Who should bear the burden? The regulatory problem posed by decentralised finance (‘DeFi’)

Introduction

Decentralised finance (‘DeFi’) ‘provides the same financial services without any traditional central authority or intermediaries’[1]. This presents a massive economic opportunity. Currently, payment processing firms such as Visa and Mastercard have gross profit margins around 60-80%[2]. So, a shift towards a more decentralised system for processing payments can free up significant amounts of liquidity.

Yet, the lack of intermediaries poses a problem. In the absence of intermediaries, it is not clear who regulators should target.

This article will firstly discuss the underlying concepts involved in DeFi to illustrate how it works in more detail. Then it will discuss three different people who could bear the burden for regulations. The article then concludes.

The concepts underlying DeFi

DeFi relies upon a technology called blockchain. Blockchain can be defined as ‘a distributed, append only database, which enables - without a central trusted intermediary - transactions between human or software agents’[3].

Smart contracts can then be used with a blockchain. Smart contracts are programmes that the blockchain contains. These execute when particular criteria are met[4].

The result of the use of blockchain and smart contracts is that there is no need for intermediaries. A network of individuals ensure that a blockchain is accurate by solving cryptographic problems[5] so the ledger can be updated and distributed. Meanwhile, the use of smart contracts means that there is less scope for justifying a high commission because virtual assets are automatically transferred once a condition has been met.

This decentralisation explains the growing popularity of DeFi. The total assets in collateral in DeFi were $50bn as of June 2021[6].

What is the problem?

DeFi poses a challenge to the traditional way of regulating finance. Traditionally, regulators have looked at intermediaries and held them accountable[7]. This seems fair. As intermediaries collect vast sums of money, they are in a financial position to comply with regulations.

There has been significant movements to update regulations to deal with virtual assets in recent years. The Financial Action Task Force (‘FATF’) currently targets what are described as Virtual Asset Service Providers (‘VASPs’)[8]. These are businesses that transfer virtual assets.

However, the FATF does not consider DeFi to involve a VASP because DeFi refers to underlying software rather than a central actor[9] [10].

Meanwhile, although the UK is taking note, they are slow to act. In a report on the 24th of March, the Financial Policy Committee emphasised that the growing influence of DeFi needs to be monitored[11]. However, this represents a rather fudged position.

It is understandable why regulators are struggling with this issue. The central problem, as repeatedly noted, is that it is unclear who should bear the burden of regulations. Once that has been settled, there does not seem to be any great difficulties with regulators designing a system of regulations for virtual assets traded on DeFi[12]. What follows is a discussion of three different individuals who could be targeted by regulations. The article leans towards regulating the third actor mooted.

Should programmers bear the burden?

It has been proposed that programmers exert considerable influence over the resulting transactions that occur on through DeFi and so should bear the burden[13]. By holding programmers accountable, it may be the case that they ensure that systems are designed in a way that prevents regulatory breaches.

The problem is that it is not clear that programmers can necessarily exercise the sort of foresight to stop all regulatory breaches from taking place in a DeFi space. A programmer inherently does not want to release a system that is faulty because there are reputational harms from doing so. Users on a DeFi system might find all sorts of ways to avoid regulations and it is simply unrealistic to think that programmers can pre-empt all of these ways.

Should users bear the burden?

Given that transactions involve users transacting between themselves with no intermediaries, a natural position might be to regulate the users themselves[14]. The users could be required to ensure that they know who they are transacting with to prevent fraud and held individually liable for any breaches of the regulations that they carry out.

However, the issue is that it is just not clear that average users will be in a position to ensure that regulations are upheld at every stage. If DeFi reaches the scale that is promised then most users simply will not know when a breach of regulations has occurred. This is shown by the fraud that has already occurred through DeFi. For instance, $2 million of Vericoin was stolen in July 2014[15].

Should VASPs bear the burden?

A method mooted by the most recent FATF guidance is to require a regulated VASP to be involved in any transaction[16]. This would require programmers to ensure that the code is changed so that a transaction will not execute where there is no VASP involved.

At first glance, this looks contradictory to the allure of DeFi. VASPs seem to be the sort of intermediary that DeFi is supposed to remove. However, the role of VASPs could be seen as more of an insurance policy for users executing transactions through DeFi.

