal, and SEC chair Gary Gensler has singled out the programs as raising “a number of challenges” for investors and regulators.

“There’s so much happening so quickly that regulators just cannot respond, as a practical matter,” said Lewis Cohen, a partner at DLx Law, a cryptocurrency law firm. 

Cohen compared the boom in DeFi to a “giant DDoS attack on global financial regulation”, referring to a kind of cyber security assault where hackers overwhelm their targets with huge volumes of activity.

A representative for Iosco declined to comment on the event, saying that it had been organised to “support internal work”. The CFTC confirmed the agency’s attendance but declined to comment on the discussions. Uniswap, dYdX and the SEC declined to comment.

DeFi apps push back against early rules

While employees at DeFi projects said they would welcome clearer guidance from regulators, increased oversight could pose an existential threat to the growing sector, which has ambitions to create an entirely new financial system.

Regulators have traditionally monitored the activity flowing through intermediaries such as banks, and may decide that the decentralised nature of DeFi apps makes the sector unaccountable.

Founders of some of the largest projects, such as Uniswap, have begun introducing governance systems that aim to spread responsibility for the apps among their users, rather than with a central authority.

Several projects have also distributed tokens that have surged in value in the past year, raising concerns that regulators might classify them as securities and introduce greater oversight.

The total assets pledged as collateral in DeFi applications has soared in the past year, growing from less than $2bn to more than $50bn, according to data collected by DeFi Pulse.

Cryptocurrency advocates have resisted early attempts to regulate the underlying software programs, arguing that the open-source projects are protected speech. 

“If you try to put prior restraint and permission-based regulations on these activities, what you’re basically doing is creating a ban on certain types of speech,” said Peter Van Valkenburgh, director of research at Coin Center, an advocacy group.

An early flash point emerged around new guidelines developed by the Financial Action Task Force, an intergovernmental organisation that develops standards to prevent global money laundering.

A draft version of the group’s newest guidance appeared to widely expand the group’s definition of “virtual asset service providers” to include decentralised software programs.

Cryptocurrency groups have protested against the measures, which could force DeFi apps to begin implementing know-your-customer rules similar to those required of banks, and FATF said on Friday that it would delay the final guidance until October.

US regulators yet to take firm action

US regulators have also taken notice. Berkovitz, the CFTC commissioner, said in a recent speech that automated software programs for derivatives trading appeared to violate the Commodities Exchange Act, which requires futures contracts to trade through regulated bodies and bars individuals with less than $10m of invested assets from entering swap contracts.

“I’m totally open to having certain applications that can be done more efficiently without intermediaries,” Berkovitz said in an interview. “But the intermediaries in many respects do serve an important function, and we can hold them accountable.”

Berkovitz’s comments suggested that the CFTC could begin regulating DeFi apps if they begin replicating traditional derivatives markets. So far, though, the CFTC and SEC have not taken any concrete action against DeFi.

“If it were to be an unregulated direct competitor in the futures market, that would be problematic,” Berkovitz said.

DeFi project founders argued that users of their open-source software programs benefited from transparent, rules-based systems for executing transactions.

For the SEC to take action against DeFi, it would need to assert “securities jurisdiction” over the programs and their related digital assets, said Michelle Bond, chief executive of the Association for Digital Asset Markets, a cryptocurrency industry body. 

“Just as a doctor shouldn’t recommend heart surgery for a knee scrape, regulations from one asset class or platform shouldn’t be broadly applied to non-similar asset classes or technologies,” Bond said.

Antonio Juliano, founder of dYdX, said the project had held multiple discussions with the CFTC, and its so-called perpetual contracts were not yet available for trading in the US largely for regulatory reasons.

“A lot of things that had to be done manually before, no longer have to,” Juliano said. “That’s great for investors.”