The inevitable
The story of King Canute, who was the king of Denmark, Norway and England in the 11th Century, told of the King who sat on a beach in his chair and commanded the sea, which was a rising tide, to not encroach on his land or wet his clothes. Predictably he got wet and scurried, chastened, back up the beach.
It is a nice analogy of what is happening in the world of Decentralised Finance (DeFi), where there are many proclamations that they are a new paradigm in investment and through clever structures are somehow exempt from regulations.
The arguments are that DeFi is different, through the use of automated smart contracts, governance tokens and Decentralised Autonomous Organisations (DAO) owning the structures are well founded. Clearly DeFi is different from the traditional world of investment, through good design there are many risks that have been mitigated (such as the use of collateral in place of credit checking), the clever way that Flash Loans work, and eliminating many of the intermediaries.
Dean Steinbeck discusses in an article DeFi Lending: How Will it be Regulated how the DeFi community claim that their products are not loans but interest rate protocols does not absolve them from regulations as whatever you choose to call them they look like loans. Bitcoin Suisse make a case for regulating the financial intermediaries and not the DeFi protocols as they act as the gatekeepers of money in and out, however, this can only work if all DeFi participants go through intermediaries who do the necessary compliance checks.
While the regulators did not stepped in initially into the DeFi space as it did not represent a significant risk they have begun to flex their muscles.
Binance ran into trouble with BaFin when issuing tokens that represented popular stocks such as Apple, Coinbase and Tesla, and argued they were not securities as they were being sold through a 3rd party broker and were non-transferable. BaFin countered that they were securities and must follow the rules, such as issuing a prospectus which would need regulatory approval. There are also questions about what the tokenised stocks represent, they could be seen as total return swaps and thus be classified as a derivative or as Binance claim a fractionalised stock. The Binance announcement describes the tokens but does not clearly state what it is or give any suitability warnings.
The Financial Conduct Authority (FCA) in UK has tightened the rules on crypto-related businesses which has resulted in over 60 businesses withdrawing their applications with the FCA, with only 6 passing the “fit and proper” tests. Clearly this is a blanket ruling and not DeFi specific but it illustrates the mood of the regulator.
The European Union following consultation published a draft Regulation of Markets in Crypto-Assets (‘MiCA’) in September 2020 which laid out a proposed framework for Crypto-Assets in general including DeFi. There have been many responses, including those from the DeFi community who make a case for DeFi to be exempted or risk the EU members being excluded from the innovative and emerging sector.
The MiCA initiative is a clear move from the regulators to begin the process of regulating Crypto-Assets broadly and begin the path to regulate DeFi.
Is all of the DeFi industy having a King Canute moment or are there some moves towards compliance?
There are protocols that promote the issuance and trading of synthetic stocks as a means of democratising access to US and European stocks. The synthetics are typically collateralised by 150% and prices are maintained using oracles. Synthetics are an evolution in Global Depository Receipts where collateral is used in place of the underlying asset, the difference being that GDRs are issued on a country by country basis ensuring they comply with local regulations. We see nothing like that with the synthetic protocols issuing stocks, only collateralisation, oracles and pairs open to anyone to trade.
An interesting one to watch is Aave Pro which was recently announced and is introducing a whitelisted version of the popular protocol in conjunction with Fireblocks who provide the KYC service. The whitelisting of the participants who are KYC checked ensures that participants are institutional and comply with the necessary regulations.
The Aave Pro announcement prompted a lively discussion on how decentralised DeFi should be and whether a 2-tier system is being built, one for decentralised and the other more centralised around institutions.
Bitcoin Suisse and Sygnum are offering DeFi services to their clients with their services that include onboarding, custody and approach it from regulatory compliance around the on/off boarding of fiat and safeguarding clients’ assets.
While there is still legal uncertainty in interpreting regulations on how DeFi is classified, especially in the detail where a DAO runs a platform and where collateralisation and smart contracts are turning Peer to Peer and matching trading on their heads, one thing is becoming clear is that regulators are looking at DeFi and seeing securities. The challenging part is being pragmatic and ensuring that there is equivalence, not a prescriptive following of existing patterns. The challenge of regulation and DeFi was explored in an earlier article Regulations and Crypto. Oil and water?
Tgrade is approaching the issue of decentralised and regulatory using governance frameworks to support the creation of Trusted Circles in a self-sovereign approach. This creates the necessary frameworks for DeFi and regulations to co-exist.
