Regulation Is Required For DeFi To Bank The Unbanked
For hundreds of years, business transactions were always done face-to-face, man-to-man and peer-to-peer, until the advent of longer distances and the absence of trust forced individuals to rely on intermediaries like banks to carry out their dealings on their behalf.
Now, with the emergence of decentralized finance, or DeFi, we're finally reverting back to the old way of doing things, transacting peer-to-peer in a trustless fashion through the use of smart contracts. It's an innovation that promises to bring about a financial revolution that will do more than just eliminate intermediaries, by bringing fair access and opportunity to all.
Regulators have largely ignored this nascent and alternative financial system. However, with DeFi growing more popular, and recent events like the Terra ecosystem crash and insolvency of protocols such as Celsius Finance and Babel Finance wiping out millions of dollars' worth of investors' savings, calls for DeFi regulation have grown louder.
One of the reasons regulators have ignored DeFi is that it's designed to be out of their reach. The blockchain stores a copy of transactions on multiple servers located across the world, making it all but impossible to compromise. But there are examples in the existing world of how regulators can apply their reach to DeFi.
Take the Foreign Account Tax Compliance Act (FATCA) of 2010, which enabled U.S. authorities to regulate far beyond their own currency and citizens by striking intergovernmental agreements on enforcement with other jurisdictions. In the EU, regulators took a similar approach with their General Data Protection Regulation, which ensures a substantial degree of control over the data of European citizens, no matter where they are in the world. These examples of extraterritorial control provide some insight into how DeFi can also be regulated.
Regulation Through Choke Points
The main challenge for regulators is to identify the choke points through which decentralized protocols can be controlled. The world of DeFi cannot stand on its own two feet - it needs an on-ramp to the world of traditional finance somewhere (so people can exchange crypto for fiat) and it's here where it becomes possible to apply the controls.
Such on-ramps include stablecoins operated by legal entities and exchanges that offer fiat-to-crypto transfers. These can be pressed to introduce procedures such as "Know Your Customer" to ensure they remain compliant with financial regulations. In order to be effective though, such controls must be implemented with DeFi in mind.
The good news is that action is already being taken on this front. One of the most popular DeFi protocols in the business, Aave, has created KYC versions of liquidity pools that provide limited access to DeFi for large institutions. It does this by creating on-ramps to KYC participants. In this way, it relies on organizations such as Chainalysis to analyze blockchains to comply with Know Your Transaction (KYT) rules. However, doing things in this way has resulted in less depth of liquidity, with fewer individuals who are willing to participate.
Another promising solution comes from SOMA Finance, which is the first compliant multi-asset decentralized exchange and issuance platform for tokenized equities, crypto assets and NFTs in the U.S.
SOMA, which has identified challenges around the lack of regulation, bad actors and market manipulation in DeFi, is aimed squarely at onboarding institutional and retail investors into the space with its integrated KYC and compliance functions. It is the creation of Mantra DAO, a leading DeFi ecosystem company, and Tritaurian Capital, which is a FINRA-licensed broker-dealer. By leveraging a Uniswap-style DEX with integrated compliance layers, it becomes possible for institutions to stake and trade crypto assets in a compliant manner through Tritaurian's broker-dealer license.
SOMA Finance is building the foundations for companies to compliantly enter DeFi markets and issue tokenized assets of their own. At the same time, because it comes with a compliant ring around it, users are reassured that they're only investing in safe and secure projects, rather than scams. As such, SOMA will make it possible for both crypto and public equity to be traded in an AMM-style, while also offering a money-market for all supported assets that enables borrowing and lending.
While platforms like SOMA provide viable solutions on how to regulate DeFi, other protocols may respond with further decentralization. For instance, Maker DAO last year moved in that direction when it shut down all of its legal entities in an effort to stay out of reach of regulators. While that has made it untouchable, it wouldn't take a great deal of effort by regulators to isolate it from the fiat economy.
Striking A Balance
With these examples in place, the question for regulators is not so much how to enforce compliance, but rather, what regulation hopes to achieve. In that regard, we now stand at a crossroads, with the opportunity to introduce an appropriate amount of regulation that doesn't stifle innovation or access. A balance needs to be struck if DeFi is to achieve its goals of boosting financial inclusion and prosperity by "banking the unbanked".
What's important to recognize is that regulators actually share the same goals as DeFi. They want to eliminate the inflexible restrictions that prevent wider access to financial services, in order to promote greater stability and cheaper transactions. Liquidity has long been a concern to the world of traditional finance, just as much as it is to the crypto space. The Bank of England said as much in its speech "Run Lola Run", where it called for wider access to foreign exchange markets for the benefit of everyone.
The promise of DeFi - which includes fairer and more transparent access, greater liquidity, less fragmentation, reduced fraud and the creation of markets that are more effective, fair and accessible - have been espoused multiple times. DeFi is yet to deliver on these promises though, and it has become clear that regulation will almost certainly be necessary for it to do so.
With that said, it's necessary to set clear objectives and create rules that pave the way to this new world of financial inclusion, while avoiding creating the same kinds of obstacles that make our existing financial services so inaccessible.