Decentralized Finance (DeFi) already feels like it’s been around for a long time despite it being only a few years old. This shows how incredibly fast crypto moves. The first DeFi primitives were built in 2018. Eventually, in 2020, DeFi protocols took the crypto space by storm. That’s why the summer of 2020 is often referred to as DeFi summer. Since then, the DeFi sector has matured, and regulators have been carefully watching the developments within the space.
DeFi – A long way from Niche Market to Mainstream
While the first DeFi users were self-hosting their wallets and directly interacting with the blockchain, that is often not possible for the early majority that needs to be onboarded next to the DeFi ecosystem.
These people depend on intermediaries that abstract complexity away for them and make complicated operations accessible. Coinbase understood that and started to build solutions for the less technical masses. The exchange wanted to enable its users to participate in the higher yields offered by DeFi and prepared the launch of a product called Coinbase Lend. However, the SEC was threatening to sue Coinbase over the launch of this product. In the end, Coinbase decided to launch a similar product without making it available to US customers.
This incident shows that the further evolution of DeFi, to a large extent, depends on the regulatory framework that is defined for DeFi. So what’s next? Which regulation can we expect for DeFi moving forward? In the following, we take a look at what we can expect from the regulation that will be implemented in the DeFi space.
DeFi Regulation in the United States
The regulatory framework for cryptocurrencies in the United States was often perceived as insufficient by both institutional investors and blockchain businesses. Due to the missing regulatory guidance, many blockchain enterprises decided to incorporate in countries such as Switzerland or Singapore. The basis for overseeing cryptocurrencies in the US is in many cases set by old laws such as the Securities Act of 1933.
In the Securities Act, the Howey test is articulated, which classifies whether an asset is a security or not. The SEC so far has clarified that it does not consider Bitcoin and Ethereum as securities. However, there is a lawsuit pending regarding the classification of Ripple, which Ripple appears to be winning. The results of this lawsuit will have potentially far-reaching consequences for the future of digital assets in the United States since it gets defined which cryptocurrencies should be considered securities.
Currently, in the US, the authority for regulating cryptocurrencies is divided among several federal agencies such as the SEC, the CFTC, FinCEN, and state-level regulators. Proponents of digital assets such as FTX’s Sam Bankman-Fried have pledged to create a single regulatory authority that is responsible for regulating cryptocurrencies.
Due to the increase in market capitalization of crypto assets in recent years, the pressure increased for regulators to react and create a framework for the emerging asset class. In March 2022, President Biden eventually signed an executive order directed at regulating the cryptocurrency space. Federal agencies are now instructed to develop a regulatory framework for cryptocurrencies. The executive order was positively received by cryptocurrency commentators and investors.
The president’s mandate is to identify the risks and benefits associated with cryptocurrencies and for the regulatory agencies to take a unified approach to regulation and oversight of digital assets. The order signed by Biden is trying to find a balance between enabling the technological advance brought by cryptocurrency in the United States and the protection of consumers and investors. Further objectives of the order are to prevent illicit activity and keep the United States open to innovation coming out of the digital assets space.
DeFi Regulation Overseas
In the past, a lot of DeFi innovation happened overseas. Popular DeFi protocols such as dYdX have even opted to exclude US users from their airdrop due to regulatory concerns.
On the other hand, Switzerland has one of the most favorable crypto legislations. This is the reason why many blockchain businesses choose Switzerland as the base for their operations. It is reported that the country is home to 14 blockchain-related unicorns. Since the space is entirely decentralized and no physical offices are needed, there is a lot of regulatory arbitrage happening.
Regulation of cryptocurrencies in Europe has so far mostly been in the competence of the individual countries. Most European countries pursued a rather liberal approach toward regulation of DeFi and taxation of cryptocurrency assets.
However, this approach was challenged recently by the European Union. In an anti-money laundering (AML) proposal, the European Parliament voted in favor of a bill that requires that transactions involving unhosted wallets need to be identified. This means that before an exchange transfers money to a private wallet of the user, the exchange would need to identify that wallet and the person in possession of that wallet.
There was severe opposition from exchanges like Coinbase against these rules. If this legislation enters into force, then it would tremendously increase the administrative burden for exchanges and complicate the interaction of ordinary people with DeFi.
The most important invention of DeFi is stable coins. Stable coins are digital assets targeted at mirroring the performance of the US Dollar.
Essentially there are two types of stable coins:
● Stable coins issued by a central party such as USDC (Circle) or USDT (Tether)
● Stable coins issued natively on the blockchain without the involvement of any central authority such as Dai
What makes stable coins interesting for investors is the ability to gain yield on an asset that is stable. The yield generated through stable coins is typically higher than the yield the traditional financial system offers. However, they also come with a different set of risks. Investing in decentralized stable coins exposes the investor to the protocol risk on which the stable coin is based. Investing in a centralized stable coin exposes investors to risks with regard to the financial stability of the entity that issues the stable coin.
The market capitalization of Dai has continuously increased from around 100 million US Dollars in 2020 to around 10 billion US Dollars in 2022. The same is true for the centralized stable coin USDT, which increased from a market capitalization of below 1 billion US Dollars in 2017 to more than 80 billion US Dollars in 2022. As the market capitalization of digital assets and stable coins increases, they start to represent a larger threat to overall financial stability. Therefore, the regulatory pressure on stable coin issuers such as Tether (USDT) has been increasing lately. The CFTC even fined Tether Holdings Limited in 2021 due to misrepresentations with regard to the financial reserves that are used to back the issuance of the stable coin USDT.
Central Bank Digital Currencies
As the DeFi stable coins, wallets, and infrastructure were built out, the central banks were watching carefully. The technology seemed promising and, if used by central banks, could potentially extend the control that central bankers have over money and interest rates. For these reasons, several central banks have made their plans for a CBDC (central bank digital currency) public. Advantages of CBDCs are that central bankers can potentially discriminate against savers with regard to the interest rates they receive and settle money directly without the necessity of third parties like banks.
It is not surprising that China is among the countries rapidly pushing the CBDC agenda forward. The country is not really concerned about the privacy of the financial transactions of its citizens, so there are very few obstacles to implementing a digital Yuan. In 2021, the first tests of the digital Yuan had already commenced. The United States, in comparison, is only at an early discussion stage with regard to the potential development of a CBDC.
Final Considerations regarding the Regulation of DeFi
A lot of DeFi essentially consists of protocols that run on a decentralized network. In this setting, there is no single entity that assumes responsibility for the hosting of the code. Furthermore, these protocols are mostly open source. This means anyone can fork them and build a derivative protocol based on the code of a DeFi protocol. Writing code essentially is equivalent to conducting free speech, and the activity of doing so, therefore, is unlikely to be prosecuted by a regulator. Furthermore, there is the possibility of releasing code in an anonymous way, as was the case for Bitcoin.
Due to the nature of DeFi and open source, it is extremely hard for regulators to prevent activities in DeFi since they are not dealing with a single counterparty. Therefore, a lot of regulation targeted at DeFi will be directed towards the gatekeepers, which mostly includes exchanges where end-users purchase and store cryptocurrencies.
While regulation obviously comes with risks and additional burdens for the sector, it is also required for the space to grow. DeFi can only be integrated into our centralized financial system once regulation provides clarity. Institutional money will only enter the space at scale once a clear regulatory framework for DeFi exists.