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DeFi is Novel Technology that Requires Unique Rules

Rashan Colbert
Rashan Colbert
DeFi Needs Its Own Rules
Rashan Colbert
Rashan Colbert

FUD

When disruptive technologies emerge there are generally two basic reactions that policymakers, and people of all walks, tend to have. One: ‘this is scary and we need to do whatever is necessary to stop this thing from taking hold and disrupting my comfortable and familiar way of life.’ Two: ‘oh, this looks a lot like this other thing that happened in the past; let’s treat it just like that and do our best to move forward without too much fuss.’

We’ve seen both reactions as responses to the rise of crypto and decentralized technology. News headlines since 2008 have heralded both the end of Bitcoin and the destruction the technology would bring to the existing financial system. The market price of Bitcoin, and the subsequent plethora of crypto assets that have followed its introduction, have risen to stratospheric highs and plunged to surprising depths (over and over again) without causing the existential collapse predicted. And Bitcoin, from a technological perspective, is still going strong.

Alongside the doomsday predictions we’ve seen financial fortune tellers, market prognosticators, and skeptical policymakers and regulators saying ‘this is nothing new.’ 

The problem with these two very understandable reactions is that they fail to adequately assess -and thus, understand - the paradigm shifting possibilities this new technology enables, both for good and for ill. Technology is neither good nor bad, but incentives and regulation can be used to increase good outcomes and mitigate bad ones. Regulations are being contemplated by some policymakers that would apply the requirements of legislation created for a different era, like the Bank Secrecy Act, to all crypto, including DeFi.  In the current legislative vacuum, some government agencies are opting for “regulation by enforcement,” seeking to overlay rules and regulations designed for the traditional financial markets onto DeFi.  

We can’t force new ideas into old models; regulation must adapt when technology evolves.

Evolution 

Bitcoin emerged in the late fall of 2008 as a response to the failures and excesses of the traditional financial system during the great financial crisis. Bitcoin - though it has primarily served as a store of value, with overwhelming usage as a speculative instrument - introduced genuinely novel technological capabilities. With a transparent, fully auditable, immutable, and equally accessible public ledger, untrusted parties could reliably interact with one another via a digital substrate for the first time.

The Bitcoin network, from a software perspective, operates as a computer protocol. A protocol is a set of detailed and specific instructions that control and order actions within a network. Essentially: they tell computers how to interact with other computers in order to achieve specific outcomes. Some familiar protocols include TCP/IP (the Internet protocol suite), SMTP (Simple Mail Transfer Protocol, i.e. email), or HTTP (used to load web pages using hypertext links). The Bitcoin network is maintained by a variable number of computers (nodes) networked with one another, acting in an automated fashion (verification), in response to manual actions (transactions) with the purpose of maintaining a simple and transparent accounting ledger. That ledger is measured in a token, fittingly called “Bitcoin.”

As with all technological innovation, the original creators of a thing have no control over, and little idea of, what will come in the future.

Enter DeFi

Though it had already been bubbling for some time, around the summer of 2020 - affectionately referred to as “DeFi Summer” - a new movement within crypto, branded Decentralized Finance (DeFi), began to reach general public awareness. DeFi works via a protocol substrate like Bitcoin (some refer to Bitcoin as the first DeFi application) with the goal of delivering financial services, such as trading, borrowing or lending, directly between consumers without the need for a traditional intermediary like a bank, broker or clearing house. By designing a software protocol that can execute autonomously and in an automated fashion, users can reliably access financial services in a fundamentally new way; transparently, immutably, with the ability to individually audit, and with unprecedented accessibility. For the first time, anyone can act as a first order participant in a financial system. No fee-charging middleman required.

This development - giving the everyman tier 1 access to financial services - is a new paradigm, and thus requires new kinds of thinking and new governing regulation to best serve users.

TradFi and CeFi Regulation

The first thing to unpack is the need for regulatory clarity between traditional finance and centralized crypto. This is a topic that’s been unpacked at depth for the last few years. In short: there are some gaps in current regulation. There is a need for clarity to help regulators effectively regulate centralized entities that focus on crypto based on similar principles that undergird traditional financial market regulation, but with appropriate fine-tuning for the novel technological aspects that distinguish crypto assets from traditional finance.

There are several pieces of legislation, at home and abroad, that have attempted to close the so-called regulatory gaps within the centralized crypto ecosystem. In the United States, serious proposals have been put forward from members of both major parties and in both the House and Senate. The Responsible Financial Innovation Act from senators Lummis and Gillibrand takes a comprehensive swing at the entire crypto ecosystem. The Digital Commodity Consumer Protection Act, led by Senate Agriculture Chair Debbie Stabenow looked to answer outstanding questions for so-called digital commodities like Bitcoin and Ether for the Commodity Futures Trading Commission (CFTC). And most successfully, the Financial Innovation in Technology Act for the 21st Century Act, led by House Financial Services Chair Patrick McHenry looks to bring structure to the crypto market by settling jurisdictional issues between the Securities Exchange Commission (SEC) and the CFTC, establishing rules for secondary trading of digital assets, and providing some obvious consumer protection standards.

What each of these pieces of legislation gets right is that there is a clear alignment between what is needed to protect investors and consumers within the traditional financial ecosystem, and those who engage with crypto through centralized intermediaries. To put it plainly; if there is someone who must be trusted to hold onto another person’s money or assets, they should be monitored and regulated closely. Digital assets themselves are game-changing innovations with dynamic new potential uses, but custodians and exchanges who help customers acquire, store, and trade them, are essentially new versions of old institutions.

How Should DeFi Be Regulated?

Legislation, and subsequent regulation, can be written and enacted with myriad intended outcomes, ranging from the codification of existing societal norms to the propping up, or crushing of, a favorite or least favorite domestic industry. Policymakers must be extremely intentional when crafting legislation and should optimize for an ideal balance of outcomes for a variety of constituencies. Financial and technological regulations should be designed with the goals of protecting citizens and serving their best interests, including future innovation and the economic dynamism of the country.

DeFi has a unique set of tradeoffs that should be properly evaluated and considered in order to achieve the best possible outcome for Americans. Unlike centralized financial entities, no black box third party is in control of your assets, so it doesn’t make sense to regulate through an entity disclosure based paradigm. The code of open-source DeFi protocols is transparent and self-executing. Because there is no person in the middle with their finger on the button, it is critical to ensure the quality of the code used, that the protocol does what it purports to do, and that the violation of other laws, like sanctions evasion or illicit financing, is mitigated. 

Unlike some other heavily regulated industries, DeFi is advancing rapidly and actively developing technological and structural solutions to address the concerns raised by critics, including policymakers and regulators. Blockchain-based technologies offer unique transparency and can provide unprecedented levels of information disclosure for regulatory purposes and consumer assurance. This transparency also allows protocols to be easily audited by authorities or anyone else when necessary to trace the actions of malicious actors. Furthermore, as protocols become more decentralized, they significantly reduce the potential for manipulation by individual actors. All of these solutions, and many others, require additional time for further development before implementing harmful regulations that could restrict their potential. It is crucial to have well-designed and thoughtful policies to ensure appropriate regulation for DeFi.


About dYdX

dYdX is the developer of a leading decentralized exchange on a mission to democratize access to financial opportunity by building open, secure, and powerful financial products. dYdX currently runs on audited smart contracts on Ethereum, which eliminates the need to trust a central exchange while trading. We combine the security and transparency of a decentralized exchange, with the speed and usability of a centralized exchange.