The writer is a partner of Klaros Group
US regulators have intensified their scrutiny of decentralized finance, a burgeoning market for crypto assets that operates without significant regulatory oversight.
The Securities and Exchange Commission issued a revised proposal last month, clarifying that DeFi cryptocurrency trading systems should be regulated like stock exchanges. And the United States Treasury too issued a paper in April that pointed out the illicit financial risks in DeFi.
These moves are the latest sign that even as regulators crack down on centralized crypto brokers in the wake of the FTX bankruptcy, they are trying to prevent DeFi from becoming a crypto haven. Doing so will challenge the core tenets of animation underlying DeFi: self-sufficiency and the โcode is lawโ creed.
The failure of FTX exposed the conflicts inherent in the business model of crypto platforms. These platforms play the roles of broker, exchanger, market maker, and custodian, all required to be independent in traditional markets. FTX allegedly used client assets to shore up its affiliated trading company, putting those assets at risk and ultimately resulting in losses for customers.
In the wake of FTX, some members of the crypto community pointed to DeFi as the answer. In DeFi, market participants maintain custody of their own crypto assets and conduct transactions using protocols: a set of codes, standards, and processes. This happens without the open participation of centralized intermediaries. Decentralized exchanges and lending protocols have posted for more than 10 percent of daily cryptocurrency trading activity at times in 2023.
Regulators around the world, anticipating DeFi as the next frontier in crypto, have study is risks, guided by the principle that risks must be regulated. The SEC notes that despite assuming functions commonly performed by a stock exchange, DeFi trading protocols have not even attempted to comply with securities laws.
But while compliance with securities laws is necessary, it is not enough to make DeFi a trustworthy market. What would it take? At a minimum, market participants must be confident that they will receive the basic benefit of their deal and have a recourse if they do not.
DeFi does not adhere to that principle, and arguably turns it on its head. DeFi aims to replace trust in institutions (brokers, laws, regulations) with trust in DeFi protocols. In DeFi, in other words, โcode is lawโ. But, as we discussed in an article by Antonio Weiss, Jonathan Everhart, and myself, DeFi has no answer to the simple question: what happens if something goes wrong?
Smart contracts, the "instructions" that allow transactions to be executed on blockchains, will robotically execute the task for which they are programmed. However, smart contracts cannot be programmed to address all circumstances that arise in the markets.
In traditional markets, harmed participants can turn to intermediaries, regulators, and ultimately any counterparty through the legal system. DeFi participants, on the other hand, are expected to accept the outcome even when they get scammed. And DeFi protocols are hacked or exploited on a seemingly daily basis. In 2022 alone, more than $3.1 billion worth of crypto assets were stolen from DeFi protocols, accounting for more than 80% of all crypto asset-related thefts, according to Chainanalysis.
Ultimately, "code is law" means "caveat emptor." That doctrine, with its sense of self-sufficiency, resonates with many in the crypto world. But all of the world's significant financial markets provide remedies to hurting investors and accountability for actions that undermine the integrity of the market.
This would require a sea change in DeFi and puncture its self-sufficient aesthetic, which seems driven by nostalgia for a (largely fictional) time before the purity of the markets was disturbed by haphazard laws and regulations designed to drive business of the financial market within social norms. .
In fact, cryptocurrency advocates have all but ruled out adhering to existing standards, with some saying it would actually be impossible. SEC Chairman Gary Gensler has made it clear that the approach will fall on deaf ears from the regulator. โCalling yourself a DeFi platform is not an excuse to defy securities laws,โ he said last month.
In the end, DeFi is unlikely to prosper if it remains outside of regulatory parameters. And yet it is not clear what remains of the concept if it is fully included in its scope. The transition will be jarring for those who believe that laws and regulations can be replaced by trustless markets where code reigns supreme.
Antonio Weiss contributed to this article
