We discussed the difficulties of developing long-term laws for decentralized finance (DeFi) protocols earlier this week. These systems allegedly exclude intermediaries from the trade of any asset represented on a blockchain, but for the greater part of a century, those intermediaries have been the ones enforcing rules on behalf of regulators. As a result, practical DeFi regulation will most likely diverge significantly from current securities and finance legislation in terms of substance and enforcement.
Although the rethink may take years, regulators in the United States aren’t waiting around. With SEC Chairman Gary Gensler hinting that he’s paying attention, there’s a good chance that enforcement proceedings will be taken against DeFi well before any new regulations are finalized. Those enforcement actions are likely to emphasize cases of clear lawbreaking on DeFi networks, such as fraud or money laundering.
They will be important tests of decentralization’s legal ramifications. And things could get really ugly – especially for people operating “DeFi” systems that aren’t all that decentralized.
Three significant points regarding how things are likely to play out in the coming months and years, based on interviews with lawyers, former regulators, and DeFi executives.
New rules will come after enforcement
The first and most unpleasant truth of DeFi regulation is that it will always be too late. UniSwap and Celsius were created in such a way that they question the core foundations of traditional financial regulation, but regulators will be slow to adjust their models to reflect reality. Meanwhile, DeFi systems are becoming more popular, ensuring that they will be scrutinized more.
Jai Massari, a lawyer at Davis, Polk and Wardwell who focuses on trade and markets, expects a three-step procedure to reconcile such contradictory information. It’s known as the Regulatory Grieving Stages.
“I believe enforcement should come first,” she argues, “since enforcement is easier than regulation.” These efforts could be similar to recent proceedings that resulted in hefty fines for crypto exchanges such as Kraken and services such as Tether. They could, however, go even further and include criminal charges against individuals, as discussed further below.
Then, according to Massari, “we’ll see an effort [by authorities] to force these DeFi operations into established regulatory categories.” “However, I don’t believe that will work out. I believe it will be a shambles.”
To put it another way, she doesn’t expect serious consideration of a new regulatory framework that genuinely fits how DeFi works until regulators have spent time hammering square pegs into round holes. In the United States, this could entail legal battles between the Securities and Exchange Commission and other financial regulators.
Putting enforcement ahead of legislation will be viewed by many crypto operators as closing the barn door after the horse has escaped. To some extent, it’s a result of a new administration’s shifting goals. Between 2016 and 2020, as crypto and DeFi rose from marginal to significant, Trump administration authorities made only gradual headway in laying out rules, for better or worse.
There are indicators that regulators believe things are getting out of hand. “It looks [Gary Gensler] is associated with folks like [Massachusetts Senator] Elizabeth Warren who believe it’s the wild west, that it’s under-regulated,” says Katherine Kirkpatrick, co-chair of King & Spalding’s Financial Services working group.
In other words, Gary Gensler and his colleagues regard themselves as attempting to lasso a racing steed. As a result, extra-vigorous enforcement measures may be used.
“They’re operating from the standpoint of attempting to tackle the most egregious thing going on with typical law enforcement instruments,” says Duane Pozza, a former FTC official who is now a partner at Wiley Law. “Because it implies that there will be less restrictions.”
Decentralization’s “veil” will be “pierced” by investigators
DeFi protocols, in theory, function without the presence of owners, leaders, or managers. The protocols, like Bitcoin, are essentially just software that is managed by a group of node operators or validators that neutrally support transactions while earning liquidity yield and fees.
Users might, in theory, manage governance decisions, including changes to the protocol itself. However, there are few examples of this in practice today; instead, “DeFi” is frequently used as a fig leaf for a small group of powerful leaders who are actually in authority. The clearest evidence of this is the freezing or shutting down of accounts, coins, or entire “decentralized” networks.
“Whether or not there is a kill button is one of the design options in an autonomous system,” says Stephen Palley, a lawyer at Anderson Kill who focuses on crypto legislation. “The issue with a kill switch is how much culpability or exposure does the person who controls it have?” You can’t have a kill switch if you want to be genuinely autonomous. It’s a way of saying you’re not responsible if you don’t have that.”
The imminent confrontation of DeFi with legal reality has a cruel irony: DeFi administrators who have been taking direct action to curb harmful activity may have given law enforcement concrete evidence that they are in command, making them targets.
Experts think this could lead to regulators and investigators “piercing the veil” in their DeFi enforcement activities, especially in circumstances where there is no legal organization associated with a DeFi platform. “Piercing the veil” is a legal term that refers to corporate misbehavior prosecutions that target individual company officers rather than the formal corporation itself.
The readiness of the SEC and others to pierce the curtain of crypto organizations, even those with traditional corporate structures, has been demonstrated in at least two recent crypto prosecutions. One was the SEC’s charge of unregistered securities offering against individuals at Ripple, including CEO Brad Garlinghouse. The other was the filing of criminal accusations against BitMEX executives, including CEO Arthur Hayes, for money laundering.
Similar direct action against people who have influence over DeFi equipment could be on the horizon. SEC Chairman Gensler has already stated that he is skeptical of most claims of decentralization in DeFi. Law enforcement may search for evidence of control and accountability in public representations of a protocol’s team, or control of multisig wallet keys, in addition to kill switches.
Clarity will take a long time to arrive
It will be extremely difficult to develop regulations that limit dangers such as fraud and money laundering while keeping technology benefits like as open access, self-custody, and democratic governance through DeFi. If new laws are correctly drafted, it may be worth the trade-off in the long run.
“We’re at a point where some enlightened regulatory thinking, a little inventiveness, and a little open-mindedness might result in a far better outcome,” Jai Massari says. “I believe the best approach is to take a step back and consider the policy goals we’re pursuing.”
It’s possible that this process will take years. Meanwhile, enforcement efforts are likely to increase, potentially putting DeFi inventors and administrators in the awkward position of defending themselves against rules that can’t be applied equitably to the new technology.
Even then, there’s no guarantee that the end result will be competent and well-considered regulation. There is still a big technical knowledge gap among legislators and regulators, as we witnessed this summer with the poorly written reporting requirements in the US infrastructure bill, and it can have serious implications.
“There’s a substantial technology gap,” argues Duane Pozza. “The legislators are preoccupied with a slew of other issues. We’re still a long way from grasping the concept of DeFi. I believe the infrastructure bill served as a wake-up call, requiring at least some powerful individuals on [Capitol] Hill to understand and think about this new technology.”
This creates an uneasy situation, at least for those who work in the world’s largest financial market. There will be no adjustments to US banking legislation to accommodate the way DeFi really works for a period of time that could last years. At the same time, law enforcement and regulators will almost certainly make anyone with authority or control over DeFi systems feel extremely uncomfortable.
Unless something changes quickly, this will almost probably drive DeFi innovation outside of the United States, just as large, centralized crypto exchanges like Binance and BitMEX have found it more convenient to base their operations overseas. At least some would-be artists are receiving this warning straight from their legal counsel.