We need to talk about DeFi

By Darren Parkin

by Elise Soucie, Director of Policy & Regulation, GDF

The International Organization of Securities Commissions (IOSCO)’s Consultation on Decentralised Finance (DeFi) closed for comments on October 19. IOSCO is due to prepare a report incorporating the feedback submitted by industry by the end of 2023.

IOSCO’s reach is global, with 35 of the largest securities regulators, and their recommendations and principles will exert a profound influence, shaping regulatory frameworks not just in the UK and US, but globally.

Industry players have sharpened their pencils to get their responses to the consultations right. This starts with clear definitions of exactly what IOSCO is trying to regulate and who is delivering the regulated financial product or service that falls within their remit.

A big focus on the consultation is an expansive term used by IOSCO called “DeFi Arrangement”.

Industry leaders believes this term would be more clearly articulated as, “a distinct financial product or service built on or interfacing with a DeFi Protocol”. A DeFi Arrangement should be clearly delineated from a DeFi Protocol which is a Credibly Neutral Decentralised Network on top of which financial products and services are created.

DeFi Arrangements are facilitated through technology infrastructure designed to enable end-users or investors to engage in financial transactions communicated or recorded through the DeFi Protocol. They may exist in many forms across the DeFi continuum and in some cases, they may be still evolving and would benefit from a sandbox approach promoting better industry regulator engagement and learning.

In other cases, DeFi Arrangements may be centralised entities masquerading as decentralised in which case the appropriate regulatory, supervisory, and enforcement treatment should be applied. Wherever the arrangement exists, the use of DLT should not result in either more or less stringent regulatory treatment than other forms of technology.

The term “Credibly Neutral” here is a key term. It means a verifiable and transparent system that aligns incentives with its users and a Decentralised Network is distributed, permissionless, and jurisdiction-neutral infrastructure. Its architecture inherently facilitates user autonomy, value management, and an open-source ecosystem.

What’s the point?

Many ask why this matters when the past two years have exposed criminals exploiting decentralisation and emerging technologies for fraudulent purposes, or presenting themselves as ‘DeFi’ whilst operating with centralised profit motives?

Many across traditional industry and regulatory agencies are cynical about the need for DeFi. IOSCO also highlights many of these examples of bad practice in their consultation and underscores the need for regulatory outcomes that protect consumers.

Consumer protection, however, should not come at the expense of technology neutrality.

The unintended consequences of imprecise or overly expansive regulation may not only hamper innovation but may ultimately discourage market participants from using not only DLT, but also cloud-based systems and other open-source communities like Hyperledger and GitHub.

High-level principles may be appropriate, but there must be technical parameters that accompany them for successful jurisdictional implementation. For example, the principle of have a “Responsible Person” is reasonable, but if framed to widely this could result in those Responsible Persons having regulatory obligations for use of technology by third parties even when they do not directly participate in the services provided.

This would be like requiring an order management software vendor to register as a broker or perhaps an exchange. Once registered, the vendor would then need to take responsibility for everyone’s use of the technology.

The effects of such requirements would prohibit the use of open source or permissionless technology in financial services requiring financial market transactions to take place through a central intermediary instead of peer-to-peer.

This could have a chilling effect on innovation in financial services more broadly as TradFi and DeFi are become more interconnected. Financial services firms may reject technology and innovation due to concern about punitive regulatory treatment which would ultimately impact innovative countries’ competitiveness and GDP in a globally connected and increasingly digital world.

What’s to come?

As DeFi evolves, use-cases develop, and industrymust mitigate risks in parallel for each underlying process. If a DeFi Arrangement is providing regulated financial services, it should then be subject to the appropriate regulatory treatment.

Industry must also work towards common standards, and alongside these developments, policymakers should foster responsible innovation, and not stifle the good actors in a growing market.

Eric Hess commented, in a recent article, “DeFi remains in its early stages. It’s essential for regulators to work alongside hybrid finance stakeholders instead of trying to force them back into traditional moulds. This is the time to press for creative solutions that harness DeFi’s potential without stifling its unique features.”

So, we need to talk about DeFi, and industry must work collaboration with regulators and policymakers to evolve DeFi to meet the market demands for greater access to innovative digital products and services, while meeting appropriate and robust regulatory outcomes.