BGIN SR 010
February 13, 2023
Revised on May 15, 2023

Proposal of Principles of DeFi
Disclosure and Regulation

This study is a work product of IAM, Key Management and Privacy Working Group of BGIN.
©2022 BGIN (Blockchain Governance Initiative Network) is registered as BN Association, a Japanesegeneral association with its principal place of business at Shiba Building, 704, 4-7-6, Shiba, Minato-ku,
Tokyo. All right reserved.

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Introduction - Executive Summary The crypto-asset industry has seen a surge in DeFi, or Decentralized Finance,transactions since 2020. What does DeFi mean? DeFi itself has emerged recently andthus probably does not have a widely accepted definition (OECD, 2022). Nonetheless,
DeFi has been explained in various ways in papers, reports, and speeches by various
public organizations and academic researchers. For example, the FSB (Financial
Stability Board) (2019) defines "decentralized financial" technology as "Technologies
that have the potential to reduce or eliminate the need for one or more intermediaries orcentralized processes in the provision of financial services.” The BIS (The Bank ofInternational Settlements)(2021) says that the term DeFi refers to the financial
applications run by smart contracts on a blockchain, typically a permissionless (ie,public) chain. Ushida and Angel (2021) also define it as a "financial application that
could consist of a part of a decentralized financial system" to emphasize the aspect that
it is an application. In any case, it is definitely one of the focal points related to
crypto-assets, which has attracted a lot of attention from crypto-asset investors,
professionals, engineers, financial institutions, and regulators in recent years.
Since DeFi stands for "Decentralized Finance," the first characteristic of DeFi is that it is"decentralized," whether it intrinsically is or not. In other words, monies (in most cases,
the crypto-assets) are exchanged or lent through an automatic program without theintervention of traditional financial intermediaries such as banks and securities
companies. From a technical point of view, the essence is in the blockchain’s feature of
not having any single point of failure, meaning that the system will never fail. However, it
is clear that this "no single point of failure" is not always realized in DeFi, as isdemonstrated when a DeFi system is proven to be vulnerable to hacking and fraud.
Under the DeFi framework, the exchange of money (in this case, crypto-assets) is done
automatically according to an Ethereum program (in most cases).
In addition, the second characteristic of DeFi is mimicking the transactional aspects oftraditional finance such as payments, exchanges, lending, lending/borrowing,
investments(asset management/derivatives), and insurance. Table1 shows thesummary of existing DeFi initiatives shown in FSB(2022).
This paper will define DeFi as financial applications that are automatically operated bysmart contracts or other code on a blockchain. However, this would leave out otherservices that self-identifiy as DeFi. Thus, this paper will discuss implications forregulatory constructions by further screening it from the perspective of whether it is truly
financial or not.

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Table1: Summary of existing DeFi initiatives
Description
Lending

By using smart contracts, users can become lenders or borrowers on
DeFi platforms. Users typically post crypto-assets as collateral andthen can borrow other crypto-assets. The most prominent platform
typically requires $150 of collateral for every $100 of lending. Many
platforms set interest rates automatically, depending on demand andsupply of liquidity. Some of these platforms have characteristics
analogous to commercial and/or central banks.

Investment(AssetManagement/Derivatives)

Many projects offer a suite of yield-generating crypto-asset productsby automatically routing crypto-asset “deposits” to highest-yield
opportunities within a set risk-tolerance for particular pools. Other
platforms allow derivative products such as synthetic assets, options
or perpetual futures as well as crypto-asset tranches.

Decentralised
Exchanges(DEXs)

Decentralised Exchanges claim to be peer-to-peer marketplaces
based on smart contracts that allow trading in crypto-assets.
They use automated liquidity pools, where investors ‘lock’ in theircrypto-assets (in exchange for fees) to facilitate trading.

Payments

Many applications focus on increasing interoperability between
blockchains, with the aim to increase scaling. Others focus on
increasing the safety of existing means of payment (e.g. through theuse of QR codes), by using the blockchain to validate transactions inreal time.

Insurance

Some DeFi protocols, called discretionary mutuals, allow members topool and share risks from smart contract failure, or mutualisepremiums into smart contracts that trigger payouts when pre-definedrisks or events materialise.

(Source) Excerpt from FSB(2022a)

DeFi has become quite popular among crypto asset investors, and there are several
possible reasons for this. The primary justification for using DeFI is that by eliminating
counterparties to financial transactions to the bare minimum number of participants,
only the customer or investor and the DeFi system that has no possibility of humanintervention whatsoever, counterparty risk can be eliminated. The DeFi system itself
intermediates financial activity with other counterparties in a manner that generally
requires overcollateralization and the automatic liquidation of positions to ensure thesystem has no possibility for insolvency. Thus, the overall risk profile of a DeFi system3

can be dramatically lower than for alternatives in a traditional, centralized financial
system.
An alternate explanation for DeFi’s recent popularity may be due to, the possibility it has
been driven by a kind of bubble associated with the creation of many capital surpluses
since interest rates had been very low and there was a strong sense of a money surplus
due to fiscal and monetary policies in response to COVID-19. Another possibility is that
DeFi became the receiver of such surplus money because DeFi had transactions(lending) that allowed users to earn a certain level of yield on crypto-assets just bydepositing them.
DeFi is also noted for its cost savings, traceability, and its contribution to financial
inclusion. However, while DeFi has these merits, various issues and problems have also
been pointed out. For example, the fact that transactions are of varying traceability, thenegative effects associated with anonymous transactions (specifically, the use of suchtransactions for money laundering and illicit activities), numerous hacking incidents,
doubts about contribution to financial inclusion, inadequate governance when problems
occur, and the protection of general users. In light of this situation, some regulators
have argued that official regulation of DeFi may be necessary (Gensler, 2021;
Crenshaw, 2021). U.S. Senator Elizabeth Warren has drawn attention to the DeFi
market in particular, calling it "the most dangerous part of crypto"1.
Thus, this paper summarizes the issues surrounding DeFi under these circumstancesand presents some discussion points and suggestions for appropriate future regulatory
considerations. Ultimately, we would like to propose principles for DeFi disclosure andregulation. Firstly, applying a traditional regulatory strategy to a new technologicalecosystem has proved conceptually difficult because there is a policy trilemma called an
innovation trilemma for introducing regulation for innovative services and products. Thatis, when we seek to provide clear rules, maintain market integrity, and encourage
financial innovation, regulators have long been able to achieve, at best, only two out ofthese three goals (Brummer and Yadav, 2018).
Secondly, considering DeFi regulations, whether a DeFi constitutes the "financial
service" which participants are subject to consumer/investor protection need to beconsidered first. Additionally, regulations from the perspective of systemic risk andanti-money laundering may be important regardless of such need for protection.
1

See the article of The Block (March 2, 2022), " Democratic senators ask Treasury to report on work on
crypto sanctions"(https://www.theblockcrypto.com/linked/136064/democratic-senators-ask-treasury-to-report-on-work-on
crypto-sanctions) (Last viewed on February 8, 2023)

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Lastly, the most important point would be to establish a disclosure system and common
platform suitable for the characteristics of DeFi and crypto-assets, as well as an
enforcement framework, considering the innovation trilemma. This is because
establishing a suitable disclosure system for DeFi and crypto-assets is the mostessential infrastructural foundation, when considering self-regulation, enforcement bygovernment agencies, or for investors to pursue their own responsibilities. Establishing
an appropriate disclosure framework is, while challenging, necessary to provide all
market participants information about the potential risks and benefits for any particular
DeFi applications. To create a common disclosure platform in which national authorities
and international standard-setting bodies could also participate and give authority would
be desirable. Such a framework would provide basic information regarding a DeFi, suchas disclosure of data, governance mechanisms, token information, as well as
information on audits, etc., and it is also a convenient way to check for compliance.
Designing an appropriate common disclosure platform that also considers participants'
incentive structure is very challenging and will be the subject of further research.
This paper is considered to be a publication that further updates the BGIN (2021)
produced by the IKPWG (IAM, Key Management and Privacy Working Group) in the
BGIN. The structure of this paper is as follows. First, Chapter 1 describes the targets
and objectives, and Chapters 2-4 provide terminological and technical explanations andnotes on the use of this paper. Chapter 5 presents the issues and problems surrounding
DeFi, followed by discussion, implications, and suggestions on regulation in Chapter 6.
In Chapter 7, after a brief survey of the current disclosure and regulatory landscape,proposals for DeFi disclosure and regulatory principles are presented. Finally, asummary and further potential topics will be presented.

The technology described in this document was made available from contributions
from various sources, including members of the BGIN and others. Although the BGIN
has taken steps to help ensure that the technology is available for distribution, it takes
no position regarding the validity or scope of any intellectual property or other rightsthat might be claimed to pertain to the implementation or use of the technology
described in this document or the extent to which any license under such rights mightor might not be available; neither does it represent that it has made any independent
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implementing this document is assumed by the implementer. The BGIN Intellectual
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invites any interested party to bring to its attention any copyrights, patents, patentapplications, or other proprietary rights that may cover technology that may berequired to practice this document.

