5 Key Takeaways from Regulating the DeFi Frontier: Industry Leaders Discuss Fostering Innovation & Consumer Protection on the Financial Frontier

With the advent of financial institutions exploring the DeFi space, panelists for Merkle Science’s second Regulating Defi webinar Jai Ramaswamy (Chief Regulatory Officer at a16z), Jason P. Allegrante (Chief Legal & Compliance Officer at Fireblocks), Vanessa Grellet (Head of Portfolio Growth at CoinFund), and Sandra Ro (Chief Executive Officer at Global Blockchain Business Council) discussed the possible implications of the convergence between traditional financial and crypto markets. With the DeFi industry witnessing a massive surge from financial institutions (FIs) and the regulatory scrutiny around DeFi increasing, our panelists forayed into several timely topics including striking a balance between fostering innovation and the need to protect consumers, combating anti-money laundering activities, and preserving financial stability. 

1. The DeFi Industry Needs to Proactively Create AML Solutions

According to Jason P. Allegrante, it is counterproductive to hold onto the notion that decentralization and regulatory controls can never be in alignment. In fact, to promote the mainstream adoption of DeFi and ensure consumer protection, it is necessary to put in place a safe and proportionate regulatory framework that fosters innovation and fair competition. 

Vanessa Grellet added that the most proactive thing DeFi platforms can do is to come together and propose technical solutions to regulatory problems surrounding DeFi. Since the protocol runners understand the concentration of control, governance structure, and systematic risks existing between protocols the best, the regulators will hugely benefit from the constructive and technical solutions provided by the protocol runners.

On the flip side, Jai Ramaswamy urged regulators to acquire technological expertise and engage with a wider group of stakeholders — such as software developers — to effectively regulate DeFi. He also stated that the DeFi industry should come up with constructive solutions to the regulatory challenges, without viewing it as somehow compromising the underlying promise of the technology.

2. Bridging the Gap Between Traditional Finance and DeFi

Jason P. Allegrante believes that similar to the internet and cloud computing, traditional financial institutions will slowly but surely see the benefits of the open-source community. However, to inject trust and attract more investment from traditional FIs, DeFi must come to terms with AML/KYC as institutional investors will require KYC as they move capital into DeFi.

Panelists pointed out that when it comes to conducting money laundering activities, illicit actors generally use similar types of criminal typologies, whether its in fiat or crypto; DeFi, however, introduces a new layer of complication. In DeFi, smart contracts may serve a function similar to that of mixers, making it difficult to track the funds’ origination and where they exited. Panelists were hopeful that the crypto industry would come up with new solutions that would ensure AML/KYC compliance, such as models currently being developed that allow building an AML compliance layer on top of the DeFi protocol. While the DeFi industry creates such solutions, regulators will also have to change the way in which they view identity. 

Additionally, the DeFi industry is attempting to bridge the gap between TradeFi and DeFi by building institution-mediated products. These DeFi products are specifically tailored to meet the requirements of institutions that have strict compliance needs with segregated white label products that have robust KYC processes. For example, Aave Arc enables institutions to access DeFi yields through private liquidity pools where participants have completed know-your-customer requirements. Upon approval of a governance proposal, Fireblocks may become the first Aave Arc whitelister.

3. Safeguarding Consumers Against Bad Actors in DeFi

As consumers increasingly engage with the digital world in substantial ways, Vanessa Grellet noted that the definition between consumers and investors is starting to blend. Using NFTs as an example, they are art and collectibles that NFTs carry value, but they are not financial instruments. As a result, NFT owners do not receive consumer protection the way that investors of financial instruments would. To ensure consumer protection, regulators will have to intervene in the digital world and ensure that the consumers are aware of the risks and dangers surrounding the products. To effectively regulate new technologies such as DeFi and NFTs regulators may have to rethink what it means when an entity offers a product or conducts solicitation. They will have to revamp the current legislature in addition to coming up with new solutions that capture the digital experience.

Another point of focus for regulators would be where to place the regulations. Most of the DeFi applications are built on the protocol layers that are algorithms. According to Jai Ramaswamy, regulators need to get comfortable with the fact that regulation cannot exist at the protocol layer but needs to be applied at an application level. This doesn’t necessarily mean that the code in itself will not be policed, but that the policing will need to be done through intermediaries. 

4. Ongoing Tension Between Financial Access and Regulation

Jai Ramaswamy noted that, ultimately, there is tension between access to financial systems and the types of regulations required to collect information. The regulators will have to find a novel way to approach this problem. The U.S. has taken a step in this direction. On 11 December 2020, the Senate passed the Anti-Money Laundering Act of 2020. The new AML rules seek to modernize the AML/CFT regime and recognizes the adverse implications of de-risking — that, in an attempt to derisk, financial institutions will choose to terminate or restrict business relationships with clients, rather than managing risks. The new AML act also requires the regulators to take into account financial inclusion while reviewing reporting requirements and propose changes to reduce any unnecessarily burdensome requirements.

5. Institutional Pressure Will Usher in Creative RegTech Solutions

With DeFi providing unique financial services without the investor protection provided in traditional finance, DeFi industry may witness reg tech innovation outpacing regulatory developments. Jai Ramaswamy observed that the pressure will be  from the institutional side to “move the ball in this space with some organic solutions that aren’t imposed from the outside, but developed from within.”

How Merkle Science Can Help

Merkle Science provides a predictive crypto risk and intelligence platform, setting the standard for the next generation of financial safeguards and criminal detection. We are creating the infrastructure necessary so that a full range of individuals, entities, and services may transact safely with crypto. 

Merkle Science’s highly customizable platform and proprietary Behavioral Rule Engine is easy-to-use, allowing institutions to detect illicit activity beyond the blacklists so that FIs may catch undetected suspicious activity that legacy providers might miss and better meet AML and KYC obligations as per guidance from the FATF and jurisdictions around the world.

To find out how Merkle Science works for your business, please contact us via our website.