Bridging Policy and Practice: A Pragmatic Approach to Decentralized Finance, Risk, and Regulation

Abstract

Confronted with a Hobson's choice of either implementing stringent enforcement of uncertain regulation or geo-fencing the United States, it's become paramount for regulators and stakeholders to consider collaborative alternatives for shaping the future of decentralized finance (DeFi). Championing collaboration, this paper emphasizes the need for all DeFi stakeholders, from intermediaries to builders, to proactively enhance transparency and risk management, irrespective of regulatory dictates.

Starting with its formation in the 1930’s, this paper explores the evolution of the SEC's initial technology forward approach to the regulation of intermediaries and disruptive technologies. The 2008 financial crisis marked a shift by both the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) towards regulating disruptive technologies, like automated trading and digital assets, as potential threats to financial stability. This shift resulted in a more reactive top-down regulatory approach towards emerging technologies that disincentivizes innovation. This underscores the need for early collaboration to ensure that regulation is better informed by market and technological realities.

DeFi offers an opportunity to reconsider that approach by pursuing achievable initiatives aimed at bolstering transparency and risk management. Public private collaborations are explored as a reasoned alternative to a blunt application of the “same risk, same rules” paradigm to DeFi. In contrast, the proposed collaborative approach would foster actionable risk mitigation practices and resilience through a more informed process, despite the increasingly hostile regulatory approach to DeFi.

This paper delves into the possibilities for innovative AML verification and risk processes for DeFi as part of an open collaborative approach. It also evaluates potential adaptations of existing SEC and CFTC rules and guidance to diligence, risk management, and pre-transaction, smart contract-encoded controls for institutional users of DeFi.

As envisioned, pursuing this path would have far reaching benefits for the DeFi ecosystem by enhancing outcomes for both regulators and stakeholders, striking a balance between regulatory objectives, risk management, and innovation, while reducing the need for stringent enforcement and facilitating a more effective enforcement paradigm.

Keywords: Decentralized Finance, digital assets, DeFi, crypto, risk management, financial regulation, SEC, CFTC, AML, Fintech, Systemic risk, permissionless, policymaking, bottom-up, top-down, Innovation, Automated Trading

JEL Classification: G28, G18, K22, K23, O31, O33, O38, G15, G32, L86