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Table of contents
Introduction - Executive Summary -Table1: Summary of existing DeFi initiatives

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3

Table of contents
1. Scope
2. Normative reference
3. Terms and definitions
4. Abbreviations and symbols

7
9
9
9
10

5. Issues related to DeFi
5.1 Benefits, advantages, and possibilities of DeFi
5.2 Challenge, risks, and questions related to DeFi

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11
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5.2.1 General

125.2.1.1 Lack of AML/KYC
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Figure 1: Total value received by DeFi from illicit addresses vs. illicit share of
all value received by DeFi
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5.2.1.2 Hacking
14
Figure 2: Cryptocurrency stolen by victim type, 2020 - 2021
15(3) Is it really "Decentralized"?
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Figure 3: Share of users holding 90% of all governance tokens by DAO
17(4) Is it really "traceable"?, Is it “accessible to all”?
19(5) Market manipulation and difficulties in investigation
20(7) Operational risk in DeFi
21(8) Characteristics of procyclicality and the potential for systemic risk associatedwith it22(9) Lack of ability to address risks associated with information asymmetry
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6. Implications for regulatory consideration
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6.1 Innovation trilemma
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Figure 4: Innovation trilemma
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Figure 5: Framework for regulatory considerations
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6.2 Perspectives on whether financial regulations should be applied
27(1) Is DeFi really "finance"?
27(2) Should a DeFi participant be subject to investor/consumer protection?
27
6.3 Need for regulation for providers of financial functions
28(1) Safety and soundness regulation as a "financial institution"
28(2) How to ensure appropriateness as a "financial transaction"28(3) How to implement the audit and ensure DeFi's reliability?
28(4) How to establish a regulatory enforcement framework?
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(5) How to establish a disclosure system suitable for DeFi and crypto assets
31(6) Need to consider the impact on the financial system if the scale of DeFi becomeslarge
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6.4 How to ensure AML/CFT
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7. Proposal of Principles of DeFi disclosure and regulation
35(Principle 1) Need to establish the Scope of Coverage
36(Principle 2) Establishment of a Disclosure Platform
36(Principle 3) Harmonization with Traditional Financial Regulations
37(Principle 4) Consideration of DeFi specialities
37(Principle 5) Addressing the Potential for Systemic Risk
37
(Principle 6) Periodical Audit
38(Principle 7) Ensuring Regulatory Effectiveness38(Principle 8) AML/CFT and other measures to legal financial activities
38(BOX 1) IMF’s considerations for regulatory frameworks
39(BOX 2) FSB report
40(BOX 3) IOSCO report
42(BOX 4) FSOC Recommendations
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8. Conclusion
45
Appendix A – Acknowledgement
A.1 Editors and Co-editors
A.2 Contributors

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46
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Appendix B – Informative reference

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1. Scope
The targeted audiences of this document are regulators, academia, DeFi participants
including developers and engineers, and more generally anyone looking to expand
his/her knowledge on the topic.
We are going to introduce the current status and challenges we face in a decentralized
finance society. At the first, we explain the benefits, advantages, and possibilities of
DeFi and the surrounding ecosystem. Next, we will discuss the problems, risks, andquestions of DeFi. Then we will discuss implications for regulatory consideration andpropose the principles of DeFi disclosure and regulations.

2. Normative referenceThis document has no normative reference.

3. Terms and definitions
This document uses the following terms as the shortcut for more complete wording provided as
the definition. When the term appears within this document, it should be read as being replacedby the term.
3.1
decentralized financial technologies
technologies that may reduce or eliminate the need for one or more intermediaries orcentralized processes in the provision of financial services[SOURCE: FSB (2019)]
3.2
decentralized financial system
new financial system that could be the result of decentralized financial technology[SOURCE: FSB (2019)]
3.3
decentralized FinanceDeFifinancial applications that are automatically operated by smart contracts or other code9

3.4
smart contract
collection of code and data (sometimes referred to as functions and state) that is deployed using
cryptographically signed transactions on the blockchain network[Source: NIST (NISTIR 8202)]

4. Abbreviations and symbols
In this document, the following abbreviations and symbols are used.
AML
BGIN
BIS
DeFi
DAOs
FATF
DEX
FSB
IOSCO
KYC
SBTs
SEC
NIST

WEF

Anti Money Laundering
Blockchain Governance Initiative Network
Bank of International Settlements
Decentralized Finance
Decentralized autonomous organizations
The Financial Action Task Force
Decentralized Exchange
Financial Stability Board
International Organization of Securities Commissions
Know Your Customer
Soulbound Tokens
The U.S. Securities and Exchange Commission
National Institute of Standards and Technology
World Economic Forum10

5. Issues related to DeFi
5.1 Benefits, advantages, and possibilities of DeFi
There are, of course, certain reasons why DeFi is getting so much attention andexcitement. This section points out some advantages and possibilities. The expected
benefits of DeFi have been pointed out in preceding literatures (Chen, 2020; FSB, 2019,
etc.). However, again, and this point is very important, it should be noted that some of
the advantages listed below are subject to reality check.
First of all, DeFi can be identified as a potential contributor to promoting innovation andcompetition. Activities that used to take a lot of cost and effort in existing financialtransactions can be done automatically by utilizing smart contracts (persistent scripts).
As a result, it is clear that this has the potential to contribute to reducing costs andpromoting innovation toward the automation of transactions. Currently, DeFi is mainly
limited to crypto-asset trading. However, if the technology is extended to traditional
financial institutions, it could encourage competition with existing financial institutions
and thus promote innovation.
Secondly, as FSB (2019) pointed out, the DeFi technology may reduce some of thefinancial stability risks associated with traditional financial institutions andintermediaries. In financial transactions, there is a risk called "concentration risk.""Concentration risk" refers to the risk that entire transactions will be affected if an entitythat concentrates most of the transactions is in halt/insolvent. If transactions andsystems were decentralized, it would clearly contribute to reducing concentration risk.
From a technical point of view, this benefit may be attributed to the feature of having nosingle point of failure.
Third, DeFi transactions are currently mostly traceable.. As the majority of DeFi
protocols currently exist on the Ethereum blockchain, rather than other blockchains, orlayer two solutions (FSB, 2019). As a result of this, it is relatively straightforward to tracetransactions through tools such as Etherscan. This is rapidly changing, however, as
centralised layer two solutions may not necessarily provide the same level oftransparency. Zero-knowledge technologies, designed to obfuscate transaction history
and promote privacy, are very important in preserving privacy, but may make tracking
and traceability more difficult.
Fourth, transactions can take place regardless of national borders, making internationaltransactions easier. While centralised exchanges are often bound by similar laws tobanks, DeFi has proved to be a powerful asset in cross-country transactions,particularly for those in crypto-negative countries. Stablecoins aim to denominate a fixedvalue over time, which is very useful for transactions within the crypto ecosystem, as
well as cross-border transactions. These coins are often fully collateralised orover-collateralised with real-world asset backing, such as short term US treasury bonds,
crypto-asset backing, or alternatively, maintain algorithmic balance when traded. Whilethey only account for a small part of the crypto market, the most trusted stablecoins hold11

this crucial role in payments and cross-border transactions, reducing volatility. They also
currently provide most of the liquidity in DeFi applications (Born et al., 2022).
Fifth, their contribution to financial inclusion is often pointed out. It is estimated thatabout 1.7 billion adults remain unbanked—without an account at a financial institution or
through a mobile money provider (The World Bank, 2017). DeFi has the potential toextend the benefits of finance to many more people since financial transactions can bedone with a smartphone. The World Bank (2017) indicates that digitalization(technology) contributes to financial inclusion, and financial inclusion is contributing to
the wellness of countries. WEF (2021a) also pointed out that decentralized finance(DeFi) was emerging as a tool for smaller businesses in developing markets, particularly
for remittances and small loans, and may contribute to financial inclusion.
Lastly, DeFi also may be the basis for a future version of the internet or Web3. Web3 isalso being considered as one of the elements of the future Internet, although it has not
yet been clearly defined. DeFi forms the basic structure on which a future Web3 internet
may grow. By establishing financial structures that are resilient, efficient andpermissionless, it could form a foundational infrastructure on which private companies
may grow. Easy, trusted transactions allow payment for services, products and use of
these systems, and also act as a proof of concept for emerging uses of non-financial
token registration, distribution, use and transfer that we are seeing now, such as SBTs
and governance. The permissionless, global nature of DeFi means that systems can bebuilt with user bases that aren't limited by geography, political stability, or technologicalmonopoly - as long as effective governance protects these core principles.
In summary, the benefits of DeFi (including potential benefits) are: it may (1) contributeto innovation, with increasing efficiency and potentially a dramatic decrease in the costand overhead of financial services, (2) reduce the risks of financial concentration andcounterparty default, (3) bring the traceability of transactions that blockchain brings (butat the same time raises concerns about privacy, which, at the same time, can be adisadvantage). (4) make international financial transactions easier, (5) contribute tofinancial inclusion, and (6) contribute to the future of the Internet, Web3

5.2 Challenge, risks, and questions related to DeFi
5.2.1 General
On the other hand, a number of problems have been pointed out with DeFi, althoughmany of them seem to come from the flip side of the advantages presented above.

