The latest news has put the decentralized financial community in a collective fetal position. In response to the threat of increased regulatory oversight, leading decentralized exchange Uniswap recently restricted trading in certain tokens. In early July, Dan M. Berkovitz, chairman of the Commodity Futures Trading Commission (CFTC) said DeFi derivatives platforms could violate the Commodity Exchange Act (CEA):
“Not only do I consider unlicensed DeFi markets for derivative instruments to be a bad idea, but I also don’t see how they are legal under the CEA.”
Most worrying is the first version of the US Senate Infrastructure Bill, worth $ 1 trillion, which would impose impossible tax compliance requirements for crypto firms.
Related: The Senate infrastructure design isn’t perfect, but could the intent be right?
Be ready, DeFi – there’s more to come
However, as long as DeFi grapples with these looming regulations, it risks ignoring an impending and existential regulatory challenge that doesn’t have to make the headlines just yet.
Crypto-related guidelines and regulations usually come in three flavors:
- The first, like the Infrastructure Act, aims to increase revenue and allow the Internal Revenue Service to collect taxes.
- The second aims to ensure safe and solid markets for investors. These laws include the US Securities Exchange Act, which gives the Securities and Exchange Commission (the executor of Howey’s famous test of whether an asset is a security) to regulate the securities markets, and the Commodities Exchange Act, which the CFTC gives the powers to regulate derivatives markets.
- The third variant of regulation focuses on the fight against money laundering (AML) and counter-terrorism financing (CFT). The U.S. For example, the Bank Secrecy Act empowers the US Treasury Department’s Financial Crimes Enforcement Network to ensure that companies have a robust AML / CFT program in place, including explicit Know Your Customer requirements.
Related: The United States is updating its crypto AML / CFT laws
Global standards for these regulations are set by the Financial Action Task Force (FATF), an intergovernmental organization established by the G7 to align AML and CFT efforts. Those who work at DeFi need to understand and comply with these regulatory rules, which are not intended to incriminate businesses but rather to prevent transactions that have profound national security implications, such as terrorist attacks, human and drug trafficking.
DeFi and AML / CFT
DeFi is on shaky ground here, as many of its developers believe the AML / CFT regulations don’t apply to them. For example, Uniswap argues that it is a software development studio and therefore is not liable under AML / CFT requirements as it does not control the funds within its protocol. While I understand this position, it puts our industry at risk and sells it empty.
Related: The FATF draft guide aims to achieve DeFi compliance
First, if DeFi developers don’t stick, who is it? The more logical party can be liquidity providers (LPs). After all, their capital in any pool is the counterparty to any trade. While crypto-native LPs tend to ignore this responsibility, traditional institutions and their personally liable officials need to know that they are not inadvertently facilitating illegal transactions before allocating funds on behalf of their investors. Institutional capital will certainly be required to catalyze DeFi’s next phase of growth, so the DeFi community needs to find a way to offer regulators and traditional banks a clear solution.
Second, laws change just as quickly as security risks. Consider the Patriot Act, which went into effect less than two months after 9/11 and added AML / CFT protocols to the Banking Secrecy Act. President Franklin Roosevelt also ordered the internment of Japanese Americans less than three months after the attack on Pearl Harbor.
Governments rarely allow bureaucratic bureaucracy or legal hurdles to hamper national security. DeFi is not yet in a critical moment of importance for national security, but such a rite of passage is not unthinkable – especially since DeFi poses a threat to traditional finance. Just look at the $ 4.4 million Colonial Pipeline paid in Bitcoin (BTC) to end a ransomware attack in May. A major geopolitical security incident related to a DEX transaction may not be a question of if, but of when.
Third, as an industry, we have moral obligations. You are probably familiar with the claim that we are building “a secure, transparent and resilient financial infrastructure that empowers users around the world”. These should not be mere words: to make this vision a reality, you must do everything in our power to prevent any funding that could be linked to black markets, terrorist financiers, drug cartels or other troubled entities.
Related: Bitcoin can no longer be viewed as an undetectable “crime coin”
It won’t be easy to get there. For example, the Know Your Customer requirement could lead merchants to accept less compliant – and potentially less secure – DeFi protocols published by anonymous developers.
However, practical and effective AML / CFT protections can be used at the protocol level. In my company we set up our first DEX with an on-chain blacklist. This means that addresses identified by the Office of Foreign Assets Control cannot be traded on our DEX.
This protection does not affect the user experience for regular merchants, most of whom are unlikely to be aware of it, but it is very effective in preventing problematic transactions. If possible, developers can easily implement such technical solutions. However, this is unlikely as long as the leading DEX and de facto industry model says it is not liable.
DeFi will never go mainstream without accepting the AML / CFT requirements. If the DeFi community doesn’t self-regulate, governments will surely do the job for us – and with a much heavier hand. Just look at the Infrastructure Act, which aims to hold DeFi developers responsible for users’ lack of tax compliance. Rashly written AML / CFT laws for crypto could be even more debilitating.
Self-obedience is the moral and has the added benefit of ensuring the long-term survival of the industry. The alternative is waiting for the hammer of a much tougher obedience. The choice is ours.
This article does not provide investment advice or recommendations. Every step of investing and trading involves risk, and readers should do their own research when making a decision.
The views, thoughts, and opinions expressed herein are those of the author alone and do not necessarily reflect the views and opinions of Cointelegraph.
Mark Lurie is CEO of Shipyard Software Inc., which develops the Clipper exchange and is supported by Polychain, 0x Labs, 1inch Network, and other members of the DeFi community. Mark is a former investor at FJLabs and Bessemer Venture Partners and holds an MBA and BA from Harvard University.