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Perhaps no set of innovations in the crypto space poses a greater challenge to regulators than decentralized finance (DeFi).
Over the past few years, regulators around the world and multilateral organizations such as the Financial Action Task Force (FATF) and the International Organization of Securities Commissions (IOSCO) are putting an increasing focus on the DeFi space – fueled by concerns that if the DeFi space continues to grow at a rapid pace, it could ultimately prove increasingly resistant to regulation. Since the types of highly centralized, intermediary entities that regulators typically oversee are missing from the DeFi space, regulators are left to wonder whether they will be able to effectively oversee the space at all, and see an increasing urgency in trying to deal with it.
This concern is reflected by US regulators such as the CFTC and the SEC took enforcement action against DeFi projects for alleged violations of commodity and securities laws. US Treasury issued report on the financial crime risks of DeFi in the spring of 2023 and also famously undertook sanctions against Tornado CashDeFi mixer, to enable money laundering and sanctions evasion on behalf of North Korea – an operation run by the courts confirmed so far despite the industry’s legal challenges. Organizations such as Financial Action Task Force have raised warnings about growth cross crimewhich relies on components of the DeFi space, such as decentralized exchanges (DEX) and bridges.
At the international level, policy makers are seeking to align and coordinate their efforts to address the perceived challenges related to DeFi. The FATF has urged regulators to address DeFi-related risks through measures against financial crime, while IOSCO has set policy recommendations to align countries with common approaches to solving DeFi.
These evolving trends will make 2024 a pivotal year for the DeFi space – and one that could have a decisive impact on the evolution of DeFi going forward.
Enforcement a lot
One aspect of the regulatory response to DeFi that will be introduced this year and will be led in particular by regulators in the US will be the use of enforcement measures to shape the behavior of DeFi market participants.
This process is in fact already well underway in the US, where the CFTC and SEC have taken numerous enforcement actions against the founders of DeFi projectsas well as decentralized autonomous organizations who support them. These efforts will only increase in 2024, and we expect this year to see the first seven-figure fines issued against DeFi arrangements for alleged compliance violations. The SEC’s own aggressive stance toward DeFi is likely to only deepen in light of its recent adoption of new regulatory definitions that will bring DEXs under the purview of US broker-dealer regulations.
Efforts to impose economic and financial sanctions in the crypto space are also likely to affect DeFi innovators. The aforementioned action taken by the US Treasury Office of Foreign Assets Control (OFAC) against Tornado Cash will certainly not be the last action OFAC will take with implications for the DeFi ecosystem. In 2024, OFAC is likely to take additional measures aimed at reducing North Korea’s ability to launder cryptocurrencies through the DeFi space.
Enforcement, however, is a crude tool and by itself will not offer a coherent, long-term means of dealing with the challenges of DeFi. Consequently, regulatory agencies and multilateral bodies will spend more and more time in 2024 focusing on how to develop regulatory frameworks to tackle DeFi.
The CFTC, for example, has published report on DeFi in January 2024 in which it outlined its intention to assess how to apply anti-money laundering and countering the financing of terrorism (AML/CFT) to a range of DeFi market participants. In a research paper published in February, former acting director of the US Treasury’s Financial Crimes Enforcement Network (FinCEN) Michael Mosier proposed a new framework for the application of SPN/FT measures in the disintermediated DeFi space.
Policy makers and regulators in jurisdictions such as EU, UAE, Hong Kong and elsewhere are likely to spend increasing amounts of time throughout 2024 assessing how and whether their new regulatory frameworks for cryptocurrencies can be applied to DeFi.
Aligning DeFi with Regulation
With increasing regulatory focus on the DeFi space, innovators in the space will be forced to answer an important question: can the DeFi space be made compliant with regulations in a way that allows it to remain decentralized and truly innovative?
If participants in the DeFi space can answer yes to this question, then 2024 may be the year that regulators gain more confidence in DeFi. If not, then 2024 could be the year regulators take steps to try to limit the activities of DeFi market participants – with unfortunate consequences for innovation.
In this environment, it will be increasingly important for participants in the DeFi space to consider how they can leverage compliance solutions such as blockchain analytics to ensure that they do not conflict with regulatory expectations.
Contact us to learn more about how Elliptic can work with you to manage regulatory expectations and compliance challenges involving DeFi.
Crypto Regulation DeFi Global
