WHO’S IN CHARGE?

STUMBLING BLOCK? What is the path ahead for DeFi through the eyes of policymakers?

18/01/2024

2023 marked a shift in the US regulatory outlook for decentralised finance (DeFi), with the protocols (i.e., the standards, codes, and procedures) that govern DeFi increasingly becoming subject to regulatory scrutiny. The UK, on the other hand, continued to be friendly in its approach to crypto regulation, taking a ‘wait-and-see’ tack instead. There is no doubt that 2024 will see further legal and regulatory changes affecting the sector. The question is whether those changes will strike the right balance between innovation and guarding against risks to financial stability.

DeFi development carried quietly on throughout 2023, but DeFi protocols also faced significant hurdles. In the US, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) increased their pushback on DeFi. By contrast, the UK and EU looked more favourably upon DeFi.

Most telling are the perspectives of two leading crypto proponents: SEC Commissioner Hester Peirce and UK Prime Minister Rishi Sunak. Both champion crypto as revolutionary and advocate that the technology should be allowed to grow without serious regulatory interference.

As 2024 unfolds it is likely that the industry will see significant legal and regulatory developments in relation to DeFi. We predict that this year will see:

  • Increased litigation and legislative proposals around DeFi in the US;
  • Acceptance of DeFi within the constraints of the existing regulatory frameworks in the UK and EU; and
  • Potential outflows of DeFi projects from the US to other countries unless the US significantly alters course.

Hester Peirce: defending DeFI innovation

Despite the SEC having been dealt a series of blows by the judiciary on its securities and spot exchange-traded fund (ETF) theories, the regulatory focus in the US remains firmly on DeFi. Earlier in 2023, the SEC clarified that its proposed rule for Alternative Trading Systems (ATS) would “includ[e] some so-called ‘DeFi’ systems.”[1] In reopening comments for its amendments to Rule 3b-16(a), the SEC made clear that DeFi protocols would fall under the ambits of its Regulation ATS. Additionally, the SEC’s crypto enforcement chief recently stated that his office would “continue to conduct investigations… and adding the label of DeFi is not going to be something that’s going to deter us from continuing our work[.]”[2]These developments come off the back of a recent legislative push in the US Senate to place strong anti-money laundering requirements on DeFi, as well as KYC requirements.

Enter: Hester Peirce. Beloved by the crypto community, and famous for her dissents, Peirce is a staunch proponent of innovation. In response to the SEC’s proposed rule change for Rule 1b-16(a), Peirce issued a fiery dissent to defend DeFi. Pushing back against the inflexibility of the current SEC, she stated that “[t]oday’s Commission treats its basic approach to exchange regulation as something that must not—indeed cannot—be altered to allow room for new technologies or for new ways of doing business.”[3] Similarly, the DeFi industry’s response to the SEC’s proposal was just as forceful: “Practically and technologically speaking, it would be impossible for many DeFi protocols to comply with the Proposal, giving many protocol development companies no choice but to either shutter their operations or move offshore.”[4] Peirce recognises that DeFi protocols do not function like exchanges—rather, they are simply code, and as such, compliance with Regulation ATS would pose significant challenges. As such, she has placed the ball in the SEC’s court to defend innovation.

Rishi Sunak: building a crypto hub in the UK

While the SEC attempts to force DeFi as an issue in America, the UK—and EU more broadly—have both taken much more relaxed approaches. In 2022, Rishi Sunak, the then Chancellor of the Exchequer and now Prime Minister, promised to turn the UK into a “global hub for cryptocurrency technology”.[5] Much like his US counterpart in Hester Peirce, Sunak emphasises that the UK should “always [be] at the forefront of technology and innovation.”

Now that Sunak is Prime Minister, he is following-up on that promise. In October 2023, the UK Treasury released its feedback response[6] following a consultation on a proposed regime for cryptocurrency regulation, confirming that it was taking an “innovation-forward approach”. The response specifically noted that “the [UK] government does not intend to ban DeFi.” As such, the UK found that “it would be premature and ineffective for the UK to regulate DeFi activities currently.” These developments seem to suggest a friendlier regulatory environment for DeFi in the UK compared to the US.

This contrast is even more sharply drawn by Andreessen Horowitz’s crypto arm recently opening a UK office. Their forceful statement noted that “UK policymakers and regulators are taking an approach that is uniquely tailored to blockchain and digital asset regulation.”[7] To that end, under Sunak, the UK is making great strides to guarantee an innovation-first future for DeFi.

However, the UK government’s approach in this space may seem at odds with that of the UK FCA Conduct Authority (FCA), which, amongst other things, introduced significant restrictions on crypto marketing to UK consumers. It remains to be seen precisely how this tension between the FCA’s seemingly anti-crypto position and the UK government’s positive approach will play out in the context of the UK developing its regulatory framework for the crypto-asset sector over the next 12 months. Given that the FCA will be responsible for drafting many of the detailed rules, the UK government may be required to take steps to curtail some of the perceived anti-crypto sentiment at the FCA to ensure that the UK is genuinely open for crypto business.

the UK government’s approach in this space may seem at odds with that of the UK FCA Conduct Authority (FCA)

All the while, the EU has delayed placing DeFi within the scope of its recent Markets in Crypto-Assets Regulation (MiCA) to instead study protocols more in-depth before regulating. In September 2023, the European Securities and Markets Authority (ESMA) released its risk analysis for DeFi in the EU. Notably, the report found that “DeFi does not represent a meaningful risk to financial stability at this juncture,”[8] but did identify real vulnerabilities such as flash loan attacks as pain points for protocols.

The US’ recent actions threaten to push DeFi protocols out of the country and into the open arms of regulators in other jurisdictions, such as the EU or UK. Some members of the DeFi and digital asset industries have called this a “full frontal assault from [American] regulators[.]”[9] Even though Federal Reserve Chair Jerome Powell has stated that regulation of DeFi should be handled “carefully and thoughtfully,”[10] US policymakers seem intent on pushing for greater regulatory control over DeFi. Instead, they should take a page from their overseas cousins’ books and approach regulation of DeFi with an innovation mindset.

The US’ recent actions threaten to push DeFi protocols out of the country and into the open arms of regulators in other jurisdictions, such as the EU or UK.

 

CONCLUSION

As members of the DeFi industry look toward 2024, one thing is clear: regulation is on the horizon, but it remains to be seen what form it will take. Hopefully, on both sides of the pond, DeFi is welcomed as it already has been by Peirce and Sunak.

 

The authors would like to thank Gage Salicki, law clerk and law student at the University of Illinois College of Law, for his assistance with this article.

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Samantha Paul

Senior Knowledge Lawyer, London