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5.2.1.1 Lack of AML/KYC
One of the main points of contention with DeFi is the potential for money laundering.
Many DeFi platforms do not perform KYC (Know Your Customer) or identity verification
for transactions. For example, a decentralized exchange or “DEX”, one of thefundamental DeFi activities, allows the exchange of cryptographic assets and allows
transactions across international borders without an intermediary. This may make iteasy for money launderers to clean up illegal funds If the DEX's compliance system wasinadequate. In the case of traditional financial transactions, financial institutions such as
banks and securities companies perform AML/KYC. In contrast, AML/KYC in the DeFi
context is generally only performed by regulated centralized exchanges when fiat
currencies are exchanged for digital assets, the on and off ramps to the digital asset
ecosystem. Given that DeFi systems typically do not provide for human intervention to
verify the identity of participants, KYC is not possible without new capabilities to identify
participants in the DeFi context . For example, according to Chainalysis (2022b), illicit
DeFi transactions have risen steadily over the last three years, in terms of both raw
value and also as a share of all transaction value. Chainalysis (2022b) said that this is
primarily in two areas: Theft of funds through hacking, and abuse of DeFi protocols formoney laundering (Figure1).
FATF (2021) has identified this as a problem, and AML (Anti Money Laundering) iscurrently a significant concern in DeFi. However, since a DeFi is enabled by automatedapplication programs, applying AML proves to be a challenge, and this point will be
discussed later.
However, there is also the counter argument to increased DeFi regulation, that on andofframps are increasingly monitored and most comply with AML/KYC guidelines. This,
along with the inherent traceability of blockchain, and cooperation of many protocols
suggest that inherent hard laws requiring KYC/AML for all DeFi protocols may be
regarded as overregulation. Many DeFi users also suggest that increased regulation of
DeFi protocols may stifle growth of this budding industry, and replicate some of theissues in traditional finance on-chain. This is particularly an issue when laws andregulations are unclear and everchanging - let alone the fact that these protocols would
be required to comply with the laws of every single country in which their protocol is
used.

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Figure 1: Total value received by DeFi from illicit addresses vs. illicit share of all value
received by DeFi

(source) Chainalysis (2022b)

5.2.1.2 Hacking
Recently, there has been a lot of hacking related to DeFi platforms in which
crypto-assets have been specifically targeted for hacking and successfully stolen.
According to Chainalysis (2022a), in 2020, $162 million of crypto-assets were stolen
from DeFi platforms, but in 2021, that rose significantly by about 13 times to about $2.2
billion. In 2021, a total of $3.2 billion in crypto-assets were stolen, with DeFi's share ofthat total nearly doubling from 31 percent to 72 percent, a significant increase.
Most instances of theft from DeFi protocols can be traced back to errors in the smart
contract code governing those protocols, which hackers exploit to steal funds(Chainalysis 2022a). It has also been pointed out that DeFi itself is very new, and thefact that the programs are typically open to the public makes it easier for hackers to findvulnerabilities, which may be leading to increases in hacking.
However, with improved smart contract auditing, and improved education of end users
regarding responsible management of funds, and self-custody, it is also pointed out thatthese hacks will decrease over time (Chainanalysis, 2022a). It is important to rememberthat in traditional systems, funds are usually managed by sophisticated investors,
whereas the onboarding of retail to DeFi means base education is generally lower.
While traditionally, retail risk may be constrained to losses on bad investments, there isa larger risk in DeFi, with a diverse range of financial instruments, with varied resilienceand safety to hacks. It is also worth mentioning that when hacks occur on-chain, it is14

easier to track the transactions following the hack than in traditional finance, with animmutable record of the offenses. In addition, the scale of DeFi hacks must also becompared to losses in traditional financial institutions and funds in order to provide avalid measure of severity.
Figure 2: Cryptocurrency stolen by victim type, 2020 - 2021

(source) Chainalysis (2022a)

Cross-chain bridges are especially at heavy risk, and they are crucial infrastructure of
the multi-chain ecosystem. They facilitate and lock a large amount of capital, andprovide considerable ease to consumers interacting and moving funds across a multichain DeFi ecosystem. According to the statistics by Dune Analytics2, the total locked-invalue (TVL) of Ethereum's 15 biggest cross-chain bridges was about $5.58 billion
dollars as of February 2, 2022. Currently, the highest TVL is Polygon Bridges ($3.6
billion dollars), with the second largest being Arbitrum Bridges ($1.44 billion dollars),followed by Optimism Bridges ($1.241 billion dollars).
Firstly, due to the high quantity of liquidity and low degree of decentralisation,
cross-chain bridges are often an ideal attack vector for hackers. According to SlowMist
2

See Dune site (https://dune.com/eliasimos/Bridge-Away-(from-Ethereum) (Last viewed on February

8, 2023)

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Hacked data reports3, as of June 30 2022, there were seven cross-chain bridge security
incidents, with losses totalling $1.043 billion, which accounts for 64% of DeFi's total
losses and 53% of total losses overall in the first half of the year. Furthermore, thecross-chain bridges create an environment where money laundering can occur without
effective mitigation controls in place. Due to the decentralised nature of permissionlessbridges, and smart contract technology, the traditional KYC/AML/CTF controls any given
centralised exchange must perform and utilize, such as freezing funds or enhanced due
diligence are not nearly as possible. As seen in the Elliptic (2021);“Proceeds of crime can be transferred between blockchains without going through acentralized service provider such as an exchange, where users’ identities areverified and funds linked to illicit activity might be seized. Decentralized cross-chain
bridges have been used to transfer proceeds of hacks, ransomware, darknet market
sales and other criminal activity”
As the blockchain enabled economy, and DeFi ecosystems respectively inevitably growto include more regulated money, such as CBDCs, it will be important to explore ways toboth reduce the technical risk of hacking and money laundering risks associated withmultichain interoperability performed by cross-chain bridges. These bridges could evenrepresent an ideal vector for regulation of DeFi to place itself, as many straddle
decentralised and centralised controlling entities, something regulation can more clearly
define outcomes for.

(3) Is it really "Decentralized"?
In transactions through DeFi, there is no primary financial intermediary. However, many
have questioned whether DeFi is truly decentralized. In fact, the definition of"decentralized" seems to be unclear. IOSCO (2022) mentioned that what should beconsidered "decentralized" is not clear. For example, the governance functions of a
DeFi, such as voting power, ownership structure, the authority to control the provision ofservices or products, the authority to manage customer assets, the authority to improve
services or products, and so on may or may not be truly decentralized. IOSCO (2022)
points out that the extremes of the decentralization spectrum are explained from "Pure
Decentralized Protocols" to "Pure Centralized Protocols," and it is unlikely that most
DeFi products and systems fall squarely into either extremity, with most sitting
somewhere between the two. In practice, it is often the case that some parties candominate and exert influence in changing the code of the DeFi protocol, that3

See website “2022 Mid-Year Report for Blockchain Security”,(https://slowmist.medium.com/overview-of-blockchain-security-2022-mid-year-report-15078f52b072)(Last viewed on February 8, 2023)

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governance is not fully decentralized, or that the revenue that comes from DeFi is not
distributed equally. "Decentralized" could be in some cases just a marketing word, andthe actual DeFi is often centralized or near-centralized.
For example, BIS (2021) points out that "there is a “decentralisation illusion” in DeFi dueto the inescapable need for centralized governance and the tendency of blockchain
consensus mechanisms to concentrate power.” BGIN (2021) also points out that thedegree of decentralization varies from one DeFi project to another, and many of themare quite centralized, especially early in their operation. Specific individuals or groups
typically have the authority to change the protocol or freeze locked assets. However,given the variety of DeFi forms, it is important to point out that there is no"one-size-fits-all" solution for DeFi governance forms and that the degree ofconcentration varies from project to project.
Chainalysis(2022b) points out that the governance of DeFi, which is supposed toaccount for most of the DAOs(Decentralized autonomous organizations), is actually not
so much decentralized as promoted and is surprisingly centralized. Figure 3 shows that,across several major DAOs, less than 1% of all holders have 90% of voting power.

Figure 3: Share of users holding 90% of all governance tokens by DAO(source) Chainalysis(2022b)

In addition, Ushida and Angel (2021) and BGIN (2021) point out that some DeFi
projects have a specific party with administrative authorities to modify the protocol at its
17

discretion via private keys called "admin keys," and the existence of "admin key" can beevidence to question decentralization to a certain extent. The owner of the "admin key"
may change programs and parameters related to the DeFi project without permission.
Moreover, not only that, if this "admin key" is stolen by hackers, the user's assets could
be stolen in the worst-case scenario. The existence of "governance tokens" can also be
considered from a similar perspective, pointing out that DeFi projects where governancetokens play a major role in governance may be less decentralized.
As a concrete example of centralized governance in a DeFi project, Allen (2021) points
out that the "BadgerDAO" has recently suspended smart contracts due to reports ofunauthorized access. However, if they were "decentralized" they would not have beenable to do this so quickly4. If there is no central operator, then there is no one to comply
with enforcement action. Therefore, enforcement action against the DeFi platforms
would be impossible, nevertheless there have been cases of enforcement action
against the DeFi platforms. Specifically, in August 2021, the SEC issued an
enforcement action against a DeFi platform. The SEC imposed a cease-and-desist
order on Blockchain Credit Partners (the company that operates the DeFi Money
Market) and two others who controlled and operated the company for selling more than
$30 million in "securities" through the DeFi Money Market using smart contracts andso-called "decentralized finance" (DeFi) technology between February 2020 and
February 20215. According to the SEC's announcement and related press reports, thiscase is the first time that securities using a DeFi have been the subject of enforcement
action (the case ultimately ended in a settlement in which the defendants did not evenadmit or deny). SEC Chairman, Gensler, referred to this action as a specific example ofa case where the DeFi was not actually decentralized in the sense that there was anentity that could be punished. Specifically, based on this case, he pointed out that "These platforms facilitate something that might be decentralized in some aspects but
highly centralized in other aspects"6. In addition, Gensler points to the existence of a"promoter and sponsor" structure as the core group that creates the software for the4