Users could choose between different VASPs who will make sure that there are protections from the fraud and regulators can ensure that VASPs carry out these obligations. The choice of different VASPs would ensure that extortionate fees cannot be charged.

This could in itself actually encourage the use of DeFi. If ordinary people think DeFi is regulated and involves insurance then they are more likely to put their faith in the system and use it[17]. Obviously, this is not a perfect solution by any stretch. However, when compared to the issues with the other two solutions mooted, it seems to be the least bad option.

Conclusion

In conclusion, DeFi poses a regulatory challenge that existing regulators have not fully settled yet. It is proposed that introducing VASPs into transactions and regulating those VASPs is the best solution of all the current options.

[1] Salami, I (2020) Financial Crime Update Journal of International Banking and Financial Law 35 (7) pp. 497 [2] The Economist (2021) Curioser and curiouser: Adventures in DeFi-land [Online] Available: https://www.economist.com/briefing/2021/09/18/adventures-in-defi-land Accessed: 25/03/22 [3] Bodó, B; Gervais, DJ & Quintais, JP (2018) Blockchain and smart contracts: the missing link in copyright licensing? International Journal of Law and IT 26 (4) pp. 313 [4] Swan, M (2015) Blockchain: Blueprint for a New Economy Cambridge: O’Reilly pp. 11 [5] Rathee, P (2020) Introduction to Blockchain and IoT in Kim, S & Chandra Deka, G (eds.) Advanced Applications of Blockchain Technology Singapore: Springer pp. 6 [6] Kruppa, M & Silverman, G (2021) Regulators begin to grapple with DeFi [Online] Available: https://www.ft.com/content/e6e7d9d6-7778-4286-ba6f-e5831fcbc538 Accessed: 25/03/22 [7] Ibid [8] Salami, I (2020) Financial Crime Update Journal of International Banking and Financial Law 35 (7) pp. 498 [9] Ibid [10] Boucher, LJ; Fisch, EJ; Nguyen, B; Maalouf, KN; Perry, JE & Seidner, G (2021) FATF Updates Its Global Guidelines for the Regulation of Virtual Assets With an Eye to Emerging Technologies [Online] Available: https://www.skadden.com/insights/publications/2021/11/recent-developments-in-the-regulation-of-virtual-assets/fatf-updates-its-global-guidelines Accessed: 25/03/22 [11] Linklaters (2022) UK authorities team up to remind regulated firms about crypto standards [Online] Available: https://www.linklaters.com/en/insights/blogs/fintechlinks/2022/march/uk-authorities-team-up-to-remind-regulated-firms-about-crypto-standards Accessed: 25/3/2022 [12] Salami, I (2020) Financial Crime Update Journal of International Banking and Financial Law 35 (7) pp. 497 [13] Chan, E & Yoong Tian, S (2022) Decentralised finance (DeFi): a game-changer or just a passing fad? Journal of International banking and Financial Law 37(1) pp. 339 [14] Boucher, LJ; Fisch, EJ; Nguyen, B; Maalouf, KN; Perry, JE & Seidner, G (2021) FATF Updates Its Global Guidelines for the Regulation of Virtual Assets With an Eye to Emerging Technologies [Online] Available: https://www.skadden.com/insights/publications/2021/11/recent-developments-in-the-regulation-of-virtual-assets/fatf-updates-its-global-guidelines Accessed: 25/03/22 [15] Swan, M (2015) Blockchain: Blueprint for a New Economy Cambridge: O’Reilly pp. 84 [16] Boucher, LJ; Fisch, EJ; Nguyen, B; Maalouf, KN; Perry, JE & Seidner, G (2021) FATF Updates Its Global Guidelines for the Regulation of Virtual Assets With an Eye to Emerging Technologies [Online] Available: https://www.skadden.com/insights/publications/2021/11/recent-developments-in-the-regulation-of-virtual-assets/fatf-updates-its-global-guidelines Accessed: 25/03/22 [17] The Economist (2021) Curioser and curiouser: Adventures in DeFi-land [Online] Available: https://www.economist.com/briefing/2021/09/18/adventures-in-defi-land Accessed: 25/03/22