Additional Decentralization Is Required for DeFi

The in-depth report on DeFi released by the US Commodity Futures Trading Commission at the beginning of January received less attention than it deserved amidst the recent focus on ETF news.

The majority of the news coverage primarily emphasized the report’s recommendations regarding the implementation of identity and AML practices. However, it is essential to note that this was just one aspect of the document’s comprehensive scope.

The Main Types of Risks Have Been Taken Into Account

The 79-page report, developed by the Commission’s subgroup on digital currencies and blockchain technologies, provides a comprehensive analysis of the risks associated with the rising decentralized banking system.

Of particular interest is its analysis of the extent to which these risks can be mitigated through regulatory measures employing various methods of decentralization.

It is widely believed, even among those involved in the crypto industry, that DeFi must adopt a more professional and regulated approach. Given the crypto industry’s current trajectory, some form of regulation is likely to occur.

However, this report takes a more comprehensive approach by explicitly stating that embracing innovation without requiring permission is necessary in order to explore and fully reap the advantages of DeFi.

DeFi founders should wholeheartedly embrace decentralization in their projects to enhance resilience and minimize regulatory risk. This concept goes against the prevalent thinking in DeFi, which suggests that decentralized projects are exposed to significant regulatory risks. By accepting decentralized systems and partners and ceding control to a distributed community, the project can demonstrate its compliance with established regulations.

Encouraged Reading for the Company’s Founders

This report is highly recommended for all DeFi founders, as it provides valuable insights for policymakers. The CFTC’s report presents a framework to evaluate DeFi protocols and unique risks not typically encountered in traditional finance, such as vulnerabilities in code or rug pulls.

By utilizing the report’s objective framework, founders can assess the level of decentralization within their projects across various components. Although governance and token ownership play a crucial role in decentralization, the development and operations aspects often tend to be more centralized in practice. They heavily rely on a limited number of businesses for facilities and construction activities.

The CFTC report illuminates the various aspects that regulators view as potential financial risks in DeFi. From a regulatory standpoint, these areas are potential vulnerabilities for DeFi’s protocols and entrepreneurs.

In our field, there is a strong emphasis on understanding our customers (KYC) as a crucial aspect of compliance. However, this narrow focus sometimes overlooks the intricate nature of regulatory risks. From a professional standpoint, founders can utilize the report to gain a regulator’s perspective on their project and identify areas where they may need to improve in compliance.

There Are No Strict Boundaries

In the end, the various aspects of decentralized governance make it challenging to definitively determine if a project meets the criteria of being “sufficiently” decentralized. Entrepreneurs and regulators face a common challenge here.

However, determining the appropriate boundaries is not solely about mitigating risk. Excessive oversight in DeFi could have negative consequences by potentially hindering innovation. Governments are likely to prioritize maximizing the benefits while acknowledging the need to manage specific risks.

Founders should also reassess their notions of both professional and personal achievement, as the existence of a founder with significant control over other token holders can indicate a level of centralization. Thus, achieving success in DeFi careers may require a distinct path, diverging from the conventional trajectory followed by billionaire rockstar founders who typically dominate centralized tech companies.

In addition, when control is decentralized, there is a risk that the community may make decisions that go against the founder’s or project’s interests. This was demonstrated in the case of AragonDAO, where the community voted to sue its founders, the Aragon Association, ultimately contributing to its downfall last year.

The report urges DeFi founders to prioritize the establishment and nurturing of genuinely decentralized systems that effectively demonstrate decentralization’s advantages.

Given the potential for future DeFi regulation, fostering more vital collaboration among the industry and legislators is undoubtedly a step in the right direction. For the foreseeable future, the ecosystem will continue to be driven by fully decentralized innovation.