Identity Crisis: Is “Regulated DeFi” an Oxymoron?
Today’s financial services ecosystems and the regulatory structures that monitor and oversee them are built upon networks of financial intermediaries that serve as the link between market participants and regulators seeking to establish fair and orderly marketplaces. The regulatory regimes crafted over the past several hundred years have been predicated upon the concept that governments must license and oversee financial intermediaries — banks, exchanges, payment clearing facilities, etc. — in order to promote fairness, reduce fraud, protect investors, and ensure safe and sound markets. In short, regulators look to promote public policy by instructing, monitoring, and, where necessary, punishing financial intermediaries so that those intermediaries may, in a sense, serve as proxies in the implementation of these public policies. Thus, the foundational assumption underlying this approach is that market participants can trust financial intermediaries because those intermediaries are answerable to responsible regulators, which, as a practical matter, requires a dual-layer of trust: market participants must trust that the policies are fair and effective and they must also trust intermediaries to conduct themselves responsibly and in accordance with those policies.
The emergence of blockchain technology and (in our view) its most significant offspring, decentralized finance or “DeFi”, has been premised upon a fundamentally different — indeed, seemingly contrary — philosophical approach to human economic interaction. Specifically, the foundational assumption of blockchain technology is that only “trustless” systems can actually be trusted. At the very great risk of oversimplifying what is an increasingly sophisticated body of almost crowd-sourced economic and even political philosophy that has been built upon the electrifying Satoshi white paper, we can broadly characterize these principles as:
· Decentralized verification establishes an objective “truth” about transactions
· Immutability ensures finality of transactions
· Computer code establishes the clear agreement between parties
· The intended peer-to-peer nature of the ecosystem expands access to finance
Depending upon the lens through which one wishes to evaluate this philosophy, it can be characterized variously as either a call to establish some form of anarchic globalism, a form of enlightened regulation of human interaction through the pure objectivity of computer code, a self-serving get-rich-quick scheme for a handful of tech-savvy geeks, or a principled extension of the classical liberal concepts of individual liberty set out in the Declaration of Independence of the United States. In any event, as we have watched the growth of crypto and DeFi markets (and the corresponding capturing of the public imagination by everything from Bitcoin to Dogecoin, Beeple non-fungible tokens (NFTs) to Compound and Uniswap protocols), there should be little surprise in the fact that national governments, transnational bodies, and prudential regulators have gone from ignoring crypto and blockchain as a quirky and ephemeral cultural phenomenon to viewing it with trepidation as a threat to everything from orderly markets to monetary policy — or even to social order.
At the extremes, this dichotomy can be illustrated in the juxtaposition of the following statements:
Computer technology is on the verge of providing the ability for individuals and groups to communicate and interact with each other in a totally anonymous manner. Two persons may exchange messages, conduct business, and negotiate electronic contracts without ever knowing the True Name, or legal identity, of the other. Interactions over networks will be untraceable, via extensive re-routing of encrypted packets and tamper-proof boxes which implement cryptographic protocols with nearly perfect assurance against any tampering. Reputations will be of central importance, far more important in dealings than even the credit ratings of today. These developments will alter completely the nature of government regulation, the ability to tax and control economic interactions, the ability to keep information secret, and will even alter the nature of trust and reputation. — Timothy May, The Crypto Anarchist Manifesto
This utopian vision, of course, stands in stark contrast to recent comments emanating from policymakers, such as this one:
All of these currencies have one thing in common — they’re not real dollars, they’re not backed by the full faith and credit of the United States. And that means they all put Americans’ hard-earned money at risk. From tech giants like Facebook’s Libra — or Diem, or however their PR consultants attempt to rebrand it next — to fly-by-night operations, we’ve seen far more empty promises than we’ve seen viable cryptocurrencies. A cottage industry of decentralized financial schemes has also cropped up alongside these alternative financial products, in the hopes of creating a parallel financial system with no rules, no oversight, and no limits. They claim to enable “transparency.” Their backers talk about the “democratization of banking.” There’s nothing “democratic” or “transparent” about a shady, diffuse network of online funny money. After a decade of experience with these technologies, it seems safe to say that the vast majority haven’t been good for anyone but their creators. This technology is almost never used to buy real goods and services. Which is what any currency is supposed to be used for, after all. Some cryptocurrency supporters see these technologies as a way to take power back from the Wall Street bankers, whose complicated and opaque financial scheming crashed the economy…. But as these technologies have developed, most of them seem to mirror — rather than to challenge — the Wall Street model. In fact, traditional financial institutions are angling to become the biggest players in these markets, and it’s a good bet they’ll find even more creative ways to use these new technologies to dodge accountability and put our entire economy at risk again. We should all be concerned. –U.S. Senate Banking Committee Chairman Sherrod Brown (D-OH)
A reasonable person may find compelling points embedded in each of these statements. But the conclusory nature of these pronouncements clearly indicates that they are hardened positions that do not admit to good faith discussion and compromise.
