DeFi is the “perfect” regulator, aligns with US values

Speakers at the US Securities and Exchange Commission‘s (SEC) final Crypto Task Force roundtable posited that decentralised finance (DeFi) is not only an improvement to the current regulatory framework, but also compatible with core American values.

Opening the event, entitled DeFi and the American Spirit, SEC chair Paul Atkins said: “American values”, such as “economic liberty, private property rights and innovation”, were the “DNA” of DeFi. Blockchain technology that enables ownership of crypto assets without reliance on an intermediary or central party is a “free market system”, he added.

Another “core feature of blockchain technology” is the ability for individuals to have “self-custody of crypto assets in a personal digital wallet,” said Atkins, adding: “The right to have self-custody of one’s private property is a foundational American value that should not disappear when one logs on to the internet.”

The debate around whether to regulate the technology — specifically the distributed ledger technology that underpins DeFi — or to regulate the activities conducted via the technology, was a central theme of the roundtable.

SEC commissioner Hester Peirce compared the freedom to transact with peers without permission, interference or intermediation in a DeFi environment to freedom of speech.

“Code is protected speech. Because the First Amendment protects someone who writes a DeFi software protocol and publishes it, the SEC has no authority to demand pre-publication approval rights, even for code that could be used to exchange securities,” she said. “The SEC must not infringe on First Amendment rights by regulating someone who merely publishes code.”

If someone violates the law using the software protocol, “the user, not the developer” of the software should face legal and regulatory scrutiny, Peirce said.

SEC commissioner Mark Uyeda outlined the main areas of discussion as where DeFi systems and smart contracts might eliminate the need for a financial intermediary; where they fall outside the scope of the securities laws; and what key safeguards are necessary when the securities laws apply.

Lack of definition

One issue was that of definition: according to Rebecca Rettig, chief legal officer at Jito Labs. No industry, regulator, or policymaker has yet reached a consensus on how to define DeFi.

“I typically define DeFi as a blockchain-based open software system that allows users to engage in economic transactions in a self-directed and entirely self-custodial manner, without the need for traditional intermediaries, while others have defined it as simply a blockchain-based system,” she said.

The latter definition is “very broad”, she noted, and encompasses much of what banks are building with crypto assets.

She described decentralisation as “a philosophy” that generally espouses movement away from power, authority or control being centralised in a single entity. This philosophy should influence how regulators view DeFi because some DeFi activities don’t resemble those used in traditional finance. For example, in cases of emergency, the question of holding private keys to a multi-signature wallet to pause a DeFi protocol “does not look anything like pulling the circuit breakers on the New York Stock Exchange”, said Rettig.

She said there are three main risks a regulator should consider when monitoring a DeFi environment: cybersecurity risks, system management risks, and risks from illicit actors.

Meanwhile, Peter Van Valkenburgh, executive director at Coin Center, spoke out against what he called “utilitarian calculations”. When looking to improve the social utility of markets and reduce investor harms, the “consequential” utilitarian calculation is “almost always the right calculation to make, except where long-held American values are at stake”, he added.

“We’re always going to want to try to craft our regulation or the way that we address public dilemmas with an eye for maximising the good, but at a certain point, even if it’s the socially beneficial outcome, there are certain areas [where] we don’t tread in this country,” said Van Valkenburgh. “At a certain point, a right like my right to publish code trumps the risk that that code creates in the world.”

However, he added, the risk created by a DeFi trading algorithm might be very similar to the risks that we see in centralised exchanges.

American spirit

Taking it further, Erik Voorhees, CEO at Venice AI, described DeFi as “the most American spirit rushing back in to help bring economic commerce back to where it should be”.

That “American spirit always entails a strong degree of rebellion, a strong degree of individual liberty, a strong degree of risk taking, and a strong degree of entrepreneurialism”, he said.

He described DeFi as a “machine of perfect regulation” because “it does precisely what it is told to do, it executes regardless of who is using it”.

However, Kevin Werbach, professor and chair of the department of legal studies and business ethics at the University of Pennsylvania’s Wharton School later took issue with Voorhees calling DeFi “the perfect regulator”.

Voorhees adjusted this statement by saying that cryptocurrency, blockchains and DeFi were a “step forward improvement” on human-driven regulation, and “far from being a tool of anarchy” were instead a tool for better market stability.

TradFi veneer of continuous operation

Omid Malekan, adjunct professor at Columbia Business School, reminded the roundtable that the crypto industry tended to treat traditional finance (TradFi) as being bad, but “we would not have the modern, successful economy that America has if it wasn’t for the very robust financial markets and the banking system that we have, and that wouldn’t be possible without both the institutions and the regulators that got us here”.

Malekan added, however, that the problems of TradFi are “becoming increasingly apparent, especially in the global digital economy”. This is because it has a “veneer of continuous operation” yet the actual settlement is often done with “significant delays, and the system is not transparent. This is why “TradFi needs to be heavily regulated, because otherwise it’s practically impossible to know what’s going on inside of it”, he said.

As this was billed as the last roundtable from the current series, many voices during the discussion lamented the past administration’s attitude towards cryptocurrency and DeFi, claiming it had harmed the US’s status as a global innovation leader.

A word of caution

But SEC commissioner Caroline Crenshaw — often the lone voice of caution as the country moves towards a friendlier regulatory environment — warned against speed over prudence.

“In sum, these roundtables have given us a lot to grapple with, to say the least. While the series was billed as a ‘spring sprint towards crypto clarity’, I am unsure whether we’ve identified much that can be simply or quickly clarified,” said Crenshaw. 

“When it comes to crypto, it does not appear to me that the SEC is facing problems [that have] ready or easy solutions. What we are facing is heightened expectations of rolling out major changes — quickly — to pave the way for crypto expansion into the capital markets. With issues this complex and stakes this high, it’s better to do it right than fast,” she warned.