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The writer is partner at Klaros Group
US regulators have been stepping up their scrutiny of decentralised finance, a burgeoning marketplace for crypto assets that operates without meaningful regulatory oversight.
The Securities and Exchange Commission issued a revised proposal last month clarifying that DeFi crypto trading systems should be regulated like stock exchanges. And the US Treasury also issued a paper in April that pointed out the illicit finance risks in DeFi.
These moves are the latest sign that, even as regulators crack down on crypto’s centralised intermediaries in the wake of the FTX bankruptcy, they are attempting to prevent DeFi from becoming a crypto haven. Doing so will challenge the central animating principles underlying DeFi: self-reliance and the credo that “code is law”.
The failure of FTX exposed the conflicts inherent in the business model of crypto platforms. These platforms play the role of broker, exchange, market maker and custodian — all required to be independent in traditional markets. FTX allegedly used customer assets to prop up its affiliated trading firm, putting those assets at risk and, ultimately, resulting in customer losses.
In the wake of FTX, some in the crypto community pointed to DeFi as the answer. In DeFi, market participants maintain custody of their own crypto assets and transact using protocols — a set of code, standards and processes. This happens without the overt participation of centralised intermediaries. Decentralised exchanges and lending protocols have accounted for more than 10 per cent of daily crypto trading activity at times in 2023.
Regulators around the world, anticipating DeFi as the next frontier in crypto, have studied its risks, guided by the principle that risks should be regulated. The SEC points out that, despite undertaking functions commonly performed by a stock exchange, DeFi trading protocols have not even attempted to comply with securities laws.
But while complying with securities laws is necessary, it is hardly sufficient to make DeFi a trustworthy market. What would it take? At a minimum, market participants must trust they will receive the basic benefit of their bargain, and have recourse if they do not.
DeFi does not adhere to that principle — and arguably turns it on its head. DeFi purports to replace trust in institutions — intermediaries, laws, regulations — with trust in the DeFi protocols. In DeFi, in other words, “code is law”. But, as discussed in a paper 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 enable transactions to be executed on blockchains — will robotically execute the task they are programmed to carry out. However, smart contracts cannot be programmed to address all circumstances that arise in markets.
In traditional markets, participants who suffer harm can seek recourse from intermediaries, regulators and, ultimately, from any counterparty through the legal system. DeFi participants, on the other hand, are expected to accept the outcome even when they are scammed. And DeFi protocols are hacked or exploited on a seemingly daily basis. In 2022 alone, more than $3.1bn of crypto assets were stolen from DeFi protocols, representing more than 80 per cent of all thefts involving crypto assets, according to Chainanalysis.
Ultimately, “code is law” means “caveat emptor”. That doctrine, with its sense of self-reliance, resonates with many in the crypto world. But every meaningful financial market in the world provides recourse to investors who are harmed and accountability for actions that undermine market integrity.
This would require a sea change in DeFi and puncture its aesthetic of self-reliance, which seems driven by nostalgia for a (largely fictional) time before the purity of markets was disturbed by messy laws and regulations designed to bring financial market activities within societal norms.
Indeed, crypto advocates have all but ruled out the possibility of adhering to existing standards, some saying it would actually be impossible. SEC chair Gary Gensler made clear that approach will fall on deaf ears at the regulator. “Calling yourself a DeFi platform is not an excuse to defy the securities laws,” he said last month.
In the end, DeFi is unlikely to flourish if it remains outside regulatory parameters. And yet, it is not clear what remains of the concept if it is brought fully within 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