DeFi regulation enters the rule-making stage

With the DeFi market approaching the US$200 billion level, money laundering and investor losses using DeFi are attracting the attention of authoritative financial regulators in various countries and even internationally.

Although DeFi has always defined itself as “decentralized finance”, the regulatory authorities do not recognize that such financial services or applications running on the blockchain are truly decentralized-behind them, there are often entities that control or influence applications. Or natural person. Therefore, how to define DeFi and identify its controller identity is becoming the key to regulatory rule-making and implementation actions.

In October this year, the international organization “Anti-Money Laundering Financial Action Task Force (FATF)” updated its 2019 virtual asset and virtual asset service provider (VASP) risk-based Methodological guide. In the latest version of the guidelines released on the 28th, FATF recommends that member states identify the attributes of DeFi based on “control or influence”. When a DeFi application actually has a person with control or sufficient influence, the jurisdiction should use VASP Define it and include it in the anti-money laundering obligations.

On November 1, US SEC Commissioner Caroline Crenshaw published a signed article “Statement on the Risks, Regulations and Opportunities of DeFi” in an international journal. She said from the standpoint of protecting investors that DeFi provides a lot of investment opportunities. , But this “unregulated market is subject to structural restrictions”-lack of adequate information disclosure, and DeFi smart contract owners are anonymous, which makes DeFi an unfair market that is easily manipulated, and retail investors often become Victims of the market. Crenshaw called for the DeFi community to solve the problems of transparency and anonymity, and called for cooperation with the SEC to explore a path to compliance.

Prior to this, the FSA of Japan’s Financial Services Agency has set up a special department to monitor DeFi. The report released hints at the intention to include DeFi in the regulatory system to prevent money laundering, price operations, and protect local investors.

Regulatory agencies with different functions have different regulatory directions for DeFi, but it can be seen that their understanding of DeFi is deepening, and the regulation of this emerging financial category has also begun to enter the stage of “ruling.”

FATF uses VASP to define DeFi and include anti-money laundering obligations

FATF is the abbreviation of the Financial Action Task Force on Anti-Money Laundering. Founded in 1989, it is one of the most authoritative international organizations to combat money laundering. It aims to study policies to combat money laundering and fund terrorist activities, and coordinate various countries to combat money laundering. The unit. Currently, FATF has 38 member states, including China, the United States, the United Kingdom, France, Germany, and Japan, all of which are members of the working group.

In October of this year, the FATF’s “Updated Guidelines for Risk-Based Approaches for Virtual Assets and Virtual Asset Service Providers” (hereinafter referred to as “Updated Guidelines”) carried out new updates on virtual assets and digital currencies such as DeFi, CBDC, stablecoins, and NFTs. definition. In 2019, in order to combat illegal financial activities in the encrypted asset market, FATF issued guidelines on virtual assets for the first time, defining encrypted asset exchanges and wallet providers as virtual asset service providers (VASP). These service providers should meet the requirements for traditional The standard of financial companies is to collect detailed identity information of the initiators and beneficiaries involved in transactions in order to fulfill their anti-money laundering obligations.

DeFi regulation enters the rule-making stage

The new FATF guide reinterprets DeFi

The “Updated Guidelines” guides the regulatory framework for each member country to VASP and VA (virtual assets) as the main targets, and emphasizes that countries should not formulate regulatory frameworks based on the technical terms, operating modes, and operating functions described by VASP and VA themselves. Instead, it looks at whether they provide basic financial services as the standard.

In the “Updated Guidelines”, DeFi agreements with control or influencers are recommended to use VASP definitions to consider regulation.

FATF pointed out that the exchange or transfer service of virtual assets is taking place in the technology of “decentralized exchange platform”. Although this type of platform runs on the blockchain in the form of software, called DApp, it usually has a participation or control. The central party of the DApp, such as creating and launching virtual assets (VA), developing DApp functions and user interfaces for accounts holding management keys, or charging fees. Generally, users need to pay a fee expressed in VA to interact with DApps. Such interaction will ultimately bring benefits to the owner/operator/developer/community. DApps can promote or guide the exchange or transfer of various VAs, and those DApps that provide financial services usually use the term “Decentralized Finance (DeFi)”.

According to the FATF standard, the DeFi application (ie software) itself is not a virtual asset service provider (VASP), but the “Update Guide” points out that those creators, owners and operators who maintain control or sufficient influence in the operation of DeFi applications Such subjects or natural persons may also fall into the FATF’s definition of VASP, that is, they are providing or actively promoting VASP services. Then, each jurisdiction should use VASP to define DeFi applications, regardless of its own so-called “decentralized” description. DeFi defined as VASP should meet the AML/CFT anti-money laundering obligations.

One difficulty is that the creators, owners, and operators behind the current DeFi applications are usually anonymous, so how can jurisdictions identify these “people” who maintain “control or sufficient influence” in the operation of DeFi applications?

The “Update Guide” explains that if it is impossible to determine the legal or natural person that has control or influence over the operation of DeFi, there may not be a central owner or operator that meets the definition of VASP. Countries should monitor the risks posed by DeFi services and operations in such situations, including contact with representatives of their own DeFi communities. If necessary, risk mitigation measures can be taken before DeFi starts the service or during the process of providing the service. For example, in the absence of a certain VASP, countries can consider choosing to require regulated VASPs to participate in DeFi activities in order to comply with the country’s RBA (risk-based mitigation method) or other mitigation measures. Countries can also consider the ML/TF (anti-money laundering/anti-terrorism) methods specified in this guide and the risk mitigation measures related to P2P (peer-to-peer finance).

