The State of DeFi Regulation

Since the earliest days of financial regulation in seventeenth century Holland, authorities have enacted laws to protect consumers and aid financial stability. Today, these objectives are reflected in an overlapping framework of global and local standards.

Digital assets (and particularly DeFi) don't slot neatly into this existing framework. So as the new blockchain-based economy grows, we are seeing regulators create another layer of definitions and approaches to govern this new technology.

On the one hand, progressive lawmakers are promoting the adoption of cryptocurrency networks; recognizing that the qualities of transparency and accountability expressed in blockchain-based infrastructure reflect the ethos of pivotal regulations like MiFID and the Dodd Frank Act.

Other efforts are aimed at balancing innovation with the need to protect society and promote financial stability. This includes legislation designed to hold crypto organizations to the same standards as banks, however, this becomes challenging when radically new approaches emerge such as DeFi.

Implementing global regulatory standards to govern a borderless blockchain-based economy is not easy to do. But just as the G20 in 2009 helped shape jurisdictional outcomes towards a harmonized global plan of action, we are now seeing supranational bodies publish papers and guidance promoting shared standards for digital assets. Though inconsistent interpretations of this regulation are already giving rise to regulatory arbitrage, and where the final text lands is still somewhat uncertain.

Below are some key pieces and proposals that are shaping tomorrow's global  regulatory landscape. We’ll keep this updated, so please keep coming back.

The Travel Rule, FATF

In June 2019, global money laundering watchdog the Financial Action Task Force (FATF), amended Recommendation 16, commonly referred to as the Travel Rule, to include virtual assets and exchanges.

Originally designed to assist with anti-money laundering (AML) and counter terrorist financing efforts, the Recommendation requires financial institutions to keep an information trail including names, account numbers and physical addresses for any transfers above $3,000 of cash or crypto.

Implementation of the requirements was reviewed in June 2020, and <span>35 out of 54</span> regional jurisdictions met the revised standards. Others have responded by delisting privacy coins, and some have been blocked from compliance by infrastructural challenges.

With only a few months left before the second review in June 2021, the race is now on to provide a unified infrastructure for sharing transaction information between virtual asset service providers (VASPs), including exchanges, brokers and custodians, and across borders.

Markets in Crypto Assets (MiCA), European Commission

This proposal from the European Commission sets out an elaborate framework that would bring all cryptoasset activity under the purview of EU regulators.

The regime would regulate exchanges, custodians, clearing houses, and firms providing investment services under the broad classification of crypto asset service providers (CASPs). All CASPs in the EEA would be held to these shared standards, along with projects based elsewhere wanting to operate or serve customers in the EU.

Under the regulation, all projects serving a European audience would need a registered legal entity in the EEA. This could pose a challenge for DeFi projects which operate globally on decentralized blockchains.

For issuers of crypto assets, the regulation introduces new shared standards. Issuers would be obligated to incorporate as a legal entity, and comply with certain marketing and infrastructure requirements. Stablecoin issuers (issuers of asset-referenced tokens and e-money tokens) would be held to even higher standards.

Perhaps most significantly, the proposals could impact one of the biggest innovations of crypto: the ability to raise funds. They would put a <span style="font-size: 24px; color: #202124;">€</span>1M euro limit on raising funds with just a whitepaper, requiring additional compliance for anyone raising more than this over a 12 month period.

Looking ahead, the commission's expectation is that MiCA will be enacted within the next four years, giving cryptocurrency organizations considerable time to prepare for compliance.

Liechtenstein Blockchain Act

Alpine blockchain hotspot Liechtenstein enacted the Token and Trusted Technology Service Provider Act (TVTG), also known as the Blockchain Act, on January 1, 2020.

Unlike the efforts of  neighbouring countries like Switzerland and Germany, Liechtenstein's pioneering legislation does not merely supplement existing regulations, but lays down an entirely new legal foundation for the token economy.

The term “token” is introduced as a new legal concept anchored in "The Token Container Model", which considers tokens to be a virtual container that can hold rights of all kinds. All of the key stages in the token life cycle — including generation, safekeeping, and transmission — are defined as clear processes, and the firms and actors responsible are held to specific requirements.

