DeFi becomes a controversial issue for regulators

Decentralized finance (DeFi) has at this point become such a significant part of the crypto world that it simply can no longer avoid the attention of various regulatory bodies. On the other hand, government regulators still cannot even deal with conventional cryptocurrencies. And since DeFi is much more difficult to figure out, it would be highly surprising if officials suddenly rolled out ready-made regulations for this field.

On top of that, even among regulators the attitude towards decentralized finance differs significantly. In March of this year, the Financial Action Task Force (FATF) – essentially, the main existing international regulator in the field of cryptocurrency transactions – updated a set of recommendations for national supervisors. In particular, “in order to more effectively combat money laundering and terrorism financing,” its experts suggest paying special attention to NFT and the decentralized finance field – DeFi.

Judging from the FATF documents, the regulator’s experts are closely watching the entire cryptocurrency field and in particular decentralized finance. After the staggering growth of the DeFi sector in 2020, the FATF started calling it “an additional challenge to the economic security of the world.” In the eyes of the organization, cryptocurrencies as such already pose enough of a problem due to transactions that are difficult or impossible to trace.

Now the FATF is introducing additional definitions for decentralized exchanges (DEX). The regulator defines them as “platforms that do not rely on software or technology, rather working through decentralized applications.”

DEXes in the FATF documents are also referred to as “Virtual Asset Service Providers” (VASP). They are the most worrying for fighters against money laundering, because, firstly, they are not subject to regulation in any jurisdiction, and secondly, they simply ignore any anti-money laundering (AML) norms – most importantly, the know your customer (KYC) requirements.

Formally, the FATF’s opinion on DeFi is just a recommendation. But one must understand that the FATF is way too influential a body in world finance. Its definitions and recommendations very often become regulatory norms for states seeking to regulate the digital currency field.

However, the very nature of decentralized finance precludes its direct regulation: there is no one to order around or instruct, there is no one even to sue. Still, we know that regulators never back off and stop pressuring just because their methods don’t work. It is impossible to take control of DeFi through the usual for government bodies ways, which means we should expect new restrictive initiatives.

In stark contrast to the FATF, the US Securities and Exchange Commission (SEC) Commissioner Hester Pearce expressed support for the DeFi sector and opposed the SEC’s enforcement approach against industry actors. On June 23, during a virtual conference, Pierce noted that she supported much of the work on decentralized finance and opposed the enforcement-based approach.

“I don’t want there to be a law enforcement approach implemented. If we can clarify some of the issues with DeFi, we should do it, – Pearce said. – There are certain obvious things: if you are a supposedly decentralized platform that is actually centralized, then you are likely to be subject to securities laws.“

Securities laws have a complicated relationship with cryptocurrency, as US regulations have long determined that the presence of a third party controlling the value of an asset is part of the definition of that asset as a security. However, the difference between DeFi and previously known mechanisms lies precisely in the desire to completely exclude third parties from the equation.

In the case of DeFi, a constant concern for regulators is the question of who can be prosecuted in the event of fraud. Pierce considers it to be a benefit: “Removing intermediaries can be very beneficial to financial stability. It provides easy and transparent access to financial services. This is a positive.”

Hester Pearce also brought up numerous legal claims against large tech companies that manipulate user data. Their entry into the financial market has already led to antitrust investigations and lawsuits. In such circumstances, DeFi could provide a safer alternative to both traditional banks and IT giants entering the financial service market.

The two opinions – those of the FATF and Hester Pierce – basically reflect two different approaches to DeFi regulation gradually forming among regulators around the world. And here is one interesting and important point: While the FATF, as an international body with certain traditions, seeks to restrict any finance on the blockchain in every possible way, many national regulators consider DeFi projects an integral part of fintech. As such, the industry has now been given the green light both in Europe and in the United States, and indeed in most countries of the world (since everyone is pretty sick and tired of the old banks). Most likely, the attitude towards DeFi will be somewhat lenient until either the technologies used there become ubiquitous in fintech (a positive outcome), or a series of financial scandals and frauds labels DeFi as a “criminal technology”, as it almost happened with cryptocurrencies in general (a negative option).