According to Twitter, they tweeted “Badger has received reports of unauthorized withdrawals of user
funds. As Badger engineers investigate this, all smart contracts have been paused to prevent further
withdrawals. Our investigation is ongoing and we will release further information as soon as possible,"(https://twitter.com/BadgerDAO/status/1466263899498377218 )(Last viewed on February 8, 2023).
5
For more information, see SEC press release (https://www.sec.gov/news/press-release/2021-145) (Last
viewed on February 8, 2023). The order is as follows.
Blockchain Credit Partners d/b/a DeFi Money Market, Gregory Keough, and Derek Acree, Order
Instituting Cease and Desist Proceedings, Securities Act Release No. 10961 (August 6, 2021).
6
Wall Street Journal (Aug. 19, 2021) " Crypto’s ‘DeFi’ Projects Aren’t Immune to Regulation, SEC’s
Gensler Says Some peer-to peer trading and lending projects have features that may trigger the need forregulation,chairman says"(https://www.wsj.com/articles/cryptos-defi-projects-arent-immune-to-regulation-secs-gensler-says
11629365401) (Last viewed on February 8, 2023)

18

DeFi platform and builds its governance, while often also doing the governance andearning the fees, in addition to writing the software programs7. BGIN (2021) makes aninteresting point about the direction of DeFi's decentralization in the future. Thus, whilesome DeFi will further promote decentralization to avoid regulation, some will go theother way and become more centralized. As mentioned above, there are numerous
indications that DeFi operates on a spectrum of "Decentralization."(4) Is it really "traceable"?, Is it “accessible to all”?
Some argue that a DeFi is not traceable in practice. Crenshaw (2021), who is acommissioner of the U.S. Securities and Exchange Commission (SEC), points out that,as for the lack of traceability, even though all transactions are recorded on a publicblockchain, in reality, DeFi investments are not fully traceable, and only a limited small
group of people can read and understand the code. Even highly qualified experts missthe flaws and dangers. Thus, these facts raise concerns that (technology) insiders willreap huge profits, while ordinary investors will take more risks, be offered unfairly badprices, and be exploited over time. It has been pointed out by Popescu (2020) andothers that one of the major issues to be addressed in the future is the user interface. In
other words, DeFi is still difficult to use for the general public. Certainly, DeFi operates
with code that is available to everyone, so it seems that it is more equal and traceable.
However, in reality, it is easy to imagine that only a small number of people can readand understand the code. In addition, the content of the code can vary from one smart
contract to another dramatically, and that can have a significant impact on investment
outcomes and safety. Even if a DeFi aims for a broad range of investment products, thegeneral public could not understand the risks associated with a code as they might witha disclosure prospectus for securities products. It is unreasonable to assume that only
technologically capable investors who understand complex codes make up the financial
system.
More concretely, many DeFi projects are funded by venture capital and professional
investors, but it is not clear how much small investors understand this situation.
According to Crenshaw (2021), professional investors bring with them rights such as
equity, options, access to project team management, involvement in governancewhether formalized or informalized, non-dilution rights, and control rights, which are
rarely disclosed. On the other hand, they have a significant impact on investment value.
It can be said that venture capital is not necessarily a good representation for public
interest such as investor/consumer protection. Therefore, Crenshaw (2021) pointed out
In the above article（Wall Street Journal on Aug. 19, 2021）, he referred“There’s still a core group offolks that are not only writing the software, like the open source software, but they often have governanceand fees,” “There’s some incentive structure for those promoters and sponsors in the middle of this.”719that small investors are at a great disadvantage compared to professional investors,
and this information gap will exacerbate the problem.

(5) Market manipulation and difficulties in investigation
It has been noted that market manipulation often occurs in the trading of crypto-assets(Gandal et al. 2018; Griffin and Shams, 2020). Despite the existence of market
manipulation, there are few market manipulation regulations and other significant issues
exacerbating the problem. In terms of market manipulation investigations, Crenshaw(2021) points out that the feature of pseudonymity can be a problem as well. In manycases, DeFi records all transaction IDs on the blockchain, they cannot be tampered
with, and everyone can see them. However, the ID does not actually identify the person
who controls the transaction. It merely indicates the address which is controlled bysome individual. Since there is often no effective way to identify who is actually theowner of addresses, it is impossible to know, for example, whether a group of people isengaging in market manipulation, or one person is controlling multiple addresses. This
makes it difficult for regulators to investigate market manipulation in DeFi markets.
Crenshaw (2021) points out that, in the U.S. securities world, sharing identities withparticipants limits privacy to some extent, but instead makes markets more comfortable,
and market participants agree to these practices. In return for a lower degree of privacy,
market participants have benefited from a fair, orderly, and efficient market, with lessfraud and market manipulation. DeFi, on the other hand, does not do so (share IDs,etc.) because investors are more privacy-oriented, according to Crenshaw (2021). Thisis because the use of alphanumeric strings to provide privacy is a core feature of Bitcoin
and is typical to most blockchains.
In a recent study, Auer et al. (2022) also noted market manipulation in the DeFi market.
Auer et al. (2022) point out that cryptocurrencies such as Ethereum and DeFi built onthem rely on validators or “miners” as intermediaries to verify transactions and update
the ledger. Since these intermediaries can choose which transactions they add to theledger and in which order, they can engage in activities that would be illegal in
traditional markets such as front-running and sandwich trades. The resulting profit istermed “miner extractable value” (MEV). MEV is an intrinsic shortcoming ofpseudo-anonymous blockchains. So addressing this form of market manipulation may
call for new regulatory approaches to this new class of intermediaries.
(6) Does it really contribute to "Financial Inclusion"?
The explanation that DeFi contributes to financial inclusion is also somewhat
questionable. It is true that even the unbanked people often have smartphones, so

20

allowing financial transactions through smartphones even without a bank accountcertainly could promote financial inclusion. However, there are two major problems.
First of all, “Competent Knowledge and Literacy” issues can be raised. Even if a person
has a smartphone, it does not mean that he or she is capable of trading through a DeFi.
Rather, DeFi is likely to require a high level of skill and knowledge/literacy, which may
even result in widening the disparity between those who have and haven’t. Especiallywhen DeFi is still a kind of nascent technology. As for stablecoins, which constitute as a
DeFi, WEF (2021b) notes that its contribution to financial inclusion is limited at this time.
This is after all, due to limited access to the internet and other resources themselves, aswell as a lack of digital-related knowledge.
Secondly, usage is currently limited. Even if DeFi could be done through smartphones, itwould only be crypto-asset trading. Although there are cases of using a DeFi to avoid
high remittance costs, the scope is still limited. Currently, most lifestyle-relatedtransactions are not covered, hence this situation is not contributing to financial
inclusion.

(7) Operational risk in DeFi
Since DeFi is automatically executed by smart contract, it is generally thought that there
is no operational risk, but in reality, there probably is.
First, DeFi transactions cannot be halted or undone basically. The fact that it isautomatically executed by smart contract can itself be a major risk. For example, whenparticipants make a wrong transaction, it cannot be easily undone or corrected. This isalso a very important point of view for regulators. There is a risk that the program will be
automatically executed, there will be nothing that can be done even if it involves unfair
trading or illicit activities where it would be desirable to order a halt or undo the trading.
Second, there is the “Oracle risk”. DeFi generally refers to external information, in theform of an "oracle". For example, this information is used to incorporate the price of
crypto-assets or other exogenous information not available on a blockchain, into theoperation of on-chain code. If the reference price is incorrect or intentionally distorted,
the trading price of the cryptocurrency within the service will be greatly dissociated fromother services, and participants may unreasonably lose a huge amount of money. Thisrisk is called the "oracle risk."21

(8) Characteristics of procyclicality and the potential for systemic risk associatedwith itSome DeFi transactions are considered to have characteristics of a so-called"procyclicality". "Procyclicality" was a major theme in the analysis of the financial crisis
after the Lehman shock in 2008, and in essence, it means that financial transactions are
self-propagating and bring about expansionary effects such as business cycles.
Procyclicality tends to occur especially when lending is dependent on the economy andcollateral. When the economy is booming and the value of collateral rises, the amountof lending rises further in response to the rise in collateral value, which in turn causes
the value of collateral to rise again, leading to further increases in lending. On the other
hand, if the economy worsens and the value of a collateral falls, this will lead to a further
decline in lending, which in turn will lead to further economic deterioration, creating a
vicious cycle.
This mechanism of procyclicality is found in a DeFi's lending as well because it is donewith crypto-assets as collateral but has systemic fragility compared to traditional
intermediaries who only retain collateral as insurance (Lehar et al. 2022). Since many
decentralized finance (DeFi) lending protocols require loans to be over-collateralized,
and loans that fall below a certain threshold are automatically liquidated by third parties.
Lehar et al. (2022) notes that these liquidations have a sustained cascading effect on
asset prices, which often triggers further liquidations. In addition, lack of regulation inleverage ratio may lead to hypercyclicality or rapid contagion. Therefore, when it comesto crypto-asset prices, a rise leads to a further rise, while a fall leads to a further fall.
There is another risk that when a large number of financial institutions are involved in
DeFi transactions it will spill over to the financial institutions. This may lead to systemicrisk. As Allen (2021) points out, DeFi is a type of shadow banking system with fragilities
that could – if DeFi reaches a significant scale – disrupt our real economy.
(9) Lack of ability to address risks associated with information asymmetry
From a financial theoretical point of view, financial institutions (in this case, assuming abank) usually exist to deal with the risks associated with information asymmetry
between lenders and borrowers. In other words, in the bank's example, it functions todecrease information asymmetry that exists between depositors and borrowers by
analyzing the credit information of borrowers instead of depositors who lack information
on borrowers, and by lending only to creditworthy firms. However, in a DeFi, there is nosuch financial intermediary with critical gatekeeper functions. Analysis of a borrower's
credit is often determined by the availability of collateral and not by analysis of otherfinancial information. Only financial transactions are carried out automatically according
to the code. In this sense, it would seem to suggest that DeFi is not currently a viable
alternative to financial institutions.

