Decentralised, but not beyond reach: regulation of DeFi is on its way
AVentures thesis series: Interview with Paul Imseih
Regulation is coming to DeFi
There are two major themes to watch in 2022: stablecoins and the FATF guidance.
The first major theme will be closer scrutiny of stablecoins, cryptocurrencies and DeFi and how these financial tools can supplement or undermine existing financial frameworks and Central Bank controls. We see this playing out in the US but several countries and the EU have already made significant advances here.
The second theme relates to how various member countries will approach and implement the Financial Action Task Force (FATF) guidance published earlier this year. FATF issued its final report on Virtual Assets Service Providers (VASP) to address perceived concerns with money laundering, terrorist financing, KYC requirements and the travel rules (knowing exactly who is sending and receiving funds and keeping records of these parties).
The broad rules applying to DeFi and dApps are no longer up for debate now that the FATF member states have voted to support the final report, so it should be assumed that the current set of guidelines and definitions are likely to be implemented in the near future. Legislation takes time to draft and pass into law but decentralised projects should turn their mind to how this guidance impacts their dApp/platform if they wish to stay ahead of the curve.
Stablecoins — déjà vu all over again
Stablecoins will be the focus of considerable debate and investigation in the coming years. Historically, the USA, Europe and many other nations have already experienced alternative mediums of exchange and effectively regulated them out of existence in order to maintain macro-economic control.
The history of money in the USA alone is littered with what were called “wildcat” currencies — scrips, IOUs and promissory notes that represented mediums of exchange before the dollar was adopted in 1863 as the sole legal tender in the US, backed as it was by US Treasury bonds.
Fast forward to the present day and we see a similar story emerging USDT, USDC, DAI etc. These stablecoins are unregulated, and more or less in the same category as some of these wildcat currencies of the 1700s and 1800s. It is very likely that sovereign nation-states looking at digital assets as means of exchanges will want to develop their own central bank digital currency (CBDC) so they can control monetary policy (which is impossible without a CBDC).
Once Central Banks issue their own CBDCs with cross-chain functionality, regulators will likely criminalise or heavily regulate the use of stablecoins, pushing them to the fringe of the cryptomarket. It does not mean that stablecoins will not be used, but centralised exchanges would be more likely to use an officially recognised stablecoin rather than something like Tether which, as the New York Attorney General’s investigation revealed, has been struggling to maintain banking relationships and suitable backing for USDT, currently being pegged to a basket of assets that includes “loans made by Tether to third parties”.
For many mainstream users, being able to quickly transfer a CBDC from a CEX or DEX straight into one’s bank account, credit card or other mainstream payment platforms will provide CBDCs with a compelling advantage over stables.
The big question is: “when”?
In the short to mid-term, stablecoins are here to stay
The stablecoins we currently know will be around for a couple of years at least as any CBDC would take years to be developed. China’s digital yuan, as a project of the People’s Bank of China, is only at a proof of concept stage and yet they have been working on that for more than a year already. It is reasonable to expect that it will take about 4–5 years before we see a CBDC widely used. And even in that case, a CBDC might only be used at an enterprise level.
For example, regulators may allow the CBDC to be used for transferring value between the exchanges and some of the large brokers, imposing minimum limits etc. On the other hand, widespread use of CBDC in retail is likely 5–10 years away unless one of the OECD nations breaks ranks and starts experimenting with CBDCs at the retail level.
Sandboxing — the story so far
As to the second major theme for 2022–23, it is worth considering the success or otherwise of regulatory sandboxes as there are some important lessons here, especially as it relates to how FATF guidance may or may not be implemented around the world.
In simple terms, a “regulatory sandbox” is a legal environment created by regulators that allows teams to build their projects under regulatory supervision. Projects can experiment with different features in collaboration with the regulator, even where those features do not have regulatory clarity.
There are benefits for both parties as the project team has some protection from enforcement action and gains legitimacy. In return, the regulators develop a better understanding of the technology and can construct a regulatory framework that is conducive to ongoing development and innovation.
The sandbox environment might result in a project having to modify their use-case or business model to get regulatory approval but this occurs as part of a dialogue with the regulator rather than waiting for enforcement actions which would force a project to shut down.
Several countries such as the UK, Australia, Singapore and Seychelles have introduced some form of regulatory sandboxing over the last few years to allow regulators to observe development and experimentation by dApps and DAOs.
In theory, sandboxes should be extremely popular and the launchpad for all major DeFi projects and VASPs. So what happened? The recent news of the failure of Libra/Diem dealt a major blow to regulatory sandboxes. Despite the Libra Consortium (the members of which were all major players in the payment space) actively courting feedback from regulators in Switzerland, the EU and the US over an extended period, the project failed. Soon after leaving their Geneva headquarters in 2021 (much to the consternation of Swiss authorities who had invested considerable time and resources in the project), Libra relocated to the US and is now in the process of shutting down completely and selling off their assets.
To date, sandboxing hasn’t been taken up widely because the sandboxes themselves only provide limited scope for projects and they are operating in an environment where the lack of regulation and clarity neutralises their value once the project is ready to go live. If one looks at the way capital is moving in the market at the moment, a lot of projects are going straight to launch, bypassing sandboxing or regulatory experimentation due to lack of regulatory certainty. The result has been most projects living by the maxim “move fast, break things”.
This is not legal advice but to date, this hasn’t worked out so badly. Projects are finding ways to raise capital as soon as they are ready to go, rendering the sandbox unnecessary. As a result, sandboxes have not proved to be as successful as regulators had hoped for and have not created an environment conducive to development in this space. On the other hand, those projects that approached regulators and tried to work with them haven’t fared so well.
Protecting retail investors as a top priority for regulators
Regulators have a plethora of law enforcement tools at their disposal even in the absence of crypto-specific laws. They are not so concerned about protecting large commercial enterprises, hedge funds or banks who can all afford specialist teams to help navigate these complex areas of law.
From a public policy standpoint, the regulators are ultimately concerned about protecting retail and unsophisticated investors as well as communities in developing nations who may not even have access to the basic technical skills needed to deal with digital assets. These are real concerns. They are precursors to widespread adoption. Where that leaves regulators today is trying to balance the need to encourage development and innovation, promotion of healthy capital markets and the protection of retail investors. This is not an easy task and has sometimes resulted in knee-jerk responses.
I anticipate that regulators will become increasingly sophisticated, particularly in light of the roll-out of the FATF guidance discussed above as this provides them with a clear definitional roadmap to respond to this emerging industry.
About Paul Imseih
Paul Imseih, a member of AVentures DAO, has more than 20 years of experience in the IT/IP/Telco market across a wide range of sectors, including nearly 10 years as EDS’s Senior Counsel working on large outsourcing deals in Asia and 7 years with NTT Australia as its Deputy General Counsel.
Since 2017, Paul has been active in the blockchain and cryptocurrency community, moderating online crypto communities and regularly presenting and hosting events. A founding member of the Hyperledger Smart Contract Working Group, Paul is now Principal at Daimon Legal, a Swiss law firm advising some of the most exciting projects and platforms in DeFi and a Director of AVentures DAO.
About AVentures
AVentures is an investment DAO composed of OG Avalanche community members on a mission to support the ecosystem. The team boasts multiple successful blockchain developers and project owners, content creators, advisors and domain experts that have come together to channel our expertise to support the Avalanche ecosystem.
AVentures DAO:
* Provides advisory and marketing support to new Avalanche projects
* Supports Avalanche projects by investing in seed/private rounds
* Incubates new projects via mentoring
* Publishes technical analysis on DeFi projects
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