Thoughtful Laws Will Empower Decentralized Finance
Article by Joshua Kaycè-Ogbonna Cover Art by Dippudo
TL;DR
Most market regulation is targeted at stability, risk control, and capital preservation of retail participants, as the uncontrolled growth of any asset poses significant risks. Regulation opens up financial markets by creating healthy and open activities that serve the interests of the market participants. However, with DeFi, regulation does us a disservice if it is used to vilify the market as a whole, treating the good and bad parts alike.
Market regulation is scoffed at within Web3 culture. Most people assume that regulation is against the idea of decentralization and the crypto-utopia should be kept safe from its clutches. However, I am going to explore how regulation can actually help your investments by providing a check against volatility caused by aggravated asset growth. While the cryptosphere remains largely decentralized, several regulatory rules and laws indirectly impact how people interact with the world of decentralized finance (DeFi). While reviewing these rules and laws, the intentions of the regulators is something to be considered while determining the utility and appropriateness of blockchain legislation.
Purpose of Regulations
The primary purpose of regulating financial activities is the enforcement of investor rights and ensuring their protection from unwholesome and predatory actions. Most policies are targeted at stability, risk control, and capital preservation of retail participants. However, overzealous regulations could cause serious complications, as it could miss out on the bigger picture: a higher benefit to risk ratio.
In the United States, Congress set up the Securities and Exchange Commission (SEC) in 1934. The SEC was created in the aftermath of the Wall Street Crash of 1929 with the primary purpose of safeguarding against market manipulation. Nearly a century later, the SEC’s operation has generated mixed feelings. Regulation, in general, goes beyond protecting investment and prosecuting infractions. It opens up the financial market by creating healthy and open activities that serve the interest of the market participants. A squared-up regulator sets the right rules and directs the flow of the market rather than controlling it.
If protection of retail participants is the aim of regulators, then we cannot leave out the discussion of stablecoins; the central banks consider them to be detrimental to the stability of their currency. For example, Facebook announced the launch of Libra on June 19, 2019, and proposed a “simple global payment system and financial infrastructure that empowers billions of people.” Their aim was to create an inclusive and innovative financial system, and their success hinged on consensus and the veto of regulators. Libra, however, could not win the confidence of regulators and it was never launched. Other stablecoins have seen widespread growth.
Regulating DeFi
There is no globally recognized legislation on blockchain ownership or trading which directly affects decentralized finance. However, we have seen a retinue of regulations on both extremes. From the DeFi-friendly El Salvador which passed its bitcoin law proposed by President Nayib Bukele on September 7, 2021, to Algeria where the 2018 Financial Law of Algeria proscribes trading or exchange of cryptocurrency, describing it as haram.
If we juxtapose this with the United State’s broad legislation, we then have a handful of regulations that impact decentralized finance investments. For instance, in several states, there are regulatory frameworks to guide the transaction of cryptocurrency assets, acting as the primary substitutes for decentralized finance investments. The research by Global Legal Insights classified these regulations into:
Sales Regulation
The sale of cryptocurrency is classified as;
(i) the sale of a security under state or federal law
(ii) money transmission under a state law making the person a money service business (MSB) under Federal law. In addition to this, all financial assets including futures, options, swaps, and other derivative contracts that refer to the price of a crypto asset are regulated by the CFTC under the Commodity Exchange Act
Securities Laws
The SEC has been clear on its position that even if a token is issued in an ICO and it meets the Howey Test, the “utility” of that token will make it be deemed as a “security” that is regulated under the Securities Act. In 2019, The SEC filed a suit against Telegram for issuing its GRAMS token. In the ruling, Judge P. Kevin Castel of the Southern District of New York issued a potentially groundbreaking decision that Telegram had “engaged in an unregistered offering of securities — in violation of the Securities Act of 1933 (the “Securities Act”) — by selling “Grams,” a digital token, to certain sophisticated investors.”