22

In traditional finance, credit or reputation is an important factor. The borrower has the
incentive to prove their trustworthiness and the lender needs reliable information toassess the risk of the borrower. Without any reliable information, it would lead tohesitance of lending, setting a high interest rate, or requiring over-collateralization. In
fact, Weyl et al. (2022) has raised the problem of a DeFi not being able to replicate realworld financial systems because there is currently no ground to build a reputation. They
introduce an idea of Soulbound Tokens (SBTs) which are “publicly visible,
non-transferable (but possibly revocable-by-the-issuer) tokens held by the soul”. A“soul” is an account or wallet which has linkage with the real world community. Though
the idea is still in an early stage, as BGIN (2022) discussed in its study report, it has thepotential to diminish unintentional information asymmetry, one of the consequences
would be being able to replicate current financial service such as uncollateralized
lending in a DeFi. The paper states that it could also have the potential to be used tocounter Illicit economic activities, promote regulatory measures such as AML/CFT, andensure fair, transparent, and accountable governance.

23

6. Implications for regulatory consideration
DeFi is not currently regulated as a financial product or trading activity in mostcountries, but there are many challenges as described above. There is no doubt thatmarket authorities are currently in the process of seriously considering how a DeFi
should be treated. In the United States for example, the President’s Working Group(PWG) (2021) refers, "Digital asset trading platforms and DeFi also raise broader
questions about digital asset market regulation, supervision, and enforcement." and "These questions are under active consideration by the CFTC and SEC." IMF(2022) also
calls for more work needs to be done on crypto regulation.
Thus how should DeFi be regulated? What kind of regulations can be considered in
DeFi, where "code is law" (De Filippi, 2019)? We discuss the viewpoints to be taken
when considering the regulations below.

6.1 Innovation trilemmaFirst of all, we consider the basic approach in applying regulations to new technologies
that create innovations, such as DeFi. Brummer and Yadav (2018) mentioned that
applying a traditional regulatory strategy to a new technological ecosystem had proved
conceptually difficult because there is a policy trilemma for introducing regulation for
innovative services and products (Figure 4).
Figure 4: Innovation trilemma(source) Brummer and Yadav (2018)

That is, when we seek to provide clear rules, maintain market integrity, and encourage
financial innovation, regulators have long been able to achieve, at best, only two out ofthese three goals. For example, if regulators prioritize market safety (integrity) and clear
rulemaking, they will have to establish detailed regulations, which may tend to inhibit24innovation. Alternatively, if regulators attempt to encourage innovation but also clear
rulemaking, they may be forced to respond with brief, high-level regulations, thusincreasing the risk of undermining market integrity. Finally, if regulators are focused on
both market integrity and innovation, they will be forced to create complex rules andexemptions, which will ultimately lead to increased difficulties in compliance,international cooperation, and enforcement, which may lead to a lower level of market
integrity.
Under these circumstances, what kind of regulatory implications can be expected for
DeFi? It is clear that the current regulations on DeFi are almost non-existent, and many
problems in the market have been identified. Thus at this point, we could sacrifice twoout of the three. Therefore, the vital question will be whether to prioritize market integrity
or regulatory simplicity while maintaining ongoing innovation.
Figure 5: Framework for regulatory considerations

25

(Source) Created by the author

26

For this reason, as Figure 5 shows, this paper will first examine whether a DeFi can be
subject to market integrity in the first place, and more specifically, whether it is regulated
as financial and whether participants can be subject to protection. If so, then we willneed regulations as required of a financial institution. Nevertheless, given the current
revelations of money laundering and the use of illicit funds, it is essential to addressthese illicit activities in one way or another. And in any case, it is necessary to consider
what kind of enforcement will be implemented without clarity about the state andjurisdiction (Figure 5).

6.2 Perspectives on whether financial regulations should be applied(1) Is DeFi really "finance"?
Since "DeFi" is an abbreviation for "Decentralized Finance," it is natural to think of it as"finance." Moreover, it is precisely whether it constitutes a “financial service”. However,in reality, first of all, we need to consider whether we can really think of it as "financial
service". If it is not a "financial service," then there may be less demand to regulate it asa financial product8. Specifically, it may not be "financial service," but part of a game.
Token lending and investment-like activities in the game are, of course, not subject tofinancial regulations. Allen (2021) stated that a DeFi is like an “incorporeal casino", andtreating stablecoins like regulated deposits will provide implicit government backing tothat casino, encouraging its growth. It is inappropriate and should be avoided tolegitimize non-financial activities, e.g. lending and borrowing within a “game”, by
imposing financial regulations. It would be outside the scope of financial regulations if it
is a non-financial transaction.
Above all, it is necessary to confirm whether a DeFi is "financial services" or a kind of"finance" in the sense that it is subject to regulation. It may be possible to identify whichparts of the DeFi are "finance" and which parts should not be regulated. The basic
principle is "Same business, Same risk, Same rule" as usually said. Thus, if a particular
project among a DeFi is not regarded as "financial service," then, of course, there is noneed for financial regulation to apply.

(2) Should a DeFi participant be subject to investor/consumer protection?
Even if a DeFi (or part of it) is "financial services," there is also the question of whether
its participants are subject to investor/consumer protection. In other words, are DeFi
market participants subject to the same protections as ordinary investors in the8See, for example, Armour et al.(2016) for a discussion of what finance is.

27

traditional financial markets? Even in the traditional financial market, qualified investors
with a certain level of knowledge and institutional investors are professional andtherefore responsible for their own investment. Nevertheless, for professional investors
to make appropriate judgments, solid explanatory documents and disclosures arenecessary, so it will be necessary to have a system in place to enable them to makeappropriate investment decisions.
In any case, if regulations are to be introduced for a DeFi, it will be necessary toconsider what portion of the DeFi participants should be protected.

6.3 Need for regulation for providers of financial functions
If a DeFi qualifies as a “financial service” and investors/consumers should be protected,
then the application of financial regulations would need to be considered. Specifically,
this would include the following elements.
(1) Safety and soundness regulation as a "financial institution"
When applying protection to a DeFi application, regulations to ensure the safety andsoundness of regulation, similar to that of a traditional financial institution, need to beconsidered. Necessary regulations, such as capital adequacy regulations, entry
regulations, restrictions on concentrated transactions, and transaction regulations would
be on the agenda if, for example, deposit-like products were to be accepted. Risk
management, such as that required of traditional financial institutions, may also benecessary. Operational risk, market risk management, and credit risk management are
key examples.

(2) How to ensure appropriateness as a "financial transaction"
If transactions in a DeFi are regarded as financial transactions, then various transaction
regulations would be required. The most typical regulation would be the market
manipulation regulation when trading on the DEX.
(3) How to implement the audit and ensure DeFi's reliability?
Even if a disclosure mechanism for risk, governance, etc., of the code is established,
the question then arises as to how to ensure its accuracy. In the normal course ofbusiness, listed companies are audited by an external auditing firm and are assured of acertain level of accuracy that investors can rely on. For corporate bonds, there are also
rating agencies, such as Moody's and Standard & Poor's, that rate the credit ofcorporate bonds and provide information to investors. So, does the DeFi ecosystem28

have the capability to develop such a financial environment that guarantees credibility?
Even if it does, how reliable are they?
Currently, it appears that there are indeed companies in the DeFi ecosystem that audit
codes, but several issues have been raised. Conflux Network (2020) indicated that audit
standards were not standardized, varying from firm to firm, and it was unclear how
reliable they were. When a DeFi application is recognized as a "financial service"
constituting a “financial system”, it will be necessary to develop an ecosystem that will
ensure the reliability of such a financial system. However, the issue of how to tackle thisissue will be raised, as it crosses national borders and the affiliation and jurisdiction are
not clear.
(4) How to establish a regulatory enforcement framework?
First, DeFi is seen as difficult to enforce because there is no principal entity andtherefore no entity for the authorities to order. However, as discussed above, in manycases, there are actual entities to be regulated. After all, some entities benefit
economically, and it would be appropriate to consider them as the main operating
entities. For this reason, it is necessary to take a close look at the actual governanceand operating situation of the DeFi.
Perhaps, the most difficult question regarding DeFi is how these regulations andenforcement can be implemented, and by which authorities. Concerns have often beenraised that, since some DeFi projects are further decentralized, there could be no
explicit entity subject to regulation. And there may be a DeFi that claims not to belong to
any country or jurisdiction. Several ideas have been suggested in this regard.
IMF (2021) mentioned that, although direct bans can have a direct impact on thebusiness of crypto exchanges (for both centralized exchanges and Decentralizedexchanges), individuals are still likely to be able to trade and exchange crypto-assets byalternative means. Thus, regulatory arbitrage could exist. Therefore, jurisdictions should
actively coordinate with the relevant authorities and international standard-setting
bodies to maximize the effectiveness of their enforcement actions and minimize
regulatory arbitrage. Greater cross-border collaboration can enhance enforcement
actions. Realistically, enhanced coordination of regulation and supervision would be themost that should be done.
There is a suggestion to use soft law, such as a corporate governance code, rather thanenforceable regulation by law (OECD 2022). DeFi, which agrees with such soft law,would then sign the agreement, which would effectively function in a self-regulatory
manner. Of course, while creating such normative standards and encouraging
29

