How not to regulate DeFi 101

In the rapidly evolving landscape of cryptocurrencies and DeFi, regulators worldwide are grappling with the task of preventing illegal activities without crippling innovation.

To this aim, a recent bill from Sens. Reed, Rounds, Warner and Romney proposes to impose the Bank Secrecy Act and sanctions compliance requirements on certain entities within the crypto space. 

While the intention behind this proposal is commendable and offices are open to constructive dialogue about next steps, analysis reveals that the bill’s requirements are largely arbitrary and poorly defined, presenting significant challenges for implementation. 

A more technologically sound approach is needed, to effectively address illicit finance in the DeFi ecosystem: One that balances regulatory goals with the unique nature of the crypto-assets.

The bill raises concerns from its inception, as it lacks clear definitions and objective criteria for determining who falls under its scope. 

For instance, the bill targets “Digital Asset Protocol Backers” and “Digital Asset Transaction Facilitators” without providing explicit guidelines to identify them. The secretary of the Treasury is expected to determine a person’s “control” of a digital asset protocol without referencing established legal guidelines, leaving room for ambiguous interpretations.

Moreover, the bill’s language is overly broad, potentially encompassing entities that have no real influence over DeFi protocols. For truly decentralized and autonomous protocols, investors and developers often lack the power to alter operations after deployment, making it impractical to hold them accountable for compliance.

In addition to the challenges posed by the bill’s arbitrary requirements, the proposal’s $25 million valuation threshold for determining Digital Asset Protocol Backers raises questions about its underlying rationale. The lack of transparency regarding how this specific amount was chosen suggests that the bill may be targeting existing ventures rather than influencing future activity since funding levels may vary widely from past projects.

The proposal also falls short in guiding decentralized protocols on how to comply with Bank Secrecy Act reporting requirements. 

DeFi protocols operate in a permissionless environment, making it challenging to collect personal identification information. The bill fails to address this technical complexity, leaving decentralized projects without practical solutions to meet the reporting obligations.

Furthermore, the bill’s provisions for crypto kiosks, or crypto ATMs, could potentially hinder financial inclusion. 

While the notion of improving anti-money laundering (AML) objectives for these kiosks is commendable, certain requirements — such as customer verification for any transaction amount and recording counterparties’ personal data — may be impractical due to technical limitations. Striking a balance between AML objectives and facilitating financial access is essential in a rapidly digitizing world.

Instead of adopting a one-size-fits-all approach to regulation, a more nuanced and collaborative effort is necessary. The Crypto Council for Innovation (CCI) is currently working on a comprehensive framework for appropriate DeFi regulation, engaging with industry experts and financial regulators to develop a technologically feasible and effective approach. 

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Recognizing the unique characteristics of DeFi protocols, this approach aims to tailor compliance measures to suit the decentralized nature of the crypto ecosystem, ensuring that the industry can continue to innovate while adhering to the highest standards of security and anti-money laundering practices.

The proposed bill’s ill-defined requirements risk impeding progress in the crypto and DeFi space while offering limited efficacy in combating illicit finance. 

It is important to note that this bill is in early stages and that its authors are interested in a constructive dialogue on how best to mitigate illicit activity in crypto. As the industry continues to evolve, policymakers must collaborate with experts and stakeholders to develop a technologically sound and practical approach to address illicit activities in DeFi. 

The path forward should involve distinct categorization of elements within the DeFi technology stack and harnessing the inherent transparency and programmability of blockchain systems. Such an approach will foster innovation, protect consumers and strengthen the global financial system while preserving the essence of decentralization and financial inclusion that makes the crypto ecosystem unique. 

As we navigate this crucial phase of regulatory development, open dialogue and collaboration will be the keys to unlocking the full potential of decentralized finance while mitigating illicit activities effectively.

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