By: Eric W. Hess*
Abstract
Confronted with a Hobson’s choice of either implementing stringent enforcement of uncertain regulation or geo-fencing the United States, regulators and stakeholders must consider collaborative alternatives for shaping the future of decentralized finance (“DeFi”). Championing collaboration, this Article emphasizes the need for all DeFi stakeholders, from intermediaries to builders, to proactively enhance transparency and risk management, irrespective of regulatory dictates.
Starting with the Security and Exchange Commission’s (SEC) formation in the 1930s, this Article explores the evolution of the SEC’s initial technology-forward approach to regulating intermediaries and disruptive technologies. The 2008 financial crisis marked a shift by both the SEC and Commodity Futures Trading Commission (“CFTC”) towards regulating disruptive technologies, like automated trading and digital assets, as potential threats to financial stability, reflecting a reactive, top- down regulatory response. Collaborative efforts between stakeholders and regulators are essential for regulations that are well-informed by market and technological developments.
DeFi offers an opportunity to reconsider that approach by pursuing achievable initiatives aimed at bolstering transparency and risk management. Public-private collaborations are explored as a reasoned alternative to a blunt application of the “same risk, same rules” paradigm to DeFi. In contrast, the proposed collaborative approach would foster actionable risk mitigation practices and resilience through an informed, pragmatic process.
This Article explores the possibilities for innovative anti-money laundering verification and risk processes for DeFi as part of an open collaborative approach. It also evaluates potential adaptations of existing SEC and CFTC rules and guidance to diligence; risk management; and pre-transaction, smart contract-encoded controls for institutional DeFi users.
Pursuing this path would substantially enhance outcomes for both regulators and stakeholders. It would aim to strike a balance between regulatory objectives, risk management, and innovation, while facilitating a more efficient enforcement paradigm.
* Eric Hess has decades of experience in top legal, compliance, risk, technology, advocacy, board level, and management roles for equities exchanges, broker-dealers, investment advisors, and fintech, digital asset and cybersecurity companies. He is the founder of Hess Legal Counsel and host of the “Encrypted Economy” podcast.
Acknowledgements: Thank you to Marvin Ammori, Olta Andoni, Dan Berkovitz, Lewis Cohen, Marisa Coppel, Gary DeWaal, Erich Dylus, Dane Lund, Steven Loftchie, Jai Massari, Michael Mosier, Nelson Rosario, Jacob Robinson, James Angel, Justin Slaughter, Andrea Tinianow, AnneMarie Tierney, JW Verret, and Gregory Xethalis for their invaluable contributions to this article along with assistants Zachariah Taylor, Dean Tetelman, and Hailey Oestreicher and numerous others who offered their perspectives.