Money Transmission Laws and Anti-money Laundering Requirements
The term DeFi is a tension point for the anti-money laundering (AML) law. FinCEN regulates MSB, hence virtual currencies are considered MSBs (money services businesses), and FinCEN’s regulations to Persons Administering, Exchanging, or Using Virtual Currencies are covered here.
Taxation
In the Guidance on Virtual Currency issued by the IRS on March 25, 2014, the IRS declared that “virtual currencies’’ such as Bitcoin and other cryptocurrencies will be taxed by the IRS as “property” and not currency.
Promotion
The US government has provided a “regulatory sandbox” for the regulation of new emerging industries like fintech, blockchain, and cryptocurrency. Arizona was the first to adopt it and states like Wyoming, Utah, Kentucky and Nevada have followed suit.
Ownership and Licensing Requirements
In 2016, The CFTC Fined Bitcoin exchange Bitfinex $75,000 for violating trading rules. Bitfinex permitted users to borrow funds from other users on the platform to trade bitcoins on a leveraged, margin, or financed basis. The Dodd-Frank Act mandates cryptocurrency hedge fund managers that use leverage or margin to register with the CFTC (Commodity Futures Trading Commission) and NFA (National Futures Association).
These laws have served the general interest of regulating arbitrage and participation in the market. However, the recently proposed Blockchain Regulatory Certainty Act by US House of Representatives member, Tom Emmer — seeking to “provide a safe harbor from licensing and registration for certain non-controlling blockchain developers and providers of blockchain services,” — reveals the extent to which regulators are keen to govern what has existed as completely decentralized. In its expansive definition of a “blockchain network,” the Blockchain Regulatory Certainty Act described the network as “any system of networked computers that cooperates to reach consensus over the state of a computer program and allows users to participate in the consensus-making process without the need to license proprietary software or obtain permission from any other user.”
Final Verdict
This brings us to the most important questions in focus. Can we make a case for regulation? Do regulations affect the utility and plurality of users’ choices? In his paper, Understanding Regulation, Andrei Shleifer discusses what he refers to as the public interest theory of regulation in which he claims has been subjected to several criticisms, associated mostly with the Chicago School of Law and Economics. One of the criticisms is that “markets and private orderings can take care of most market failures without any government intervention at all, let alone regulation”. Others include, “in the few cases where markets might not work perfectly, private litigation can address whatever conflicts market participants might have,” and lastly, “even if markets and courts cannot solve all problems perfectly, government regulators are incompetent, corrupt, and captured, so regulation would make things even worse. Consider these three lines of argument in order.”
While this might pass off as socialist and non-conformist, the third point buttresses the skepticism of proponents of decentralized finance. The intention of regulators is the focal point of scrutiny. They are often unidirectional in approach and prejudicial in evaluating use-cases, and they also come off as paranoid and pessimistic. Decentralized finance is evolving, although not without its challenges: there are myriads of complaints about the regular standardization processes not being deterrent enough for malicious activities. New York-based news site, Coindesk, in an investigation found that regulations about KYCs are not watertight to prevent criminal activities. With as little as $150, criminals can have access to the black market for a ready-to-use, verified account at established exchanges like Coinbase Pro, Binance US, Kraken, and more.
We can have regulations but if they strangle the growth of decentralized finance, that defeats the original statement credited to Satoshi Nakamoto, “I have been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.” The continual debate of regulations among centralized monetary regulatory systems will persist. Some nations, like El Salvador, will maintain a generally friendly disposition towards digital assets, providing necessary help to aid their adoption, other countries will remain in the dark or dismissive position about the benefits of running an open transactional system but as the cryptocurrency economy keeps advancing, there will be a result in loss of economic power and a shift towards decentralized economies globally.
Author Bio
Joshua Kayce-Ogbonna is a writer, columnist, and capital markets enthusiast.
BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.
Disclaimer: this isn’t investment advice. This article has been written for informational and educational purposes only and it reflects my personal experience and current views, which are subject to change.
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