signatures may have a certain degree of effectiveness, bad actors may not follow thesecodes and may not sign them even in the first place. Therefore, it will be necessary tohave certain authorities in the background of the standard. To this end, it is still essential
for national authorities and international organizations to respond in a coordinatedmanner.
It will also be necessary to deepen research on the possibility that the subject ofregulation will be "code (=computer program)," by referring to the recent thinking onlaws and regulations against market manipulation by AI (BOJ, 2018). In the financial
markets, recently, there may be a situation where it is unclear who will be responsible
for any losses incurred by investors due to algorithmic/AI based trading or trading thatharms the fairness of the market. Market manipulation by AI is indeed a crimecommitted by computer programs, and it will be very helpful to see what measures canbe taken against it.
More importantly, it will be important for regulators to develop a system, including
human resources and flexible facilities, that will allow them to keep a close eye on areas
such as DeFi. There is also a tendency for regulators to be too conservative, whichmakes it difficult for them to keep up with the application, utilizing cutting-edge
technologies, such as DeFi. Regulators need to balance "innovation and efficiency" and"conservatism in security."
In addition, As Zetzsche (2020) points out, DeFi could also take a completely new wayof thinking about regulatory design, such as an "embedded regulation" approach. The"embedded regulation" approach is to automate the regulation itself, which may be an
efficient way to regulate cyberspace, such as DeFi, and may require further
consideration in the future.
However, the question still remains. How should it be handled if it is truly decentralized,
for example, the code is the operating entity. In this regard, the August 2022 Tornado
Cash incident was highly controversial. On August 8, 2022, the U.S. Department of theTreasury's Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash, a leading
crypto asset mixing platform, for engaging in money laundering of over $7 billion in
crypto assets9. Indeed, there is no doubt that money laundering itself is a serious crime,
but it is not Tornado Cash that actually laundered the money, but the individual or groupthat used its mixing service (i.e., in this case, the North Korean money launderinggroup). Also, if that Mixing platform is computer code and has no governance authority
whatsoever, the argument seems to be whether it is appropriate to impose sanctions or
9

OFAC Press Releases (August 8, 2022), ”U.S. Treasury Issues First-Ever Sanctions on a Virtual
Currency Mixer, Targets DPRK Cyber Threats”（https://home.treasury.gov/news/press-releases/jy0768）

30

arrest the code developer10. Regarding the U.S. Treasury Department OFAC sanctions
against Tornado Cash, some argue that OFAC sanctions against computer code exceed
its legal authority and violate the Constitution (Coin Center, 2022). Moreover, Coin
Center, et al. v. Yellen et al. pointed out that Tornado Cash did not actually provide a
mixing service in that funds of users were not commingled; rather, it allowed for thedeposit and withdrawal of digital assets under different, unlinkable addresses in amanner that provided the beneficial feature of privacy in an otherwise fully transparent
system.The case is expected to be settled in a future court dispute.
Another controversial issue in the U.S. is the CFTC's administrative action against the
Ooki DAO in September 202211. The CFTC filed a lawsuit against a Decentralized
Autonomous Organization (DAO) called "Ooki DAO," including those who held andvoted for its governance tokens, for providing off-exchange digital asset transactions,registration violations, and non-compliance with the Bank Secrecy Act (BSA). The
simple question arises as to whether the tort liability of the DAO should be considered tofall on the voters of the tokens and not on all holders of the tokens, or whether, in thecase of a corporation, only the shareholders who exercise their voting rights should beheld liable for the tortious acts.The main issue may be what to think about the CFTC
approach of determining the liability of DAO token holders based on their participation ingovernance votes. In any case, the lawsuit (and the court decision based on it) is also
considered to have broad implications for the crypto asset industry as a whole.
(5) How to establish a disclosure system suitable for DeFi and crypto assets
One of the most important frameworks for investor protection is the disclosure
framework. Blockchain is inherently traceable, so while it is already disclosed totechnically sophisticated participants, it is too technical and virtually invisible to thegeneral public and investors, which is one reason why DeFi is considered
non-transparent (Brummer, 2022). Ensuring a solid disclosure system will prevent thenon-transparent situation that the DeFi has, and will allow investors to make appropriate
decisions. Disclosure is considered necessary to a certain extent not only for investors
but also for consumers, even if the product is an ordinary product. In this regard, it isessential for DeFi to provide more disclosure.

FIOD(Fiscal Information and Investigation Service, Netherland)（August 12, 2022）”Arrest ofsuspected developer of Tornado Cash”（https://www.fiod.nl/arrest-of-suspected-developer-of-tornado-cash/）
11
CFTC Press release,(September 22, 2022) "CFTC Imposes $250,000 Penalty Against bZeroX, LLC
and Its Founders and Charges Successor Ooki DAO for Offering Illegal, Off-Exchange Digital-Asset
Trading, Registration Violations, and Failing to Comply with Bank Secrecy Act"
（https://www.cftc.gov/PressRoom/PressReleases/8590-22）
1031

IMF (2021) and OECD (2022) also pointed out that establishing a disclosure framework
including greater data standardization can lead to better oversight of crypto-asset
markets, and in this regard, appropriate development of disclosure framework is anecessary measure.
Establishing the structure for how disclosure is to be made can be a very challenging
task. Even for traditional financial and corporate entities, international harmonization of
accounting standards is a challenging task. The DeFi disclosure system is not definedby one country alone, as it crosses national borders.
In this regard, Brummer (2022) points out that the DeFi disclosure is not suitable for the
SEC's EDGAR framework, as used for regular corporate disclosure and institutional
investors, and requires a different framework that is preferable for investors anddevelopers of crypto-assets. In other words, the existing disclosure systems used infinance (e.g., EDGAR) are often too detailed and too burdensome for the DeFi system
to be suitable at all. Specifically, in terms of the DeFi disclosure requirements,
participants should be aware of the issues including those listed below:➢ token governance;➢ conflicts of interest;➢ economic mechanisms (additional issuance, redemption authority, splits,
suspensions, etc.);➢ token holder privileges;➢ founder and VC influence;➢ Dapp (Decentralized Applications) business model and risks;➢ risks associated with external references (so-called, "Oracle risk" );➢ smart contract code upgrade and bug fixing mechanisms; and➢ DAO (Decentralized Autonomous Organization) decision making andgovernance.
Above issues are essentially necessary and important information that DeFi participants
need to understand, but these are rarely found in the traditional SEC regulatory forms.
For this reason, it is desirable to design a new disclosure system aimed at taking
advantage of the characteristics of crypto-assets and blockchain.
Establishing an appropriate disclosure framework, while challenging, is the mostnecessary thing to do in order to get the facts, and for investors to get accurate
information as well. This is perhaps the issue that should be addressed most urgently.
To create a common disclosure platform in which national authorities and international
standard-setting bodies would also participate and give authority would be desirable tohave a framework in which access to this disclosure platform would provide basic

32

information regarding the DeFi, such as disclosure of data, governance mechanisms,
token information, as well as information on audits, etc., and it is also a more convenient
way to check for compliance. Designing an appropriate common disclosure platformthat also considers players' incentive structure is very challenging and will be thesubject of further research.

(6) Need to consider the impact on the financial system if the scale of DeFi
becomes large
Currently, the scale (TVL: Total Value Locked) of the DeFi markets is not significant
compared to traditional financial markets. However, along with the growth of the DeFi
markets, many financial institutions would be involved in DeFi in some way. This isbecause it is difficult to exclude them from the investment portfolios of institutional
investors when the scale of the DeFi markets becomes large. In such cases, the impactof DeFi on the financial system should be considered. In particular, as pointed out in theprevious chapter, given the evident procyclical nature of the DeFi system, if the DeFi
market were to crash, the impact could spread at an accelerated rate and affect thefinancial system. Allen (2021) noted that, because DeFi still remains largely
disconnected from both real-world economic applications and the established financial
system, there would be limited pressure on the government to bail it out. However, as
DeFi grows, the possibilities for something to go wrong, and for that something to
impact the broader economy, increases.
From a simple point of view, there are two possible ways. The first is to restrict
investment in DeFi by financial institutions. In other words, the exposure to DeFi itself
should be reduced. This will reduce the negative linkages. Second, some kind ofsoundness regulation (such as capital adequacy regulation) could be introduced tomaintain the soundness of the DeFi system itself. However, since such soundness
regulations are entity-based, it is questionable to what extent they will be suitable for
DeFi, which is the subject of the computer program.

