[This piece was authored by Mainak Mukherjee, a student at the National Law University and Judicial Academy, Assam.]
Unless you have been living on a deserted island without an internet connection for the past ten years, chances are that you have heard of crypto-currencies at least once by now. By allowing peer-to-peer payments, Cryptocurrencies have elevated participation in the global economy, even for those who do not have access to traditional financial services. This has only been made possible with the expansion of DeFi or Decentralised Finance. Being completely unregulated, DeFi—a polar opposite of the traditional financial system—essentially disempowers all the intermediaries and go-betweens in a transaction and allows users to retain control over their money. However, recently, the global DeFi space’s continued exponential expansion has sparked conversations around regulations in the United States, Europe, Latin America, and other parts of the planet. In this article, the author will discuss strategies of DeFi regulations from the lens of the Wicked Problem Theory.
What is Decentralised Finance/ DeFi?
DeFi is a financial system that effectively removes intermediaries such as banks, brokerage, and other middlemen. It operates algorithmically by governing interactions between peers, and allowing them to buy, sell, borrow, and lend more efficiently. DeFi, unlike traditional finance, is a type of finance that does not rely on central intermediaries. DeFi operates using blockchain, cryptocurrencies (mainly stablecoins) and smart contracts.
Since DeFi uses blockchain technology, it eliminates the unnecessary intermediaries of a traditional financial system; users can maintain complete control over their wallets and services and can interact with them with the help of DeFi applications or dApps. As the name suggests, dApps are decentralised applications, which run on a peer-to-peer network such as a blockchain, and are made functional by smart contracts. Thus, no single entity has authority over them.
Why is there a need to regulate DeFi?
A lack of a controlling authority over the DeFi platform makes matters rather complex. There is little clarity regarding who is responsible to ensure that DeFi applications and that dApps adhere to existing regulations and protocols. For example, if a ransom ware attacker uses any Decentralised Exchange (or “DEX“) to launder their stolen funds, who is responsible for reporting such activity? Who could be made answerable for all this? All these unanswered questions, which add to the complexity of DeFi, can be answered if the sector is regulated.
Moreover, allowing individuals to invest in a market without any regulations can result in the emergence of non-fair markets. Non-fair markets can be detrimental for investors without prior knowledge of the market. These markets are vulnerable to wash-trades, spoofing, pump and dump, and privacy-related concerns as sensitive information is released and available to everyone. Regulations can level the playing field and ensure all activities are kept in check and markets operate fairly. Further, the lack of education and understanding of DeFi can have adverse effects on potential investors as they cannot comprehend the risks. Regulations can address this problem and provide investor protection. It can translate complex instruments for ordinary people to understand and digest.
Furthermore, we see that banks that are already heavily regulated, still breach the regulations. So, we can only imagine what would happen in a world where there were no regulations at all. Therefore, with regulation and protection, DeFi shall be a fairer and safer.
The challenging factor
The existing traditional regulatory framework lacks the expertise and resources to regulate the DeFi space. Given how fast technology advances, traditional regulations may become obsolete even before their ink dries. The pacing problem is characterised by growing market demand, business competition, and innovation at every end – all this combined can make it difficult for any traditional regulation to keep up. Moreover, when the DeFi market keeps growing exponentially, we see TradFi sectors becoming slower due to more legislative processes, regulations, and judicial review.
Another challenging factor may be that DeFi presents risks and concerns outside the scope of the existing regulatory framework. DeFi can often escape regulatory oversight of its regulation is subject to the existing framework. Emerging technologies raise broader social and ethical concerns, which are not within the safety and efficacy scope of the existing regulatory framework.
Moreover, DeFi is a broad application that involves different types of businesses and stakeholders, and other non-governmental players and industries. The broad application may span over different regulatory institutes, each having its own set of standards and rules. This can lead to enormous complexity and diversity in application. However, this can be solved if there is international cooperation. Participating members agree to follow a standard international guideline—soft law—for all DeFi frameworks (this shall be further discussed in the following section).
The possible ex-ante and ex-post regulatory approaches
Professor Gary E. Merchant, in his paper, Governance of Emerging Technologies as a Wicked Problem, has stated that the governance of emerging technologies presents a “wicked problem”, that is, it does not have a single solution, but a mix of substandard solutions that must satisfice. In this section of the article, the author will discuss the different regulatory approaches, both ex-ante and ex-post that could be formulated, keeping in mind the challenges that DeFi poses.
a. Soft Law
Soft law instruments have set forth substantive requirements that are not enforceable by government regulators. They comprise of private standard codes, guidelines, rules, certification, and voluntary programs. Soft laws are more agile than traditional regulations, which makes them easier to revise quickly. Moreover, they are more cooperative than adversarial, which makes them more efficient in delivery success. Further, since it is not tied to any particular regulatory agency, its approach is not influenced by any specific legal jurisdiction, which makes it inherently international in the application. Furthermore, the standard chain of DeFi, outside the soft law regulations, can act as a sandbox for DeFi innovations. These innovations can experiment before it gets adopted by any of the regulatory groups, so in no way does soft laws act as a stumbling block for any DeFi innovation that is going on.
b. Precaution “to err on the side of caution”
The precautionary principle is adopted based on the past pattern of regulators failing to take protective measures against uncertain risks. As it flips the presumption on uncertainty, the precautionary principle will help identify the uncertainties in DeFi. The programmers and regulators of DeFi can be informed about such uncertainties, which can be later resolved in favour of safety, rather than using it as a medium for taking regulatory actions. This can further bolster trust between regulators and DeFi programmers and keep the door open for further cooperation in the future.
c. Resilience
Resilience is a form of ex-post measure that is more concerned about mitigating the harm than punishing the risk creator. It seeks to restore the fundamental structure after the harm has occurred. Like any other finance, DeFi is bound to cause harm in the form of human activity or technology. However, through resilience, a prudent solution can be adopted to mitigate the harm and not impede the growth process of such an emerging technology. Resilience can be substantive: such as requirements and parameters, or procedural: prompt action for mitigating harm. After harm has occurred and has been dealt with in the DeFi sector, a used resilience strategy can be a more effective strategy for future risks.
d. Liability
The fourth strategy for regulating DeFi can be a liability. Suppose any of the proponents of DeFi cause harm. In that case, the entities at its helm shall be made liable for the resultant injuries. Liability can compensate people for their injuries and incentivise DeFi actors to ensure that all the technologies are adequately tested and used safely to evade any harm. Due to it being an ex-post strategy, it does not rely on a hypothetical assessment of risks, as it can be used right after the harm has occurred. Liability will also bring in the scope for litigation in the DeFi space as liability and damages can be determined through a proper court procedure or Online Dispute Resolution platforms [or “ODRs”].
Conclusion
In conclusion, TradFi regulatory frameworks are inadequately and poorly aligned to govern DeFi. Moreover, while bringing in governance, it has to be ensured that regulations do not act as a buzzkill for the main component of DeFi that is, not being controlled by a single entity. While regulations are welcomed, they cannot come at the cost of stagnating innovation and potential growth. Thus, DeFi poses a “wicked problem” that can be resolved by several substandard regulatory approaches—namely: soft law, precaution, resilience, and liability.
Since wicked problems are characterised by uncertainty and complexity, similar to DeFi, the strategies evolved to solve wicked problems can provide necessary insights and help in regulating DeFi. However, there will not be any perfect solution to this problem. We must “muddle through” imperfect solutions to find the best strategy. Lastly, it allows the world community to cooperate in formulating and recognising specific mechanisms, further harmonising strategies and potential regulations.