A friend of mine once joked that no financial innovation has arrived until regulators take notice of it. That moment may have arrived for DeFi. In early February, the St. Louis Fed posted an article by a Swiss professor on its website that delved into the potential promise of DeFi (recommended reading for anyone interested in learning about DeFi).
Then, on February 22, SEC Commissioner Hester Peirce spoke about DeFi and the challenges regulators face at George Washington University Law School’s “Regulating the Digital Economy” conference in a speech titled “Atomic Trades.” That the official SEC transcript of the talk included rocketship emojis was just icing on the cake.
LEGAL TOKENS
Will DeFi represent challenges to regulators? Absolutely. In Commissioner Peirce’s words, DeFi “is working on building an alternative to the legacy centralized financial system (“CeFi”) run through smart contracts rather than financial intermediaries.” CeFi is one of the most, if not the most, highly-regulated areas in the U.S. (and probably in the world), with enough regulations and licensing requirements to keep a literal army of lawyers employed (including yours truly), and for good reasons. DeFi has the promise of not only streamlining the process and making it more cost-efficient, but also making it more transparent.
But one of the core tenets of DeFi—its decentralized nature that allows for the efficiency and transparency—carries the seeds of its regulatory friction point. In a completely decentralized system, who bears the responsibility to assure that the necessary regulations are complied with? For instance, in the U.S., taking deposits (of fiat) generally is considered a banking activity, and to do so you have to have a banking license and be regulated by a banking regulator. That serves as a barrier to entry, but also means that customers’ deposits are subject to rules and regulations designed to protect them. If a DApp on a DeFi platform takes deposits of crypto, should it be regulated as a bank? If so, who would be engaging in the activity? The DApp, which is a string of code? The developer? The underlying base layer?
Clearly, these are answers that need to be addressed before DeFi can fully blossom. But as with most financial innovation, regulators lag behind the innovation, and frankly, it is not clear how many DeFi developers are actively considering whether their applications are encroaching on regulated conduct. Every successful new rocket launch program has its share of explosions during its development phase, and we can expect a few explosions before the DeFi rocketship successfully launches into the mainstream of finance.
