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5 Key Takeaways from Regulating the DeFi Frontier: Where Consumer Protection & Financial Innovation Collide

With increasingly great attention placed on DeFi and institutional finance moving into the space, our panelists Matthew Homer (Exec. In Residence, Nyca Partners & Former Executive Deputy Superintendent, Research & Innovation, New York State Department of Financial Services ), Jacob Yunger (Director Financial Innovation, FINRA), Philip W. Raimondi (Sr. Assistant General Counsel, CFTC), and our very own Mary Beth Buchanan (EVP Americas & Global Chief Legal Officer, Merkle Science) discussed the risks and regulatory challenges surrounding DeFi with Ian Taylor ( Executive Director, CryptoUK).

Merkle Science believes in smart regulation around DeFi. Merkle Science recently published “Diving into DeFi: Fundamentals from the Financial Frontier — a comprehensive primer of the current DeFi landscape especially well-suited for those who have started navigating DeFi, that gives an overview of the types of DeFi platforms, emerging trends, regulatory concerns, as well as risks individuals should be aware of when engaging with the ecosystem.

Diving into DeFi: Fundamentals from the Financial Frontier | Download the Guide
For those who missed the live discussion or would like to listen again, the full webinar can be found here.

Below are key takeaways that you may have missed.

1. As DeFi Makes Waves in Traditional Finance, Compliance Should Be in the Forefront.

Emphasizing DeFi’s growing appeal, panelists noted that DeFi has witnessed a surge of investment not only from retail investors but also from traditional finance. The institutional influx of funds will create a positive impact on the DeFi market by boosting market stability and enabling faster adoption of digital assets.

However, panelists also observed that many of the financial institutions (FIs) engaging with the DeFi projects are not conducting thorough vetting processes. Since the FIs are under strict regulatory scrutiny, having rigorous due diligence standards in place is non-negotiable. The panelists, therefore, urged FIs to adopt a risk-based approach and heed the warnings issued by the regulators. Therefore, FIs navigating DeFi should put compliance at the forefront. Further, as DeFi and traditional finance continue to merge, it is essential that the DeFi industry understand the compliance obligations placed on FIs.

To ensure investor protection and maintain market integrity, regulators are closely monitoring the DeFi space and enacting new regulations to mitigate the risks originating from different DeFi use cases.

2. DeFi Regulatory Path Ahead: Scope, Registration and Disintermediation

While discussing DeFi’s self-governing and automated infrastructure, the panelists outlined the approach that different regulators in the U.S. may adopt when looking at the DeFi ecosystem:

FINRA - As per Jacob Yunger, the Financial Industry Regulatory Authority (FINRA) — as a self-regulatory organization for brokerage firms and exchange markets — will bring those members under its supervision “that are engaged in a broker-dealer activity of digital assets.” However, before doing so, it is essential to determine which assets fall within the scope of digital asset securities and what broker-dealer activity looks like in the Defi Space.

Watch the Replay | Join Industry Regulators Discussing DeFi

CFTC - Philip W. Raimondi encouraged DeFi businesses to reach out directly to CFTC for two purposes. Firstly, to aid CFTC in risk analysis by submitting details regarding their structure, products and customer base. Using this information, the CFTC will distinguish retail customers from eligible contract participants (ECPs) such as swap dealers. If the products offered fall under the definition of a derivative, CFTC will apply additional statutory obligations if transactions involving such digital assets are done with retail customers

Secondly, after providing details of their product and structure, DeFi businesses should seek clarifications from CFTC regarding their potential registration process. According to Philip Ramiando, DeFi businesses should not get discouraged because though the U.S. derivative regime has historically been an intermediated market, it doesn’t necessarily mean that less or non intermediated registered derivative structure can not be put in place

State-level Approach - Matthew Homer pointed out that various states within the U.S. have regulated the crypto space through money transmission licenses, lending licenses, or by enacting tailored regulatory frameworks. According to him, this is especially true for the digital assets space. He gave an example of Western New York and how it has adopted a regulatory approach that focuses on five categories of activities including transmitting virtual currency, custody of virtual currency, controlling administering or issuing virtual currency, as well as other activities. To successfully conduct digital asset business, entities engaging in these activities require licenses such as BitLicense, traditional bank charter, or trust charter.

3. Challenges Deterring KYC/AML compliance in DeFi Industry

The panelists discussed some expectations that the regulators may have from the DeFi platforms regarding AML/CFT compliance. Centralized exchanges are obligated to conduct thorough KYC/AML checks. Certain DeFi platforms believe that since their users transact directly with centralized exchanges they do not need to conduct additional KYC/AML checks themselves. Mary Beth Buchanan debunked this notion stating that “it is possible, I think, for crypto transactions to occur in the DeFi space that have not been originally KYC-ed and so there has to be some mechanism to do that and that is where the difficulty [lies].”

She also noted that due to the self-governing nature of DeFi and the anonymity it accords to its developers, it might be difficult to bring DeFi platforms under regulatory oversight. Though the technology to facilitate AML/KYC compliance on DeFi platforms may not exist now, she is hopeful that this will be solved too.

4. For DeFi, Enforcement May Arrive Before Regulation

In the $600 million USD Poly Network hack, the hacker returned a majority of the stolen funds. The collective action of the crypto industry such as blockchain analytics, blocking certain transactions, and adding the individual tokens to the black lists pushed the hackers to return the stolen amount. Similar to the Poly Network hack situation, “there are going to be a lot of enforcement first situations because DeFi can provide unique services without the investor protection in traditional finance,” observed Jacob Yunger. The DeFi space may, therefore, witness enforcement activity before seeing full-fledged regulatory frameworks in place.

As per the panelists, this may not be an ideal situation, as they would not be able to provide investors and consumers the same amount of safeguards that compared to other asset classes, such as derivatives. To avoid hacks like the Poly Network hack, it is essential that certain core principles of traditional finance — such as registering trading platforms, conducting KYC/AML checks, and having the ability to segregate and secure custody of consumer assets — are also applied to DeFi.

Recognizing that DeFi could potentially be the future of finance, the panelists urged the regulators to take this opportunity to “think about the financial regulations from the DeFi context” and to adapt themselves to the new automated and digital infrastructure. Additionally, they encouraged the DeFi platforms to be proactive and aid regulators in creating effective regulatory frameworks.

5. Mitigating DeFi Risks is Everyone’s Responsibility

The panelists noted that for the DeFi ecosystem to thrive, participants — from regulators to investors to platform developers — must share the risks. Participants should analyze the underlying operational, insurance, and cybersecurity risks before entering into a DeFi project and proactively enact risk mitigation strategies.

Lastly, the panelists stated that the DeFi industry should collectively educate the customers and put warnings on their websites informing the customers about the risks associated with the DeFi ecosystem.