For Liechtenstein, the legislation offers much-needed legal security for token issuers, and protections for participants in token economies. These measures are likely to help the tiny nation carve out more of an outsized presence in the global token economy, and establish legal precedents that could soon be replicated elsewhere.

The Wallet Rule, FinCEN, U.S.

Proposed requirements from the Financial Crimes Enforcement Network (FinCEN), nicknamed the Wallet Rule, would subject all crypto wallets, even 'self-hosted' wallets or wallets held at non-U.S. institutions, to KYC and reporting requirements for transactions greater than $3,000.

Unsurprisingly, the proposals were met with widespread condemnation. They would create burdensome ID verification and record-keeping obligations for exchanges, and throw DeFi into a legal grey area. Undefined terminology like "unhosted wallets” was also lambasted for failing to reflect commonly used terms.

At present, the proposed rulemaking period is <span>due to close</span> early this year, and feedback is set to be reviewed under new Treasury Secretary Janet Yellen.

The STABLE Act, U.S.

Proposed by three U.S. congressional representatives in Dec 2020, the Stable Act is thought to be a reaction to Facebook's Diem (Libra) and other stablecoins. The proposed legislation was met with significant backlash, but doesn't appear to be a priority, and many suggest it won't be passed.

Critically, the proposals would require that any blockchain supporting stablecoins be licensed. Stablecoins could only be issued by "an insured depository institution that is a member of the Federal Reserve System"  — i.e. a bank.

Payment Services Act (Amendment), Singapore

The Payment Services Act, which came into effect on 28 January 2020, regulates crypto trading platforms Under the Monetary Authority of Singapore (MAS).

This was expanded in January 2021 to hold all “Digital Payment Token” (DPT) service providers  to strict new <span>AML/CFT compliance requirements</span>. DPT service providers include all entities facilitating the transmission, exchange or storage of crypto assets — aligning Singapore's regulation with international standards like the Travel Rule.

Taking one step further, MAS has finished a public consultation period for a "New Omnibus Act for the Financial Sector" that proposes extraterritorial regulation for DPT service providers. This would give MAS the ability to supervise entities based in Singapore that conduct business outside of the country, and the power to prohibit entities deemed unsuitable from conducting business in Singapore.

The regulation doesn't clarify a stance towards DeFi protocols, but it is possible that projects could be required to apply for a license.

Financial Transactions Reporting Act (Amendment), South Korea

Following Singapore, South Korea amended its Financial Transactions Reporting Act (FTRA) on March 4 2020 to hold all VASPs to the recommendations outlined in the Travel Rule.

Whether or not DeFi projects fall under the classification of VASP remains subject to widespread debate, though guidelines suggest that DeFi projects could be considered VASPs if they generate revenue as an intermediary.

Interpretive letters, Office of the Comptroller of the Currency (OCC), U.S.

During his tenure, former OCC Chief Brian Brooks published three interpretive letters that represent guidance for the traditional financial industry, particularly national banks.

• Interpretive Letter #1170, published on July 22, 2020, said national banks can custody crypto assets.

• Interpretive Letter #1172, published on Sept. 21, 2020, said national banks can hold stablecoin reserves.

• Interpretive Letter #1174, published on January 4, 2021, said national banks can run blockchain nodes and use stablecoins for payments.

These letters lay the groundwork for blockchains to replace traditional financial rails, paving the way for the convergence of crypto assets and mainstream banking.

Brooks, who also wrote of the need for new policies to regulate DeFi's "self-driving banks", has since been replaced by former Ripple advisor Michael Barr, and hopes are high for more crypto-friendly guidance from the OCC in 2021.

Looking Ahead

Moving into 2021, cryptoasset organizations should be prepared for more upheaval as the rapidly growing decentralized economy grows too large to fly under the regulatory radar.

At the same time, the need for technical infrastructure for sharing transaction information is likely to become more pressing as crypto-native organizations struggle to comply with existing regulations that were originally designed for banks.