6.4 How to ensure AML/CFT
Whether or not DeFi is considered financial, and whether or not its participants deserve
protection, at this time, the most urgent policy issue regarding DeFi would be the anti
money laundering (AML). Regardless of the size of a DeFi, it should not be used to fundcrime, and AML is an essential measure. To counter money laundering, KYC, such as
identity verification, is necessary to be implemented into DeFi in some form. However,
the issue is how to implement AML countermeasures for the DeFi, which is just an
application program.
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In this regard, The FATF (2021) states that items with significant regulatory uncertainty,
such as DeFi and stablecoins, should also comply with the "travel rule." "Travel Rule" isa set of rules for domestic and international wire transfers to prevent money laundering,and requires Virtual Asset Service Providers (VASPs) to collect and exchange
information on the sender and recipient of crypto-asset transactions. And in the FATF'sview (FATF 2021), almost all DeFi platforms are VASPs. The FATF has warned
regulators not to accept without question the crypto-asset industry's marketing
technique of broadly calling various platforms "decentralized." This is because DeFi
platforms usually have a natural person (maybe not a legal entity) somewhere who"controls or influences" their activities. The point of "control or influence" is theframework for analyzing who is obligated to comply with ALT/CFT regulations.
Addressing the problem of AML may also eliminate the anonymity and pseudonymity
features of DeFi, i.e., the privacy of transactions. However, anonymity andpseudonymity make it difficult to maintain fairness in the market, not only for AML but
also for market manipulation, as Crenshaw (2021) pointed out. Given that participants intraditional financial markets agree to share some degree of private information with
relevant/competent authorities in exchange for maintaining market fairness, it will benecessary to take the necessary measures to maintain a level playing field. As BGIN
(2021) also points out, this is a difficult matter and a number of participants expressed
concerns about the AML regulations in terms of privacy, level playing fields, financial
inclusion, and regulatory enforceability.
However, as will be mentioned below, the key issue is how to enforce AML as thedecentralized organization of DeFi further develops. Some have suggested that AML
itself be embedded in the code and executed automatically, which is AML Oracle(Coinfirm, 2021). AML Oracle is intended to enable AML through smart contracts,
however, is in the early stage of the development and is not clear to what extent this will
work practically at this moment.

34

7. Proposal of Principles of DeFi disclosure and regulation
Based on the risks and challenges seen in the previous chapters, some countries andjurisdictions are also considering regulations on DeFi12.
For example, in Europe, a regulation on crypto assets called the "Markets in Crypto
Assets regulation (MiCA)" is under consideration. However, it appears to focus on
stablecoins and other crypt assets, not on DeFi (EU 2022, Coinfirm 2022). Japan wasquick to address crypto asset regulation, starting in 2017, but the regulations seems to
be relatively strict, because it lists which crypto assets can be traded by crypto asset
providers. Other crypt assets, including those on DeFi, are not allowed to serve by
those providers. In the U.S. even DeFi tokens are subject to SEC jurisdiction if they are
securities, crypto asset futures are regulated by CFTC, but crypto assets in the spot
market are not currently regulated. In any event, given that DeFi is characterized as adigital asset, there may be problems in applying similar regulations to DeFi tokens andsecurities because they are different. The regulation is currently under consideration in
Congress (FSOC 2022, Coinfirm 2021). Some countries have banned crypto asset
trading itself, hence there are no regulated trading markets in such jurisdictions. Thus,
looking at the regulatory developments on DeFi in various countries and jurisdictions,many are currently unregulated, or if they are, they are inadequate. Therefore, it seems
unavoidable that new regulations should be considered.
In doing so, in light of the points discussed so far, it would be desirable to establish thefollowing principles for DeFi regulation and disclosure. The reason for the principle isthat detailed laws and regulations are highly rigid and difficult to adapt to innovation andtechnological change, as well as taking a significant amount of time to enact and costinga significant amount of operational costs. Of course, this does not prevent rules andlaws if they are enacted in a manner that allows them to adapt to change and operate ina manner that mitigates the disadvantages mentioned above. Several studies are also
being conducted by the international organizations and regulators including IMF, FSB,
FSOC, and others (see BOX 1-4 in this chapter for reference).
Please note that the following principles do not apply to crypto assets in general, but
only to DeFi, which is the subject of this document. The following is a proposal (as ofFebruary 13, 2023), which will be refined based on further comments and opinions to
finalize the document.

12

See also the IMF (2022) for a detailed summary of this point.
35

(Principle 1) Need to establish the Scope of Coverage(1) Regulators need to identify whether a DeFi constitutes a regulated financial activity
and whether its participants fall under investor/consumer protection.
(2) The requirements for whether a DeFi constitutes a financial service should bepresented in a form that is easy for participants to understand and appreciate.
(3) This coverage decision could also be considered to be made by the governing bodyof the globally uniform disclosure platform. once it is established, as described below.

(Principle 2) Establishment of a Disclosure Platform(1) Disclosure of information on DeFi could be made in a form that is easily understoodand grasped by participants in transactions through the establishment of a reliable
platform and their voluntary participation in it, taking into account the differences fromthe disclosure in securities.
Disclosure information in such cases should include the following.
● Factors that have or may have a material impact on the value of the governancetoken, such as token governance,○ Founder and venture capital (VC) influence,○ conflicts of interest;○ economic mechanisms (additional issuance, redemption authority, splits,
suspensions, etc.);○ token holder privileges;○ Others● Dapp (Decentralized Applications) business model,● Others(2) It is desirable to establish a globally uniform disclosure platform. The platform shouldbe led by neutral organizations, such as multi-stakeholder organization, international
standard-setting bodies, self-regulatory organizations, or international organizations. It
is desirable to be approved by regulators in various countries/jurisdictions. Participatingin the platform is desirable to have similar effects as registration to a regulator. This
would provide an incentive to participate in a proper DeFi disclosure platform.
(3) This globally uniform disclosure platform will have the effect of providing a certain
level of trust to trading participants, as only the DeFi that meet the principles will be36

allowed to participate. In contrast, a non-participating DeFi would also have the potential
to have concerns about investor/consumer protection (Name and Shame).
(4) Disclosure platforms should aggregate, publish and provide data from participating
DeFi platforms.
(Principle 3) Harmonization with Traditional Financial Regulations
If a DeFi's activity falls within the scope of financial regulatory coverage, the regulations
and disclosure rules should be applied under the same risk, same activity, same
regulatory outcome, and also under the principle of technology neutrality, considering
the balance with normal traditional financial activities. For example, regulation in
traditional finance could include:● Safety and soundness regulation,● Conflict of interest regulations (e.g., between exchanges and brokerage firms),● Disclosure regulation (more details below),● AML/CFT regulation (but this is not limited to financial activities)● Others(Principle 4) Consideration of DeFi specialities
Even if a DeFi's activity falls within the scope of financial regulatory coverage, DeFi
specific regulations and disclosures should be considered, including the fact that it is adigital activity. Specifically, for example, the most significant differences between
traditional finance and DeFi, even if they are the same activity, are the following.
● Electronic activities,● The ability to easily conduct cross-border activities,● the existence or non-existence of a central entity that can influence the activity,● There are cases where there is no central entity at all,● Even if a central entity does exist, the degree of its influence vary,.
● DeFi's specific risk called oracle risk,● Automatic execution risk of smart contracts (a kind of operational risk),● Cyber security,● Others.

(Principle 5) Addressing the Potential for Systemic Risk
If the connectedness with traditional finance becomes greater, it will be necessary toconsider how to deal with systemic risks, such as leverage ratios and capital adequacy
ratios.

37

(Principle 6) Periodical Audit
DeFi participating in the disclosure platform must be subject to an audit at least once ayear. A summary of the results should then be disclosed on the disclosure platform,
clearly indicating that it is an appropriate DeFi.
It is desirable that a uniform auditing standard be created and that they be approved by
the disclosure platform.

(Principle 7) Ensuring Regulatory EffectivenessA DeFi may not have a central entity or may have a small degree of influence on its
activities, and in such cases, conduct regulations that stop the illegal activity itself may
be more effective than punishment against the entity to ensure the effectiveness of theregulations.
Since "decentralized" does not allow for the absence of a responsible entity in case ofillegal activity, DeFi apps should include a mechanism for correcting or
self-discontinuing the activity.

(Principle 8) AML/CFT and other measures to legal financial activities
Even a DeFi that does not participate in the disclosure platform and is not regulated as
financial services, it should comply with AML/CFT and other legal financial measures asprescribed by FATF standards as they are developed to apply for DeFi.

