DeFi Must be Regulated in a DeFi Way

11 May 2024

Based on the SEC’s recent lawsuits against high-profile crypto firms like Coinbase, the agency is likely to claim that Uniswap illegally offered unregistered securities to the public or that it failed to register as a broker or an exchange. The impending Uniswap lawsuit comes at a time when the crypto industry has loudly complained the SEC has been operating in bad faith when it comes to the sector, pursuing enforcement actions despite clear rules while failing to account for crypto’s distinct blockchain-based technology.

This is not the first time that Uniswap Labs has faced legal issues - in a class-action suit filed against Uniswap Labs last year, they argued that the technology it had built was neutral—and that whether individuals used it for bad or for good was beyond its control. In a sophisticated ruling that described the nuances of DeFi in detail, a federal judge sided cleanly with Uniswap Labs, handing the DeFi sector a major victory.

This, coupled with new regulations being set in place in the European Union, spells trouble for the world of DeFi.

As Circle’s EU Strategy and Policy Director Patrick Hansen described it, “paying with crypto (for example to merchants) with a non KYC’d self custody wallet will be more difficult/banned depending on the merchants set up. This change, as well as the lower thresholds for anonymous cash payments, has unfortunately been agreed months ago.”

Defi Must Be Regulated in a Defi Way

MiCA is a regulatory framework proposed by the European Union to govern digital assets and their markets that came into force in June 2023 and will be fully applicable from Dec. 30, 2024.

“The AMLR (Art. 58) now explicitly prohibits CASPs to provide anonymous accounts, meaning a custodial crypto business cannot provide services for anonymous users. This is already prohibited under existing AML rules anyway, so nothing new,” Hansen said.

However, others warned that this could impact non-KYC custodial Bitcoin Lightning wallets like Wallet of Satoshi. Additionally, CASPs will not be able to provide accounts for privacy coins, though such practice is already widespread, and MiCA already prohibits crypto assets with built-in anonymization.

In this new environment, it seems that DeFi and the very values and core fundamentals it stands for are under threat, but Fiat24 co-founder, Yang Lan, believes that regulation IS in fact necessary for decentralized finance.

“I never believed that it would be possible for DeFi to continue operating in the way that it has, without much regulatory oversight. While I understand the attraction and appeal of protocols such as MetaMask and Uniswap, with their predisposition to anonymity for users, I don’t think that it is sustainable. Some form of client and investor protection is necessary in the space, and I believe it can be done in a DeFi way that does not impede too much on people’s right to privacy.”

Defi Alternatives

There are currently projects such as MicaPass, idOs, and Kinto, addressing the challenge by issuing Onchain IDs. These are stored on the public Ethereum BlockChain, in a decentralized way. They can't be hidden or deleted. No service or organization can remove your access rights to it.

Another novice solution comes from Swiss fintech, Fiat24, offering a new and safer solution via their eponymous NFT. They are a fully regulated and licensed financial institution, governed by Swiss bank law, which means they can offer a different level of security in terms of the KYC performed. The NFT could be used to access various dApps and protocols, with the security of knowing that the connected users are not on any sanctioned lists, are over 18 years old, and have a valid passport as a credential.

Other decentralized means of helping to regulate the space include:

  1. Emphasize the principle of "code is law," whereby the rules governing DeFi protocols are embedded in smart contracts.

  2. Mandate rigorous auditing of smart contracts by independent third parties to verify their security and functionality.

  3. Create regulatory sandboxes where DeFi projects can experiment with innovative solutions under regulatory supervision.

  4. Encourage the formation of self-regulatory organizations within the DeFi community to establish best practices, standards, and guidelines for responsible behavior

Nefarious actors still prevail in the world of crypto, but the majority of users are “good,” and don’t have malicious intentions. The people who are in DeFi for good deserve this delicate balance between anonymity and security, and it will become apparent with testing which solution provides the most comprehensive opportunity for a much-needed call for regulation in the space.