Amid all the ETF news that has dominated headlines in recent weeks, the extensive DeFi report released by the U.S. Commodity Futures Trading Commission in early January hasn’t received enough attention.
Most news coverage focused on the report’s recommendations on implementing identity and anti-money laundering practices, but this was only part of the document’s broad scope.
Developed by the Commission’s Subcommittee on Digital Assets and Blockchain Technology, the 79-page report delves into the risks presented by the emerging decentralized financial system.
Particularly revealing is his assessment of how effectively these risks can be addressed within the confines of regulation using multiple levers of decentralization.
The prevailing view, even within the cryptocurrency world, is that DeFi will have to clean itself up and accept regulation. And in light of the overall direction of the cryptocurrency industry, regulation of some kind truly seems inevitable.
But this report appears to go a step further, finally stating that permissionless innovation is an inherent trade-off if the broader benefits of DeFi are to be discovered and exploited.
DeFi founders must be willing to embrace the full scope of decentralization in their projects as a way to increase resilience and mitigate regulatory risk. This idea runs counter to the prevailing perception in DeFi that decentralized projects face the greatest regulatory risks. Indeed, handing over every aspect of control to a decentralized community while embracing decentralized infrastructure and partners will demonstrate that the project does not contravene established regulations.
Recommended reading for founders
Although aimed at politicians, this report should be recommended to all DeFi founders. The CFTC report proposes a framework capable of evaluating DeFi protocols and specific risks not found in traditional finance, such as code vulnerabilities or pull pulls.
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Using the objective framework of the report, the founders were able to analyze the extent to which their projects are effectively decentralized in all their different parts. While governance and token ownership are well-established levers of decentralization, in practice development and operations are often more centralized and dependent on only a few companies for infrastructure and construction activities.
The CFTC report also provides insight into the numerous areas where regulators believe DeFi presents financial risks, which can be interpreted as regulatory weaknesses for DeFi protocols and founders.
Our industry tends to obsessively focus on know-your-customer (KYC) as synonymous with compliance, often at the risk of oversimplifying the complexity of regulatory exposure. In this regard, founders can also use the report as a way to view their project through a regulator’s lens and see where they actually fall behind in compliance.
No hard lines
Ultimately, the multiple dimensions of decentralization make it impossible to present a hard line when determining whether a project is “sufficiently” decentralized. Here, founders and regulators share the same challenge.
However, deciding where to draw the line is not simply a matter of eliminating risk. Going too far with DeFi regulation could be harmful if it risks stifling innovation, and governments will be keen to reap as many benefits as possible, which could mean accepting some risks.
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Founders may also need to reconsider their ideas of personal and professional success, as the presence of a founder with sufficient control over other token holders will be an indicator of centralization. So while career success in DeFi is likely to come with its own merits, it may have to take a different trajectory than the rock star billionaire founders who dominate centralized tech companies.
Furthermore, the decentralization of control carries the risk that the community may decide to act against the interests of the founder or even against the project itself (one such case is AragonDAO, which previously voted to sue its founders, the Aragon Association – one of the factors that led to its collapse last year).
The report’s call to action for DeFi founders is to establish and cultivate truly decentralized systems that best showcase the strengths of decentralization.
Since regulation of DeFi could be a possibility in the future, better collaboration between the industry and policymakers is undoubtedly a positive move. Fully decentralized innovation will remain the key driver of the ecosystem for the foreseeable future.
Rishabh Gupta is the director of operations at TDeFi, a Web3 incubator and consultancy dedicated to driving the adoption of Web3 technologies. TDeFi has successfully guided 60 companies through the token markets, of which three have reached a market capitalization of $1 billion. Rishabh’s experience extends to advising over 70 token companies in designing a sustainable token economy, creating token supply curves, and assisting 5 VC funds and 500 angel investors in deploying capital within the token startup space.
