DeFi needs more decentralization

Amid all the ETF news that’s dominated the headlines over the last few weeks, the extensive report into DeFi published by the US Commodity Futures Trading Commission in early January didn’t get enough attention. 

Most of the news coverage focused on the report’s recommendations about implementing identity and AML practices, but this was only part of the document’s broad scope. 

Developed by the Commission’s subcommittee on digital assets and blockchain technology, the 79-page report dives deep into the risks presented by the emerging decentralized financial system. 

Especially revealing is its assessment of how effectively these risks can be addressed within the confines of regulation by using multiple levers of decentralization. 

The prevailing view — even from within the crypto space — is that DeFi will need to clean up its act and accept regulation. And in light of the direction of the crypto industry overall, regulation of some sort does indeed seem inevitable. 

But this report seems to go a step further — finally spelling out that permissionless innovation is an inherent trade-off if the broader benefits of DeFi are to be discovered and captured. 

DeFi founders must be willing to embrace the full extent of decentralization in their own projects as a way of increasing resilience and mitigating regulatory risk. This idea runs in opposition to the prevailing perception in DeFi — that decentralized projects face the biggest regulatory risks. In fact, ceding every aspect of control to a decentralized community while embracing decentralized infrastructure and partners will demonstrate that the project doesn’t contravene established regulations. 

Recommended reading for founders

While it’s directed at policymakers, this report should be recommended reading for all DeFi founders. The CFTC’s report proposes a framework that could assess DeFi protocols and specific risks not found in traditional finance, like code vulnerabilities or rug pulls. 

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Using the report’s objective framework, founders could analyze the extent to which their own projects are actually decentralized in all their different parts. While governance and token ownership are well-established levers of decentralization, development and operations are frequently more centralized in practice, dependent on only a few companies for infrastructure and building activities. 

The CFTC report also provides insight into the many areas where regulators consider DeFi to present financial risk, which can be interpreted as points of regulatory weakness for DeFi protocols and founders. 

Our industry tends to focus obsessively on know-your-customer (KYC) as a synonym for compliance, often at the risk of oversimplifying the complexity of regulatory exposure. In this respect, founders can also use the report as a way to view their own project through a regulator’s lens and see where they actually fall behind in compliance.

No hard lines

Ultimately, the many dimensions of decentralization make it impossible to present a hard line in determining if a project is “sufficiently” decentralized. Here, founders and regulators share the same challenge. 

However, deciding where to draw the line isn’t simply a matter of eliminating risk. Going too far with regulation in DeFi could be detrimental if it risks stifling innovation, and governments will be keen to capture as many of the upsides as possible, which may mean accepting some risks. 

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Founders may also need to reconsider their own ideas of personal and professional success, since the presence of a founder with enough control above other token holders will be an indicator of centralization. Therefore, while career success in DeFi is likely to come with its own kudos, it may need to take a different trajectory than that of the billionaire rockstar founders that dominate centralized tech firms. 

Furthermore, decentralizing control does come with the risk that the community may decide to act against the interests of the founder or even the project itself (one such case is AragonDAO, which previously voted to sue its founders, the Aragon Association — one of the factors that led to its collapse last year). 

The report’s call to action for DeFi founders is to establish and nurture truly decentralized systems that showcase the strengths of decentralization as best as possible. 

Since DeFi regulation in the future may be on the cards, better collaboration between the industry and policymakers is undoubtedly a positive move. Fully decentralized innovation will remain the key driver of the ecosystem for the foreseeable future.  

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