The Node: Regulating Intermediaries in a DeFi World

Crypto is a spilled can of worms for regulators that should have been squished a decade ago. That was the message Jason Furman, a senior economist in the Obama administration, told the Washington Post this week. It’s now a “$2 trillion monster,” he said.

The pace of innovation in crypto is difficult for regulators to keep up with, especially considering that, until now, there hasn’t been a proactive, cohesive, industry-wide attempt to manage the industry. Despite operating under a hodgepodge of rules, frameworks and recommendations, crypto has ballooned. And regulatory attention with it.

“The existing framework is simply inapplicable to a system predicated on the absence of intermediaries,” Director of the Blockchain Association Kristin Smith said in an interview following her Consensus 2021 appearance. This is an important point: Decentralized tools exist as the antithesis of a financial system where trusted custodians are needed to manage one’s money. 

There’s a strong argument that the technological advances in crypto fulfill the basic consumer, fraud and terrorist financing protections the old system was erected to perform. 

Current regulations are designed to regulate intermediaries, Marc Boiron, general counsel for DyDx, said during a Consensus panel. When there is no intermediary to custody your assets, make trades on your behalf or manage your personal information, there’s no point, Boiron asked. “The faults of the old system” aren’t present in non-custodial, open information DeFi systems. 

But it seems regulators have had a difficult time coming around to that view. 

Smith said regulators are working overtime to try to fill the gaps and integrate novel financial and technological products under existing rules. 

For instance, in the waning days of the Financial Crimes Enforcement Network (FinCEN), the Trump administration’s Treasury Department floated rules that would extend surveillance over certain transactions and “unhosted” (or non-custodial) wallets. The new head of the agency, Michael Mosier, who joined the public sector from crypto-analytics firm Chainalysis, said, “Nothing’s been decided” there.

Likewise, U.S. Securities and Exchange Commission Chairman Gary Gensler said earlier this month that Congress ought to clarify cryptocurrency rules, without giving any specifics. The Treasury Department asked cryptocurrency companies to provide the Internal Revenue Service with more financial information.

Separately, FinCEN wants to better understand how privacy tools like zero-knowledge proofs (ZKP) and homomorphic encryption – popular among certain cryptocurrency protocols – work in fintechs, regtechs, venture capital firms and financial institutions. 

In most of these examples, the respective agencies have opened a line of dialogue to industry participants. But it’s not always easy to know what the right course of action is, even for insiders. 

In a Consensus panel this morning, some of the top legal minds in decentralized finance (DeFi) discussed whether open systems should or should not be regulated under existing rules. They called it the “new wine in an old wineskin problem.” 

These lawyers often don’t know when or how an existing rule applies to the protocols they represent. Aave general counsel Rebecca Rettig didn’t have a clear answer, but said when confronted with a difficult puzzle she tries to think through what the rules were set up to accomplish. 

Is a rule designed for consumer protections? To eliminate information asymmetries? To mitigate risks? Often, she’s found, the rules are made obsolete by the architecture of open protocols. Still, she always asks, what are the decisions you can make to show you care about compliance? 

Compound’s Jake Chervinksy agreed. Just try to be one of the “good guys,” he said. None of the legal scholars recommended that watchdog policies be dismantled, but Chervinsky did note that particular policies could benefit from “disintermediation” in different ways. That is, self-regulating crypto protocols could benefit securities laws in different ways than commodities law.

To comply with rules designed to regulate intermediaries, DeFi “protocols would need to insert a code or human process to intermediate transactions,” Boiron said. None of the panelists think “re-centralization” is a good idea. 

Under the Financial Action Task Force’s (FATF) expanded travel rules recommendation, developers may end up responsible for malfeasance on the system, even if they do a Satoshi and walk away from what they build. 

Still, Boiron is level-headed. For as decentralized, well-intentioned or automated as many DeFi protocols are, there could be bad actors. 

“[T]he developer of the protocol or any third-party developer around the protocol could lie about the protocol, leading people to believe things that are not true about the protocol. That is where consumer protection would make sense,” he said.

But to apply traditional consumer protections to a protocol is still misguided. 

“Regulators and industry should work together to devise a new regulatory paradigm that leverages the many advantages inherent to decentralized finance in order to vindicate the core objectives that traditional regulatory frameworks seek to accomplish,” Blockchain Association’s Smith said. 

Despite the uncertainty, there’s pressure to get this right. Consumers can get hurt. Terrorists might get financed. And industries might crumble. 

“The existing framework will have to bend to fit new tech. If it does not bend, then development will move outside the U.S. Once protocols are created and released, especially without admin keys, there is no stopping them,” Boiron added over email following his Consensus appearance.