Principles for Development of a DeFi Regulatory Framework

Innovativeness

Decentralized finance promotes permissionless innovation, i.e. with a decentralized platform that allows open access developers are able to build and experiment with new applications freely since there is no controlling party to stifle creativity. However legal questions arise and regulations related to the traditional doctrines of protection of intellectual property apply fairly restrictively as of today, but it does not exclude that these issues will appear exceedingly important in the coming future.

Interoperability

Decentralized finance can enhance interoperability since its projects are built on public blockchains and open standards, increasing the interoperability across different services. Ethereum is the dominant platform for decentralized finance, and all Ethereum-based projects enjoy high interoperability (some studies claim that around 87% of all publicly funded projects within and beyond decentralized finance have been built on Ethereum. (Y. Chen, C. Bellavitis: Journal of Business Venturing Insights).

Lack of Borders

Decentralized finance is not tied to geographic locations or fiat currencies, and can be used by anybody across the globe. DeFi does not rely on any specific central bank, government or other intermediary.

Transparency

DeFi secures their public ledgers through distributed consensus and radical transparency. DeFi generates “distributed trust”, so parties can transact with each other without preexisting relationships or trusted intermediaries.

Business Models in Decentralized Finance

The financial transactions may relate to, for example:

a. Decentralized currencies, decentralized exchanges (trading, investment and position management)

b. Decentralized payment services

c. Decentralized fundraising

d. Derivatives creation – i.e. Synthetix

e. Lending and borrowing through liquidity pools

f. Decentralized contracting

Cryptocurrency

After the launch of Bitcoin, there are now more than 5’000 different cryptocurrencies in circulation. Although the design and maintenance of cryptocurrencies differ, proponents of cryptocurrencies highlight their various potential benefits and features, including (1) the ability to make transfers without an intermediary and without geographic limitation, (2) finality of settlement, (3) lower overall transaction costs compared to other forms of payment (due to lack of intermediaries with applicable fees) and (4) the ability to publicly verify transactions.

Other features of cryptocurrencies include personal anonymity and the absence of government regulation or oversight. Critics of cryptocurrencies note that these features may facilitate illicit trading and financial transactions, and that some of the beneficial features may not prove to be available or feasible in practice.

Cryptocurrency Derivatives

Another avenue for crypto investment is through the futures and options market. While Bitcoin options are nothing new, the launch of Bitcoin options trading on the Chicago Mercantile Exchange in January 2020 was a watershed moment for the industry. Crypto derivative volumes jumped 32% in May, 2020 to develop into a record USD 602 billion market.

Decentralized Fundraising

Companies and individuals increasingly have been using initial coin offerings to raise capital for their businesses and projects. Typically, these offerings involve the opportunity for individual investors to exchange currency such as U.S. dollars or cryptocurrencies in return for digital assets labeled as a coin or token.

From the legal point of view a key question for all ICO market participants is whether the coin or token is a security comparable to equity? As securities law practitioners know well, the answer depends on the facts. One important quality that securities have – they have value in a secondary market. As we see there is a secondary market for tokens which most likely allows to see the qualities of a security within tokens. As of today, several countries have approached the regulation of status of cryptocurrencies and digital tokens differently.

Decentralized Contracting

Contracts are essential for any market functioning. There is a wide and popular view that contracts are complicated, because lawyers draft them; they are costly, due to the cost of lawyer’s fees, negotiating, enforcing. Traditionally contract parties rely on lawyers, financial institutions as intermediaries to establish trust. Blockchain technology has started to facilitate financial contracting by substituting financial intermediaries with smart contracts. Smart contracts are programs that automatically execute when pre-specified conditions (contract rules) in the protocols are satisfied.

Risks and Legal Challenges

DeFi has not reached its full potential yet, due to several challenges related to fraud, volatility, usability and regulatory uncertainty. In order to succeed, DeFi needs to create a healthy ecosystem that encourages responsible innovation, such that it can weed out fraudulent actors. The industry is encouraged to start self-regulation similar to tech companies – a promising beginning would be the elaboration of a standard of excellence (including a specifically elaborated “Code of Ethics” within the industry).

Although transparency is a cornerstone of decentralized platforms and distributed trust, extreme transparency may jeopardize privacy. To achieve distributed trust, transaction records are often stored and visible on public blockchains. This has the added risk of giving rise to some legal claims based on violation of data protection rules. However as of today, it is standard for Defi projects to have detailed internal regulations regarding data protection.

DeFi may lack accountability. With little to no involvement of central entities, it can become unclear who should be held accountable for potential wrongdoing on a decentralized financial ecosystem.

The operations of DeFi tend to rely primarily on the rule of code rather than human judgement. It could be an advantage, but it can also become a serious limitation, as it may leverage human knowledge and subjective judgment in every particular case.

Facing future challenges that relate to establishing a regulatory framework, there are several legislative approaches, methods and concepts that need to be evaluated in order to properly address the industry of DeFi.

As of today, different approaches are taken in different parts of the world;

- Including some of the Defi within the regulatory cope of the securities, capital markets, financial instruments, financial transactions

- Relatively hands-off approach

- Wait-and see approach

- Banning or bashing cryptocurrencies, and some of DeFi

The result of banning, usually is migration of the DeFi industry from their jurisdictions to more welcoming ones or entrance into the black market. There is need for a systematic regulatory approach to minimizing risks of DeFi, where the market fails to do so.

The initial aim of regulation should be to address “market failures”, which became obvious since the market of cryptocurrencies and DeFi has developed since 2008 (the first appearance of Bitcoin in the market).

Lack of the policymaker’s competence over cryptocurrency

One of the greatest challenges to regulating cryptocurrencies and DeFi is that policymakers lack competence in regulating these new industries. The basic principles of public and constitutional law imply that public entities, including regulators of financial market, have limited, powers and very precisely defined duties, otherwise the regulation or activities can be declared as unconstitutional. In multi-layered constitutional arrangements such as of the European Union, the principles of conferral, subsidiarity, and proportionality impose additional limitations on the powers of the EU institutions and agencies. As an example, the European Central Bank (ECB) supervisory competences are limited to the supervision of the credit institutions within the Single Supervisory Mechanism and the oversight of the payment system. The only legal base for the ECB to directly intervene in the cryptocurrency markets is if the cryptocurrencies threaten the stability of the financial or the banking system. In reality the ECB indirectly supervise the cryptocurrency market through the banking system.

The challenge to the regulation of cryptocurrencies lies in the fact that some of the largest cryptocurrencies are decentralized and designed to be censorship-resistant. Therefore, in the absence of a centralized governance scheme, it is hard to propose a direct regulatory approach to DeFi and cryptocurrencies. Traditional regulatory methods are not a solution.