“DeFi activities will not disappear, but they may shrink, just like the booming initial coin offering (ICO) stage a few years ago.” After the FATF’s “Updated Guidelines” came out, it focused on US national security and anti-money laundering issues. Yaya J. Fanusie, chief strategist at Cryptocurrency AML Strategies, believes that the rise of new DeFi platforms may slow down in 2022; regulators and blockchain entrepreneurs may “control or influence” various DeFi agreements Controversial legal battles are launched on this key point; many organizers of the DeFi platform may also begin to accelerate their attempts to achieve true decentralization, for example, trying to remove the on-chain and off-chain links between specific individuals and the platform; they do not follow AML The DeFi platform required by /CFT will be regarded as a higher-risk enterprise and will be attacked by the regulatory authorities of the jurisdiction.

U.S. SEC Commissioner Calls for DeFi to Solve Transparency and Anonymity Issues

This time, the “Update Guide” was jointly completed by FATF global members and FATF-like regional institutions (composed of more than 200 jurisdictions), including the Financial Services Agency of Japan, the French Financial Market Authority, the Monetary Authority of Singapore, the U.S. Department of Treasury, and United States Securities and Exchange Commission (SEC). It can be seen that in countries where the crypto asset market penetrates more widely, their financial management departments have paid great attention to money laundering in this emerging market. As DeFi is included in the guidelines, anti-money laundering departments will pay more attention to this area. .

In addition to money laundering involving encrypted assets, financial regulators in various countries are also paying attention to the risks that DeFi brings to investors. In July of this year, the Financial Services Agency of Japan stated in a report that it had established a special research department to monitor DeFi to respond to the protection of local investors, which seems to have the intention of regulating DeFi.

On November 1, the SEC Commissioner Caroline A. Crenshaw published a signed article “Statement on DeFi Risks, Regulations, and Opportunities” in the International Blockchain Law Journal, which was also published on November 9 Upload to the official website of the SEC. For the encryption industry and its practitioners, it is not difficult to see the SEC’s in-depth understanding of DeFi from this article.

DeFi regulation enters the rule-making stage

US SEC Commissioner wrote an article explaining the risks, regulations and opportunities of DeFi

Crenshaw pointed out in the article that many DeFi products are very similar to the products and functions in the traditional financial market. The decentralized applications DApps running on the blockchain enable people to obtain assets or loans after issuing collateral. Like a traditional mortgage.

“Investment is usually the core of DeFi activities.” Crenshaw believes that these activities on DeFi are not only the development of new digital asset tokens, but also the development of smart contracts that enable individuals to invest, use these investments, and take various measures. This kind of derivative positions and the quick and easy transfer of assets between various platforms and protocols… “The development of DeFi is particularly impressive, but these products are not just products, and their users are not just consumers. , DeFi is fundamentally about investment.”

Crenshaw bluntly pointed out that in DeFi, investment includes the speculative risk of seeking passive profit from the expected token price appreciation, as well as putting capital at risk or locking in the interests of others for the return of investment.

In the traditional financial market, when raising funds from investors or providing regulated services and functions to investors, market participants usually have to bear legal obligations, “but many DeFi promoters may try to deny these legal obligations.” Crenshaw said, Although all parties in the market are emphasizing that DeFi is risky and investment may cause losses, the DeFi promoters did not disclose the detailed information needed to assess the likelihood and severity of risks for investors. “If there is no mandatory disclosure requirement, information asymmetry may be possible. It will benefit wealthy investors and insiders at the expense of the smallest investors and the least informed investors.”

In Crenshaw’s view, DeFi has two major structural obstacles: lack of transparency and anonymous operation.

“I am worried that this lack of transparency will lead to a two-tier market in which professional investors and insiders get huge returns, while retail investors take more risks,” Crenshaw pointed out. This opacity includes venture capital on the one hand. The letter and approval of professional investors in the DeFi project is not sufficient, which brings about the inequality between their investment rights and retail investors; on the other hand, DeFi applications run on the chain in code, and professional investors have more advantages than retail investors. More and more professional resources and costs are used to evaluate the security risks of the code. Most retail investors find it difficult to understand and read the code. They can only rely on marketing, advertising, word of mouth and social media to obtain investment information. Comparing the two, the latter obviously did not get a fair market opportunity.

In addition to the lack of transparency, Crenshaw also believes that although DeFi’s on-chain transaction records are immutable and available for everyone to view, the anonymization of DeFi smart contract developers or controllers and the anonymization of traders has aggravated the manipulation of transactions. “For example, one person uses a robot to operate multiple wallets, or a group of people collude in transactions.” She believes that the trading market usually affects asset prices and trading volume, and pseudonyms and anonymity make it easier to hide manipulation activities. Investment It is almost impossible to distinguish individuals engaged in manipulative transactions from normal organic trading activities, and it is easy to suffer losses due to manipulative transactions.

As a member of the SEC, Crenshaw also called on the DeFi community to solve the problems of transparency and anonymity in the article, and called on the community to cooperate with the SEC to discuss compliance development. “It is not enough to say that regulation is too difficult or compliance with regulations is too difficult. Many projects express that they want to operate in DeFi in a compliant manner. This is a positive sign. I believe in their sincerity on this point and hope that they In the same spirit, invest resources and cooperate with SEC staff.” She said that in a decentralized network with decentralized control and different interests, regulations can help create common incentives to benefit the entire system and ensure Participants with the least power get a fair chance.

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