As is all-too-often the case in the age of social media, nuanced analysis of these developments tends to lose out to soundbites and snap judgments, and, in an age of breathtaking technological advance and social upheaval, the ramifications of reflexive and shallow pronouncements can be quite dangerous. Among these dangers are the risks of, on the one hand, ignoring centuries of reasoned development of policies expressed in regulatory frameworks to mitigate against market manipulation and predation, and, on the other hand, curtailing innovation through draconian countermeasures or (even worse) super-imposing monolithic transnational regulations that move human beings further and further from their duly-elected policymakers who purport to manage their interactions at the national level. To this parade of horribles we might add yet another category: the risk that this remarkable and potentially liberating technology will be coopted to enable dystopian national micro-surveillance and micro-control systems, using super-convenience as the attractive bait (see, e.g., China’s Digital Currency Electronic Payment (DC/EP) + Blockchain Service Network (BSN)).
We strongly believe that technologists cannot stand morally removed from the implications of their works, nor, on the other hand, can they allow themselves to become ersatz, unelected, and unaccountable policymakers. Here, too, nuance and balance are demanded. It is from this backdrop of core principles that we analyze the question of the compatibility of DeFi with policy-based regulation and corresponding institutional involvement in this space.
TOWARD A CONCEPT OF “INSTITUTIONAL DEFI”
That the regulatory conundrum over DeFi has its roots in a philosophical debate was delightfully illustrated by U.S. CFTC Commissioner Dan Berkovitz’s recent assertion that “DeFi is a Hobbesian marketplace with each person looking out for themselves,” from which one might imply that the good Commissioner views Leviathan as the answer to this problem.
Conversely, a recent paper published by the Federal Reserve Bank of St. Louis refers to DeFi as “an open, permissionless, and highly interoperable protocol stack built on public smart contract platforms” and that the architecture, itself, is capable of creating “an immutable and highly interoperable financial system with unprecedented transparency, equal access rights, and little need for custodians, central clearing houses, or escrow services, as most of these roles can be assumed by ‘smart contracts.’’
That these two positions can be reasonably held in the mind at the same time by objective observers points out the challenge here: The substitution of central intermediaries with so-called ‘smart contracts’ has not only perplexed regulators worldwide but also calls into question the regulatory architecture that has been in place, albeit modified over time, for many years. Even the most innovation-friendly and “light touch” regulators are not immune to this dilemma, as thoughtfully articulated by U.S. SEC Commissioner Hester Peirce while contemplating regulatory approaches to DeFi: “It’s going to challenge the way we regulate. And it’s going to cause us to ask questions about what we think the role of a regulator is in DeFi — and I’m not sure I’ve answered that for myself yet.” Similarly, Matt Homer, former Executive Deputy Superintendent for Research & Innovation at the New York State Department of Financial Services (NYDFS), indicated at a Global Blockchain Convergence event last year that the NYDFS would have to revisit its regulatory approach in a world in which people are directly engaging with digital protocols rather than human intermediaries.
Although a truism, it is well worth noting that, without enforcement mechanisms, regulations are toothless and, thus, little more than suggestions. Regulators, then, seek to identify a “neck to wring” when things go wrong, and a line of code may not appear to them as something around which they can get their hands. During a Global Digital Finance event, Greg Medcraft, Director for Financial and Enterprise Affairs at the Organisation for Economic Co-operation and Development (OECD) noted the following in this regard:
“The issue with DeFi is going to be about accountability mechanisms… because you can’t actually just say ‘the dog ate my homework’, somebody’s going to have to be responsible. It’s got to be a responsible party. It’s not rocket science. We faced this when we had to deal with high-frequency trading and they said ‘the algo did it’, and we said ‘who wrote the algo?’ It’s going to be solvable. It’s a matter of guardrails and who’s going to be responsible for it…. You can’t hide from that.”
So where does this end up? As suggested above, hopefully the policy and regulatory response to this is thoughtful, nuanced, and balanced. Fortunately, there are indications that we are heading in that direction.
CFTC Commissioner Berkovitz’s recent comments represented something of a deviation from the pithy, generalized views on regulating (or, in the opposite camp, not regulating) DeFi. Not only did Berkovitz arguably deliver one of the most direct regulatory statements yet on DeFi, but his use of ‘pure’ in describing an unregulated ‘peer-to-peer DeFi system’ and questioning its legality is telling.
By this reading, the only way to bring ‘responsibility’ to the DeFi space is to comprehensively incorporate traditional market safeguards and consumer protections to prevent DeFi from becoming an “unregulated shadow financial market in direct competition with regulated markets,” as Commissioner Berkovitz stated in his remarks.
