Could Cryptocurrency Regulation Derail DeFi?
By: Yield App
Tags: Regulation, Defi, Yield Farming

Decentralized finance (DeFi) is the absolute avant-garde of the new global digital financial system and, as such, it is an area that very few people on the street have heard of. However, that doesn’t mean that regulators are not aware of DeFi. In-fact, as DeFi has exploded to become a billion-dollar market in 2020, regulators across the world have gone into overdrive in a scrambling attempt to get to grips with this emerging asset class.

The latest iteration has come from the US Treasury Department, who in mid-December launched a proposal for a rule that will require centralized exchanges to obtain Know Your Customer (KYC) information for any transaction from their platforms to a private wallet. Under this new rule, users will have to provide details of the recipient of any transaction to a private wallet that is greater than $3,000. In addition, the exchange would be required to report transactions exceeding $10,000 per day to the Financial Crimes Enforcement Network (FinCEN).

DeFi resists regulation

Should the rule pass, it would have an enormous impact on DeFi — the very foundation of which is its anonymity and easy interoperability between protocols. Many of the leading protocols in DeFi are run entirely through smart contracts with no governing management, while the wallets used to interact with them do not require user information. These include the popular Web3 wallet MetaMask, which is merely an extension built into a web browser that allows users to move money around the DeFi ecosystem freely.

Much of DeFi is, effectively, an interconnected web of computer programs that many believe simply couldn’t operate under traditional financial regulation that requires vast centralized systems to collect and store KYC information and administer anti-money laundering processes. As such, the latest proposed rule from the US has been met with condemnation by many in the DeFi community as, should it pass, it could effectively mean the end of large chunks of the ecosystem.

Global action on cryptocurrency

While the politics of an outgoing US administration attempting to force a significant piece of legislation over the line before another (perhaps more sympathetic) one takes over is not lost on anyone, the US Treasury’s move is not out-of-step with its global peers. In fact, it is much in line with action from the Financial Action Task Force (FATF), which last year recommended its members implement a rule that requires “virtual asset service providers” (VASPs), including cryptocurrency exchanges, to pass-on customer information when they transfer assets between themselves on behalf of the customer.

Known as the “travel rule”, this has been a common requirement of banks for a number of years, and means crypto asset holders must pass the name and details of customers moving money to another platform to the receiver. However, while this measure is a frequent feature of traditional finance, it is onerous for smaller cryptocurrency exchanges not equipped with the same administrative power as banks. Moreover, there are various issues with the definition of a VASP, which the FATF has indicated could mean an individual, depending on the nature of the transaction and the interpretation of each member’s jurisdiction. Recently, the industry has been working to find a technology solution that would satisfy the FATF member states’ compliance for information exchange, although it has not yet fully developed and is still coming together.

While these rules are scary enough for some DeFi users, there could be more to come from the EU, which has launched a crypto-specific consultation. The European Commission is exploring a number of wide-reaching changes to its existing financial services regulations to cover the DeFi space, including amendments to clarify when crypto assets can be deemed as ‘financial instruments’. The Commission is also considering creating a regulatory regime for distributed ledger technology (DLT) tokens (aka DeFi tokens) as well as a bespoke regime for all crypto assets not covered under existing regulation.

Self-regulation as a solution

Is regulation in the DeFi space an unjustified intrusion by central authorities, however? For some, the answer is a resounding “yes”. For others, though, the scams and flash loan exploits that are becoming an increasingly common feature of DeFi are a warning sign showing some regulation is needed in this $16 billion market. Even without foul-play, token launches are now attracting hundreds of millions of dollars, such as the notorious spaghetti.money launch of August that prompted founder of Compound, Robert Leshner, to call for the introduction of self-regulation in the industry. And then, lest we all forget, there was YAM: a ‘stablecoin’ that surged to $167 and plunged to nearly $0 all within 48 hours after a bug was found in the smart contract.

Some steps have been made toward self-regulation. The meltdown seen at Maker in March due to huge selling pressure caused by the global COVID-19 pandemic, for example, prompted a governance overhaul that has spread throughout the space, with users increasingly participating in the governance of their platforms. Flash loan exploits have also led to greater scrutiny and auditing of smart-contracts, as well as cross-protocol collaboration on remuneration and the further development of insurance products. What is yet to appear though, and which could be useful in fending off the regulators, is a set of industry-wide rules, auditing processes and risk planning that could anticipate crashes and crises before they happen.

Safe, forward-thinking innovation

As exciting and promising as the DeFi space is, it does need to be safer and, as regular readers of our blog and users of our app will know, this is a prime concern for YIELD App. Our platform was founded with the current risk and inaccessibility of much of the DeFi ecosystem in mind, which is why we have sought to create a streamlined product that can take users on the DeFi journey from depositing fiat currency right through to withdrawals. This is all without the need to become entangled in the often complex web of DeFi platforms and protocols, and all while getting market-beating returns.

Founded by a team of FinTech veterans, we are also confident that our product would stand up to scrutiny, and we welcome any regulation that can make the space safer for inexperienced users, which every DeFi protocol should be striving for. The key will be to ensure that innovation is not stifled, as that is the lifeblood of DeFi and cryptocurrency as a whole. Decentralized finance is and should remain a place where developers can be free to create cutting-edge products that offer genuine solutions to users.