38

(BOX 1) IMF’s considerations for regulatory frameworks
IMF(2022) points out the following with respect to considerations for regulatory
frameworks across crypto assets.
(1) Monitoring
Authorities should first monitor developments to accurately gauge the size of themarket and to identify areas of risk,(2) Prioritization
Authorities should consider the risks of unbacked crypto assets as part of theirbroader regulatory and supervisory duties and determine whether the crypto
asset market presents risks to their mandate that would reflect the considerable
resources required to regulate and supervise crypto assets.
(3) Scope
Authorities should determine a clear scope for regulation, that is, which entities,
crypto assets, and activities will fall within the regulatory scope(4) Domestic Collaboration
Regulatory development should be a collaborative effort of financial sector
regulators and relevant government departments, taking into account guidancefrom standard-setting bodies and regulatory approaches in peer countries(5) Continuous Assessment of Risks
Continuous assessment of risks will be needed to identify shifting risks andbusiness models that may require updating regulations to ensure effective
protection of markets, consumers, and financial stability

39

(BOX 2) FSB report
FSB(2022b, “Regulation, Supervision and Oversight of Crypto-Asset Activities andMarkets Consultative document” ) proposed 9 recommendations for the regulation,
supervision and oversight of crypto-asset activities and markets. The summary of the
proposals are below. (Excerpt from FSB, 2022b).
(Recommendation 1: Regulatory powers and tools)
Authorities should have the appropriate powers and tools, and adequate resources, toregulate, supervise, and oversee crypto-asset activities and markets, including
crypto-asset issuers and service providers, as appropriate.
(Recommendation 2: General regulatory framework)
Authorities should apply effective regulation, supervision, and oversight tocrypto-asset activities and markets – including crypto-asset issuers and service
providers – proportionate to the financial stability risk they pose, or potentially pose, inline with the principle “same activity, same risk, same regulation.”(Recommendation 3: Cross-border cooperation, coordination and information sharing
Authorities)
Authorities should cooperate and coordinate with each other, both domestically andinternationally, to foster efficient and effective communication, information sharing andconsultation in order to support each other as appropriate in fulfilling their respective
mandates and to encourage consistency of regulatory and supervisory outcomes.
(Recommendation 4: Governance)
Authorities, as appropriate, should require that crypto-asset issuers and service
providers have in place and disclose a comprehensive governance framework. The
governance framework should be proportionate to their risk, size, complexity andsystemic importance, and to the financial stability risk that may be posed by theactivity or market in which the crypto-asset issuers and service providers are
participating. It should provide for clear and direct lines of responsibility andaccountability for the functions and activities they are conducting.
(Recommendation 5: Risk management)
Authorities, as appropriate, should require crypto-asset service providers to have aneffective risk management framework that comprehensively addresses all material
risks associated with their activities. The framework should be proportionate to theirrisk, size, complexity, and systemic importance, and to the financial stability risk that
may be posed by the activity or market in which they are participating. Authorities
should, to the extent necessary to achieve regulatory outcomes comparable to thosein traditional finance, require crypto-asset issuers to address the financial stability riskthat may be posed by the activity or market in which they are participating.

40

(Recommendation 6: Data collection, recording and reporting)Authorities, as appropriate, should require that crypto-asset issuers and service
providers have in place robust frameworks for collecting, storing, safeguarding, andthe timely and accurate reporting of data, including relevant policies, procedures andinfrastructures needed, in each case proportionate to their risk, size, complexity andsystemic importance. Authorities should have access to the data as necessary andappropriate to fulfill their regulatory, supervisory and oversight mandates.
(Recommendation 7: Disclosures)
Authorities should require that crypto-asset issuers and service providers disclose tousers and relevant stakeholders comprehensive, clear and transparent information
regarding their operations, risk profiles and financial conditions, as well as the
products they provide and activities they conduct.
(Recommendation 8: Addressing financial stability risks arising from interconnections
and interdependencies)
Authorities should identify and monitor the relevant interconnections, both within thecrypto-asset ecosystem, as well as between the crypto-asset ecosystem and thewider financial system. Authorities should address financial stability risks that arise
from these interconnections and interdependencies.
(Recommendation 9: Comprehensive regulation of crypto-asset service providers withmultiple functions)
Authorities should ensure that crypto-asset service providers that combine multiple
functions and activities, for example crypto-asset trading platforms, are subject toregulation, supervision and oversight that comprehensively address the risks
associated with individual functions as well as the risks arising from the combinationof functions, including requirements to separate certain functions and activities, as
appropriate.

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(BOX 3) IOSCO report
IOSCO(2022), “Decentralized Finance Report” point out that financial innovation may
lead to benefits for investors and others, but it may also present risks. Then it pointout that DeFi appears to present many similar risks to investors, market integrity andfinancial stability as do other financial products and services, and it also poses
specific and unique risks and challenges for regulators to consider. Potential
regulatory concerns raised by IOSCO(2022) are below.
● Asymmetry and fraud risks● Market integrity risks○ Front-running ( or similar frauds)○ Flash loans● Market dependencies● Use of leverage● Illicit activity risks● Operational and technology-based risks (Blockchain, Smart Contracts,
Oracles)● Cybersecurity● Nascent stage of development (Comprehensibility, Scalability, Supportability,
Reliability)● Governance risks● Spill-over of risks to centralized/traditional markets○ Centralized Crypto-asset Trading Platforms○ Traditional Financial Institutions

42

(BOX 4) FSOC Recommendations
In the U.S., the FSOC (Financial Stability Oversight Council) suggests the following as
recommendations for building regulations on cryptographic assets.(FSOC 2022)(Recommendation 1)
Member agencies (Treasury department, SEC, OCC, FRB, FDIC, etc.) consider thesegeneral principles in their deliberations about the applicability of current authorities:
Same activity, same risk, same regulatory outcome;● Technological neutrality;● Leveraging existing authorities where appropriate;● Transparency in technology, including through potential future adoption andimplementation of federal agency SBOM requirements by industry;● Addressing financial stability risks before they impair the economy;● Monitoring mechanisms through which crypto-assets could become moreinterconnected with the traditional financial system or increase in overall scale;● Bringing transparency to opaque areas, including through disclosures anddocumentation of key issues such as interconnectedness;● prioritizing timely and orderly transaction processing and legally binding
settlement;● facilitating price discovery and fostering market integrity; and • obtaining, andsharing with other agencies, relevant market data from the crypto-asset market(Recommendation 2)
Continued Enforcements are needed.
(Recommendation 3)
Congress pass legislation that provides for explicit rulemaking authority for federal
financial regulators over the spot market for crypto-assets that are not securities(Recommendation 4)
Regulators continue to coordinate with each other in the supervision of crypto-asset
entities, such as stablecoins issuers or crypto-asset platforms, particularly in cases
where different entities with similar activities may be subject to different regulatory
regimes or when no one regulator has visibility across all affiliates, subsidiaries, andservice providers of an entity.

43

(Recommendation 5)
Congress pass legislation that would create a comprehensive federal prudential
framework for stablecoin issuers that also addresses the associated market integrity,
investor and consumer protection, and payment system risks, including for entities
that perform services critical to the functioning of the stablecoin arrangement(Recommendation 6)
Congress develop legislation that would create authority for regulators to havevisibility into, and otherwise supervise, the activities of all of the affiliates andsubsidiaries of crypto-asset entities, in cases in which regulators do not alreadypossess such authority(Recommendation 7)
FDIC, FRB, OCC, and state bank regulators use their existing authorities, as
appropriate, to review services provided to banks by crypto-asset service providers
and other entities in the crypto-asset arena(Recommendation 8)
Member agencies assess the impact of vertical integration (i.e., direct access tomarkets by retail customers) on conflicts of interest and market volatility, and whether
vertically integrated market structures can or should be accommodated under existinglaws and regulations.
(Recommendation 9)
Coordinated government-wide approach to data and to the analysis, monitoring,supervision, and regulation of crypto-asset activities.
(Recommendation 10)
Council members continue to build their capacity to analyze and monitor crypto-asset
activities and allocate sufficient resources to do so.

44

8. Conclusion
This paper summarizes the issues surrounding DeFi under these circumstances andpresents some discussion points and suggestions for appropriate future regulatory
considerations. We proposed principles for DeFi disclosure and regulation. In
considering the Principles, there were three major considerations.
Firstly, applying a traditional regulatory strategy to a new technological ecosystem has
proved conceptually difficult because there is a policy trilemma called an innovation
trilemma for introducing regulation for innovative services and products.
Secondly, considering DeFi regulations, whether a DeFi constitutes the "financial
service" which participants are subject to consumer/investor protection need to beconsidered first. Additionally, regulations from the perspective of systemic risk andanti-money laundering may be important regardless of such need for protection.
Lastly, the most important point would be to establish a disclosure system and common
platform suitable for the characteristics of DeFi and crypto-assets, as well as an
enforcement framework, considering the innovation trilemma. This is because
establishing a suitable disclosure system for DeFi and crypto-assets is the mostessential infrastructural foundation, when considering self-regulation, enforcement bygovernment agencies, or for investors to pursue their own responsibilities. Establishing
an appropriate disclosure framework is, while challenging, necessary to provide all
market participants information about the potential risks and benefits for any particular
DeFi applications. To create a common disclosure platform in which national authorities
and international standard-setting bodies could also participate and give authority would
be desirable. Such a framework would provide basic information regarding a DeFi, suchas disclosure of data, governance mechanisms, token information, as well as
information on audits, etc., and it is also a convenient way to check for compliance.
Designing an appropriate common disclosure platform that also considers participants'
incentive structure is very challenging and will be the subject of further research.
These principles will be desirable to be reviewed on a continuing and regular basis(e.g., every two years) in the future. It is then hoped that the recognition of theseprinciples will be shared by the participants involved in DeFi and contribute to thedevelopment of a healthy market. BGIN would also like to contribute to the healthy
development of the DeFi market by communicating these views through gathering andcoordinating stakeholder opinions.

45

Appendix A – Acknowledgement(Informative)

A.1 Editors and Co-editors● Tomonori Yuyama (Georgetown University) *● Ken Katayama (Nomura Research Institute, Ltd.)● Paul Brigner (Electric Coin, Co. )*Corresponding editor
A.2 Contributors
●
●
●
●
●
●
●
●

Tetsu Kurumizawa (Yale University)
Michi Kakebayashi (UC Berkeley)
Mitchell Travers (Partner, Soulbis Pty Ltd)Nat Sakimura (OpenID Foundation)
Roman Danziger Pavlov (BGIN)
Shinji Sato (Independent researcher)
Stephanie Bazley (AirTree Ventures)
Yuji Suga (IIJ)(Note) The views expressed in this paper are based on the personal views of theauthors and not the views of the organizations to which they belong.

46

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