On the other hand, SEC Commissioner Hester Peirce, while sharing Berkovitz’s concern that participants in DeFi need to be aware of established regulatory structures already in place, believes that a “shadow market” is not a bad thing in itself and that individual market participants can determine for themselves the level of transparency and protection they desire if given viable options as between two separate marketplaces:
I doubt we’ll get to a place where we have a financial system that has no intermediaries. I think DeFi will be built into the existing financial system. Certainly, a lot of what people in DeFi are trying to do is say, ‘I’m divorcing the traditional financial system, I want to do my own thing.’ And that’s fine… but there are other people who prefer to deal with centralized intermediaries, someone they can go to if something goes wrong. And so I suspect we’ll see two systems: one will be this separate set of activities; and another will be just building that DeFi into the TradFi — the traditional financial system. And I think those things can work side-by-side.” — U.S. SEC Commissioner Hester Peirce
The question that must necessarily arise here is whether these are truly the only options: one unregulated marketplace rich in privacy but lacking in transparency and consumer protections, one fully-regulated marketplace with transparency and consumer protections but lacking in privacy, or, as a compromise solution, one of each existing separately? Perhaps a true middle path exists, one in which the power of DeFi (particularly on public blockchains) can be married to responsible oversight without sacrificing privacy and without the need to flip to the opposite extreme of unitary, distant, and unaccountable transnational regulation.
Securrency has, from its inception, been committed to striking this balance between responsibility and freedom, oversight and privacy, accountability and optionality, institutions and innovators, and we endeavor daily to build a global financial services ecosystem in which value of all kinds can move in a frictionless way while respecting the policy decisions of individual states and their citizens. We have long recognized that the DeFi community must cross paths with regulatory authorities and regulated institutions at some point. As DeFi adoption and investment grows — total value locked has climbed from $2 billion in 2019 to $100 billion in 2020 — the interest of institutional investors seeking to access new asset classes and new markets has been piqued. And, of course, regulatory scrutiny has followed hard on the heels of this sudden growth. For regulated institutions to participate in these markets and harness the advantages and opportunities presented by DeFi, compliance and investor protections will be essential. As Commissioner Berkovitz made clear in his remarks, DeFi is at a tipping point.
All of this positions Securrency at the right place at the right time and with the right stuff.
In recognizing this challenge early on and setting out to address it, Securrency intentionally positioned itself as a digital asset global ecosystem builder. We have created an open framework built around a flexible compliance core that allows for the automation of multi-jurisdictional rulesets in a dynamic, attributes-based model that eschews prescriptive ‘white lists’ and allows for the protection of privacy. Around this core we have built a robust suite of financial services that can be configured to support any type of financial service — and allows innovators to build custom instruments, protocols, and services. We have emphasized global interoperability so these instruments and services can leverage different blockchains, networks, and systems and value can move seamlessly across and among these various environments.
This ecosystem reflects Securrency’s balanced approach. It marries the advantages of DeFi to flexible, configurable, and automated, compliance to encourage continued innovation while preserving investor protections that stimulate the mainstream adoption of DeFi. Securrency believes that the financial powerhouses of the future are meeting in the middle of the above Venn diagram, and we are pleased to be working with many of those leaders.
In the DeFi community, we deploy data and compliance oracles, secure wallets that provide for voluntary disclosures through registration as an alternative to hosted wallets, automated market makers, liquidity tokens, a digital asset composer, and even base protocol upgrades. This allows for transfers of regulated instruments while eschewing typical “walled garden” or “private pool” approaches that negate the primary benefit of blockchain, which is open value transfer.
On the institutional side, Securrency works with some of the largest banks and asset managers to build sophisticated financial instruments and tokenized collateral that can move between banking systems and global blockchains (i.e. the Internet) according to configurable transaction and regulatory rulesets. This results in more transparency, reduced settlement and counterparty risk, faster settlements, faster product innovation and automated decision-making. In other words, the institutions we work with are in a position to deliver a better financial product to their clients, be it a higher yield on a savings product, a faster loan-approval process, cheaper insurance or a better payments experience.
Securrency has demonstrated how DeFi and CeFi can be bridged so that the advantages offered by both sides of the equation can be simultaneously maximized in pursuit of a regulated DeFi ecosystem that promotes access, supports capital formation and global liquidity, and enhances privacy and transparency in the movement of value across legacy and distributed networks. This is the future and we look forward to continuing to engage with stakeholders that have moved or wish to move to the middle of the Venn diagram and participate on this journey.
 The “peer-to-peer” framework is a central feature of the crypto-as-payments concept; in the context of DeFi, however, it is likely more accurate to describe the framework as “participant-to-protocol”.
 To be fair to Commissioner Berkovitz, he did also suggest in his comments that, for as much regulatory angst as there may be regarding “pure” DeFi developments, regulators are open to understanding how technology can play a role in replacing “pure” with “responsible”. One might well argue that a system may be both “pure” and “responsible”, but the Commissioner’s point here is well-taken nonetheless.