In a crackdown on decentralised finance, securities markets global standard-setting association the International Organization of Securities Commissions (Iosco) has published a consultation report aimed at finalising its policy recommendations to address market integrity and investor protection issues in decentralised finance (DeFi) by the end of this year.
Iosco makes nine recommendations in its report, which include the promotion of cross-border co-operation and information sharing, the enforcement of applicable laws and the requirement for clear, accurate and comprehensive disclosures and a requirement to identify and address conflicts of interest in applying existing or new frameworks.
Q: Who stands to benefit most from regulation of DeFi?
A: Regulation can be seen as a type of administrative or compliance cost. In theory, regulation creates barriers to entry and will lead to an equilibrium where more productive blockchain companies and stablecoin issuers remain, whereas less productive companies will find it less profitable to continue.
Q: What are the negatives?
A: Regulation can potentially stifle innovation and may lead to start-ups moving to jurisdictions that are not regulated.
Q: Do you expect regulation to address widespread prevailing security and fraud issues over DeFi?
A: Activity-based regulation involves setting up a node on an Ethereum blockchain and recording all transactions that take place, at a wallet level. Although wallets are pseudo-anonymous, it is possible to set up algorithms to trace a transaction history and to identify cases of fraud. The question is whether the regulation works in terms of limiting fraud as there are always jurisdiction issues in blockchain technology, and difficulty in tracing wallets to a legal entity and their location.
Q: Do you know of any examples/stats of recorded cases of investor harm arising from participation in the DeFi market?
A: There are some famous hacks of decentralised autonomous organisations where funds are syphoned. Other risks include governance risk (example: crypto whales manipulating votes in protocols), and oracle risk, which is when data feeds are inaccurate which are the inputs into smart contract applications.
Q: Do you expect regulation to have a significant impact on DeFi market abuse?
A: Based on my prior answer I think it will be quite limited at reducing fraud based on jurisdiction and identity issues.
Q: Are there any risks the regulation will fail in its aim of maintaining transparent levels of capital?
A: Transparent levels of capital are more applicable to stablecoin issuers. In general the level of capital or “total value locked” in DeFi applications is known publicly on the blockchain. So maintaining capital requirements is more important for centralised entities like stablecoins.
Q: What measures do you hope or expect the regulator to take to strike the right balance between regulating DeFi and stablecoins?
A: Regulating stablecoins is more useful as they are a direct link to traditional markets, as the principal issuers Tether and USDC hold US dollar assets, such as US Treasuries. Stablecoins are more important to regulate because loss of credibility of an issuer can lead to losses on their dollar assets. Fire sales of their dollar assets to meet redemptions can have price impact in traditional asset classes. In contrast, losses in DeFi markets are more likely to be self-contained without any contagion or spillover effects to traditional markets.
Q: Which of the nine Iosco recommendations would you like to see pursued, and why?
A: Based on my reading of this Iosco report, I trust in four recommendations based on my prior points:
- analyse DeFi products, services, arrangements, and activities to assess regulatory responses;
- achieve common standards of regulatory outcomes;
- promote cross-border cooperation and information sharing; and
- understand and assess interconnections among the DeFi market, the broader crypto-asset market and traditional financial markets.
Q: What is your overall view of the proposed regulation?
A: The crackdown on decentralised finance is a significant step in the evolving landscape of cryptocurrencies and digital assets, and it remains essential to strike a balance between innovation and regulation to ensure the long-term sustainability of the DeFi ecosystem.
Transparency and collateralisation can be key factors in ensuring stability, and regulatory bodies should look to possibly mandating stablecoin issuers to maintain transparent levels of capital and conduct scheduled audits to ensure adequate collateral.
The future of stablecoins and DeFi will likely depend on the maturity of individual economies and payment markets. Ultimately, the responsibility lies with authorities to navigate a path forward that fosters innovation while safeguarding the interests of investors and the stability of financial markets. Striking the right balance in regulating DeFi and stablecoins is a complex but necessary task in the evolving world of digital finance.
