In the same way as ICOs (Initial Coin Offerings) in 2017, decentralized finance (DeFi) is the sector that will have evolved the most during 2021. Therefore, in the same perspective as the regulation of ICOs by the French Pact law of May 22, 2019, it seems appropriate to consider prospectively, the possibilities that the regulator may seize to frame this ecosystem.
The regulation of the crypto-asset sector is struggling to be put in place at the international level, even if 2022 promises to be a pivotal year for the regulation of the ecosystem in its entirety. In Europe, the lead taken in 2019 over our European neighbors already seems remote. The sector is constantly evolving, and legal issues are emerging every day. DeFi is part of this process and is attracting the interest of the American regulator. Indeed, the American financial regulators (SEC: Securities and Exchange Commission) are taking a closer look at decentralized finance, which has developed considerably over the last year.
The regulators’ interest in this ecosystem is reflected in the success of these platforms, where tens of billions of dollars pass through each month. However, the multiplication of scams and hacks has made the SEC shudder, which has undertaken an investigation into Uniswap Labs, the startup responsible for developing the decentralized exchange protocol.
The value of Uniswap and all decentralized exchange platforms lies in the mechanism of the protocol itself. Indeed, public blockchains such as Ethereum will guarantee transparency, security and the in censurable nature of all transactions. Moreover, decentralized exchange platforms allow tokens to be exchanged without the intervention of a trusted intermediary. In contrast to centralized platforms (CEX), where a customer identification procedure (KYC) is required, Uniswap can be used by anyone without any identification requirement. Finally, it is not possible to shut down the DEX since no one controls the execution of the protocol, it is smart contracts that will automate the actions of users.
The US regulator seems to be taking a closer look at DeFi by investigating Uniswap. As usual, this player is taking its role very seriously and knows that many countries are watching how it will take on this sector. It seems obvious that this investigation is a first approach of the regulator, to understand the functioning and the legal stakes that come from these platforms.
This sector knew that there was a sword of Damocles hanging over its head, and that one day the regulator would investigate it. It will be interesting to consider the means available to regulators and to what extent decentralized finance can be regulated.
“Code is law”?
This saying, which appeared in an article by Lawrence Lessig in 2000, hides a mistaken vision of the use of the Internet and the regulation of behavior. Indeed, the idea that legal norms were secondary to the technical architecture of the various platforms was utopian. From the same perspective as the Internet in the 2000s, one may wonder whether this notion that the code is the law can be admissible in the case of DeFi more than twenty years later.
I assume that this notion is now reversed and that this saying is obsolete.
This notion is outdated, because it has not been able to withstand the regulation of the internet and the behaviors that flow from it. Therefore, the people behind these decentralized finance projects cannot “hide” behind this concept, which should now be replaced by “Law is code”.
The legal stakes of DeFi
The key to the regulation of decentralized finance protocols lies in (i) the identification of the individuals who use these platforms, as well as (ii) the identification of the legal or natural persons who are at the origin of the provision of these financial services and products to make them comply with the existing regulations.
- The need to identify any person using platforms such as Uniswap or Sushiswap is complex and would mean setting up a Know Your Customer (KYC) procedure to filter and identify users who interact with smart contracts. However, it is not individuals who will interact but addresses that remain pseudonymous. Thus, the identification of the person through his or her address seems to be a measure whose practicability is to be reviewed.
- The need for this identification has been put forward in binding recommendations of the Financial Action Task Force (FATF). This is since the natural or legal persons behind these DeFi projects will issue a governance token that will give its holders “decision-making power over the structures that affect the intrinsic value”. Thus, the regulator must consider whether these tokens are Security by verifying on a case-by-case basis whether they meet the financial instrument of security or the qualification of crypto-asset. Following this identification, it may be possible to apply the regulation on crypto-assets or on financial securities.
The identification of the legal or natural persons who represent DeFi projects is paramount to apply regulation to them, or at least attempt to do so.
On the one hand, the fact that this protocol is decentralized does not make the identification exercise more difficult. Indeed, most of these projects are guided by associations, foundations, or companies as for Compound and Uniswap. Otherwise, the physical persons who accompany the project in one way or another (business developer, founder…) can be identified on the social networks. Moreover, most of the protocols have an interface where it is easy to collect information about the people behind the protocol.
On the other hand, the question of applicable regulations is central and can be a hindrance for players wishing to enter the world of DeFi. Indeed, one could say that the fact that the existing regulation is intended to be applied to companies that are going to provide a service in a centralized way makes its application in DeFi wrong. Nevertheless, it is appropriate to put forward the idea that these platforms, through the implementation of financial services, have a professional activity. In fact, the objective of these platforms is to make profits, whether through the fees collected or the issuance of governance tokens whose value may increase. Considering that the financial regulation of centralized actors is applicable to decentralized projects offering financial services and products, we must now appreciate the reality that would result from its application. The addition of a non-adapted regulatory layer would push all these projects to failure and the deregistration of decentralized finance and of an ecosystem that has just been born.
- The regulations surrounding the fight against money laundering and the financing of terrorism (LCB-FT) are designed to control the intermediaries and not the actors, however, in the DeFi projects there is no intermediary in the form of a centralized company. This problem is expressly exposed by the FATF in a consultation by issuing the hypothesis that if the DeFi protocols mature one day, they will allow peer-to-peer transactions and make one imagine a future without financial intermediaries, which could call into question the interest and effectiveness of the FATF recommendations. This fear seems coherent when one knows that international regulations on the fight against money laundering and terrorist financing are based on the recommendations of this organization.
- In the world of traditional finance, we regulate the actors who are the authors of intermediations and we regulate very little the users. Conversely, in the world of decentralized finance, there are no intermediaries. An entity like Uniswap is a technology provider that will make available a protocol allowing financial exchanges for users. The question that the regulators must ask themselves is whether Uniswap is a financial intermediary or not, this is the central issue of this regulatory reflection.
At present, it appears very complex for lawyers to legally accompany entrepreneurs in the deployment of their DeFi project insofar as this activity is difficult to qualify. Indeed, in most of the cases there is no intermediary and the financial products that the platform proposes do not fit into any existing legal definition. Consequently, one can wonder how to apply a regulation that is not adapted.
The appreciation of the stakes by regulatory actors
The French regulator, which had taken the lead in Europe with the regulation of digital assets in the PACTE law of May 22, 2019 by establishing a framework for ICOs and digital asset service providers (DASPs), is now lagging the United States as a leader as well remembered. This is certainly due to the European Union’s desire to harmonize the regulations of its member states and avoid some competition. The regulatory text called MiCA (Markets in Crypto-Assets) allows this regulatory harmonization surrounding the crypto-asset market in Europe.
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