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Global regulators fire warning shot that they’re about to kneecap DeFi

The US is cracking down on crypto. But globally, there are signs regulators are following suit as governments look to regulate software developers as a proxy for decentralised finance, or DeFi. That’s according to John Salmon, a partner at Hogan Lovells and co-chair of a working group within Global Digital Finance, which advocates for digital assets. The fears come amid a report yesterday from the Financial Stability Board, an international body which said DeFi amplifies risk in the financial system.

“The issue with DeFi is, how do you even apply regulation to DeFi if it is truly decentralised?” he told DL News, adding that the FSB report echoes the worries of regulators around the world.

The FSB report says that because participation in DeFi is pseudonymous, financial intermediation rests on “the use of collateral and one the leverage that such usage entails.”

“The automatic liquidation of collateral in smart contracts, which can be applied unevenly among participants depending on the protocol design, is a primary reason why deleveraging dynamic in DeFi can be especially disruptive,” it says, adding that TradFi has mechanisms to contain that sort of dynamic.

Regulators have three options when it comes to DeFi, Salmon said.

“One is to ban it outright. This is quite difficult in practice, but you could certainly mandate custodial wallets or exchanges not to deal with DeFi, preventing on-ramping,” he said.

“Second, you could say that DeFi can only be provided through a regulated intermediary and limited to a specific set of sophisticated or high net worth investors.”

But it’s the third way that Salmon sees regulators taking — they could try and regulate the software itself, or the company that develops the software.

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“There are indications suggesting that is where we are going to end up. We’re seeing policy markets and regulators around the world trying to think about it in that context, particularly where the developers have some ongoing control of the protocol,” he said.

The EU is already issuing proposals on emerging technologies that hold third-party providers accountable for operational disruptions or harm to consumers.

We’re seeing policy markets and regulators around the world trying to think about it in that context, particularly where the developers have some ongoing control of the protocol.

Salmon said the proposed Artificial Intelligence Act from the EU – the first act in any country to try to regulate AI – targets developers and distributors of complex AI systems. Another example is the EU’s proposed Digital Operational Resilience Act, which would bring Big Tech cloud services providers like Amazon Web Services or Microsoft Azure under the bloc’s ambit.

Salmon also pointed to the landmark UK case of Tulip Trading, which considered whether developers of cryptocurrencies and other blockchain-based assets have a “duty of care” to crypto investors. The UK Court of Appeal decided that yes, they do; at least to a certain extent.

It is already the case, activists and lawyers say and as DL News has reported, that writing code can land developers in prison if their protocols are used later for criminal activity. That’s even if the developer has no control over what it is used for.

FTX aftershocks

Global regulators are concerned about risks in the financial system after the collapse of FTX, and the FSB report appears to be a response to that. The report noted that while the impact of FTX on traditional finance and the real economy were limited, the linkages between the crypto-asset world and the real economy are growing.

“If the DeFi ecosystem were to grow significantly and become more mainstream as a result of the broader adoption of crypto-assets and the development of real world use cases, then interlinkages would deepen and the scope for spillovers to TradFi and the real economy would increase,” the report said.

The FSB does not make regulations itself. Rather, it coordinates and influences regulatory thinking worldwide. Its concerns could well influence local regulators in their thinking on DeFi.

Sassan Danesh, CEO of ETrading Software, told DL News that the FSB’s work on the global regulation of the derivatives industry, for instance, has been very influential, with standards promoted by the organisation now adopted by governments worldwide. “FSB recommendations carry real weight,” he said.

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