DeFi – short for Decentralized Finance – continues to be a hot topic on the cutting edge of financial trading. The appeal of somehow cutting away from intermediaries to a pure peer-to-peer trading and lending experience has a strong allure for a lot of technologically inclined investors, and as investments in the space grow, the market potential seems huge.
But, like cryptocurrencies and a thousand other digital revolutions before it, it has one big issue: these cutting edge spaces sail in murky waters when it comes to regulation and overall legality, and it’s important for would-be market participants to understand precisely what it is they’re taking on by participating, because regulators have taken notice.
It’s something that Dan Berkovitz, U.S. Commodity Futures Trading (CFTC) Commissioner, stressed caution in a talk for DACOM 2021, a DeFi conference hosted by Solidus Labs.
“You have to remember that not all regulation falls on intermediaries – some of it falls on the market participants themselves,” Berkovitz said. “So absent an intermediary, the burden of reporting, recordkeeping, making sure positions aren’t too large – that may all fall directly on the market participant. So it’s not as if you can simply take the intermediaries out and then there’s no regulation.”
Indeed, the licensed exchanges of centralized finance currently cover a number of issues that DeFi still has to solve: from regulatory responsibility for clearing and ensuring the availability of funds, to even more basic critical matters like basic market surveillance to guard against malicious actors to safeguard the integrity of the marketplace.
And making those unlicensed trades as a market participant is already illegal – just something the CFTC has not focused its enforcement actions on with intermediaries serving as a larger target for dealing with bad actors.
“We typically go after the person who’s facilitating the trading,” Berkovitz said. “But in a situation where you’ve taken out the intermediary, and you just have a bunch of people trading contracts – those contracts can still be in violation of the Commodity Exchange Act. I think, in the long run, if you want to get institutional liquidity and make the financial markets work for mainstream American businesses and consumers, you have to solve the problem of the legality of the contracts.”
It’s a core problem to be addressed – but one that Berkovitz is hopeful that digital innovators can solve for. After all, as he notes, it’s happened before.
“You look at who the exchanges are today,” Berkovitz said. “They’re CME and ICE. They were the disruptors in their day. There were questions in computer trading – who’s the broker? Who’s responsible when two computers trade? The questions now are new, but it’s not been unprecedented for there to be new questions. If you can provide regulatory objectives to the market through protocols rather than people, then more power to you! We’re not going to say you have to have a division with five people; you just have to satisfy the various functions.”
“That’s something that could work. It will take some effort because our regulations just haven’t been designed for the way these applications are evolving. But it can be done. It has been done before! And to be successful, I think it needs to be done.”