What’s happening in DeFi regulation?
Decentralised Finance (DeFi) has emerged as a ground-breaking innovation in the financial industry, offering a new system for financial services and disrupting traditional intermediaries. DeFi includes cryptocurrencies but is more than crypto alone. It expands on the idea of digital money. DeFi is an umbrella term for a financial system that comprises a wide range of financial tools and applications such as lending and borrowing platforms, decentralised exchanges, stablecoins (cryptocurrency linked to a stable currency such as the US dollar), and prediction markets. Basically, DeFi allows you to do most of the things you currently use a bank or other financial institution for — earn interest, borrow and lend money, buy insurance, trade assets, and more. The attraction of DeFi is its speed and the absence of paperwork and third parties. (For more information on what DeFi is, see What is decentralised finance?.) It utilises blockchain technology to provide users with open, permissionless and transparent financial solutions. However, it is still largely unregulated, which creates risks for investors and other users. As DeFi continues to expand, regulatory bodies worldwide are increasingly focusing their attention on this developing industry. What is the state of DeFi regulation?
Regulatory challenges of DeFi
The range of financial applications and protocols known as DeFi operate on a decentralised network, primarily Ethereum. While DeFi offers tremendous potential, its decentralised nature poses regulatory challenges. The absence of intermediaries and the global reach of DeFi platforms often blur traditional jurisdictional boundaries, making it difficult for regulators to enforce existing rules and protect consumers.
In recent years, regulatory bodies worldwide have taken notice of the rapid growth of DeFi and its potential risks. They aim to strike a balance between encouraging innovation and protecting investors and the stability of financial markets. As a result, there has been an increase in regulatory scrutiny and proposals targeting various aspects of DeFi.
Structural problems of DeFi
DeFi gives regulators two main headaches: 1) lack of transparency and 2) pseudonymity. The lack of transparency allows professional investors to enjoy excess returns, while small investors – precisely those who find DeFi attractive – carry more risk and don’t benefit from the same pricing advantages as large investors. The code DeFi uses is publicly available, but very few people are able to read the code, rendering this claim to egalitarianism meaningless. Pseudonymity – or the ability to disguise one’s identity – makes it easy to hide activity that may be manipulative or unlawful.
Purpose of regulation
More than a year ago, the US Securities and Exchange Commission (SEC) published a statement on DeFi risks, regulations, and opportunities. Commissioner Caroline Crenshaw explained why regulation is necessary. She said that unregulated markets suffer from structural limitations. DeFi is ultimately about investing, despite the other financial services it offers. The approach to investing via DeFi is simply to warn new investors to exercise caution; but Crenshaw explains why a “caveat emptor” – or “buyer beware” – attitude does not provide sufficient protection. Certain truths about financial markets apply equally to DeFi and traditional finance: 1) there will always be financial initiatives that do not invest in adequate controls unless required to do so; 2) where there are high financial rewards on offer, there will always be individuals who will exploit and victimise others; and 3) without mandatory disclosure, imbalances in information will usually favour rich investors and disadvantage small investors and those without access to information. Well-regulated markets tend to thrive, and regulation does more than impose burdens on providers. It exerts a positive force on markets.
Who regulates DeFi?
In the US, DeFi falls under the jurisdiction of multiple authorities, including the SEC, Financial Criminal Enforcement Network, Internal Revenue Service (tax authority), and others. Here in South Africa, the Financial Sector Conduct Authority (FSCA), the South African Reserve Bank (SARB), the National Treasury, the South African Revenue Service (SARS) and the Financial Intelligence Centre (FIC) all have an interest in DeFi and cryptocurrency regulation and are developing a legislative framework.
Preventing financial crime
One of the key focus areas for regulators is the implementation of Know Your Customer (KYC) and Anti-money Laundering (AML) measures in DeFi platforms. These measures help prevent money laundering, terrorist financing and other financial crime. Regulators are exploring ways to ensure DeFi platforms comply with these requirements without compromising the key principles of decentralisation and privacy that DeFi users value.
Another critical regulatory aspect is the question of whether certain DeFi tokens or activities fall under securities regulations. Regulators are analysing DeFi projects and tokens to assess whether they meet the criteria of securities, which would subject them to additional compliance obligations. The US SEC takes the view that some DeFi participants, activities and assets fall within SEC jurisdiction, and it encourages DeFi developers to register with it. Although the SEC’s approach is one of engagement with the DeFi industry rather than rigid rule making, it has exerted its enforcement capacity on occasion. For example, it settled an enforcement action (unspecified, but presumably a fine) on a DeFi platform and promoters which raised $30 million. They were chastised because they misled investors and improperly spent investor money on themselves. Where the US leads, the rest of the world usually follows, at least in matters of financial markets.
Consumer protection is a priority for regulators in the DeFi space. Given the prevalence of smart contracts that govern transactions on DeFi platforms, ensuring the security and accuracy of these contracts is crucial. Regulators are exploring mechanisms to encourage or mandate third-party audits of smart contracts to minimise vulnerabilities and protect users from potential fraud or hacking incidents.
The global nature of DeFi presents challenges for regulators who traditionally operate within national boundaries. To address this, regulatory bodies are increasingly engaging in cross-border coordination and information sharing to monitor and regulate DeFi activities effectively. International collaboration is essential to prevent regulatory arbitrage and ensure consistent oversight of DeFi platforms.
As the DeFi ecosystem continues to evolve, regulatory developments will follow suit. Regulators are striving to strike a balance between nurturing innovation and safeguarding market integrity and consumer protection. While regulation is necessary to instil trust and confidence in DeFi, policymakers are cognisant of the unique characteristics and benefits of decentralised finance. Collaboration between regulators, industry participants and legal experts will play a vital role in achieving regulatory frameworks that foster innovation while mitigating risks.
Current state of play in South Africa
In a very recent announcement, South Africa has become the first country on the African continent to require crypto exchanges to obtain licences by the end of the year. FSCA commissioner Unathi Kamlana has said that the agency has received approximately 20 licence applications and it expects more before the deadline of 30 November. The FSCA intends to “take enforcement action” against any crypto exchanges that operate without a licence after the deadline.
The Intergovernmental Fintech Working Group (IFWG), which consists of the various regulators and policymakers mentioned above, has been working on a regulatory framework for crypto assets via the Crypto Assets Regulatory Working Group (CAR WG), with the aim of bringing crypto assets into the South African regulatory landscape in a phased and structured manner. It is reasonable to assume that the broader scope of DeFi will be included in the mandate.
For more information
If you want to know more about decentralised finance and cryptocurrency, contact SD Law. We are a firm of experienced attorneys based in Cape Town, with offices in Johannesburg and Durban. Call Simon on 086 099 5146 or email email@example.com.
- What is decentralised finance (DeFi)?
- What is cryptocurrency?
- Cryptocurrency – the wild west or a carefully regulated environment?
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