Abstract
This paper proposes eight principles for DeFi disclosure and regulation based on the implications from the key challenges, risks, and questions. Such implications include Innovation Trilemma, whether a DeFi constitutes the “financial service” which participants are subject to consumer/investor protection needs to be considered, regulations from the perspective of systemic risk and anti-money laundering, establishment of a disclosure system and enforcement framework suitable for the characteristics of DeFi and crypto-assets. Creating a common disclosure platform in which national authorities and international standard-setting bodies could participate and give authority would be desirable. Such a framework would provide basic information regarding a DeFi, such as disclosure of data, governance mechanisms, token information, as well as information on audits, etc., and it would be a convenient way to check for compliance as well. Designing an appropriate common disclosure platform, that also considers participants’ incentive structure, is very challenging and will be the subject of further research.
This paper owes much to the paper “Proposal of Principles of DeFi Disclosure and Regulation”, which is the output paper of the IKP-WG (IAM, Key Management and Privacy Working Group) of the Blockchain Governance Initiative Network (BGIN). (BGIN Website: https://bgin-global.org/docs/). Authors (Tomonori Yuyama, Ken Katayama, and Paul Brigner) are editors of this paper. Authors would like to thank the WG co-chair Nat Sakimura (OpenID Foundation), Mitchell Travers (Soulbis Pty Ltd), the paper contributors (Tetsu Kurumizawa (Yale University), Michi Kakebayashi (UC Berkeley), Shinji Sato (Independent researcher), Stephanie Bazley (AirTree Ventures), and Yuji Suga (IIJ)), and all participants in this WG. This paper is also considered to be the paper that further updates the BGIN (2021) published by the IKPWG in the BGIN.
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Notes
- 1.
The Senate hearing can be viewed below. Also, the materials of the speakers are available for downloading. (https://www.banking.senate.gov/hearings/crypto-crash-why-the-ftx-bubble-burst-and-the-harm-to-consumers) (Last viewed on February 10, 2023).
- 2.
According to Twitter, they tweeted “Badger has received reports of unauthorized withdrawals of user funds. As Badger engineers investigate this, all smart contracts have been paused to prevent further withdrawals. Our investigation is ongoing and we will release further information as soon as possible,” (https://twitter.com/BadgerDAO/status/1466263899498377218) (Last viewed on February 10, 2023).
- 3.
See, for example, Armour et al. [2] for a discussion of what finance is.
- 4.
CFTC Press release,(September 22, 2022) “CFTC Imposes $ 250,000 Penalty Against bZeroX, LLC and Its Founders and Charges Successor Ooki DAO for Offering Illegal, Off-Exchange Digital-Asset Trading, Registration Violations, and Failing to Comply with Bank Secrecy Act” (https://www.cftc.gov/PressRoom/PressReleases/859022).
- 5.
See also the IMF [30] for a detailed summary of this point.
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Appendices
Appendix
Appendix A. Terms and Definitions
This document uses the following terms as the shortcut for more complete wording provided as the definition. When the term appears within this document, it should be read as being replaced by the term.
Decentralized financial technologies | Technologies that may reduce or eliminate the need for one or more intermediaries or centralized processes in the provision of financial services [SOURCE: FSB [22]] |
Decentralized financial system | A new financial system that could be the result of decentralized financial technology [SOURCE: FSB [22]] |
Decentralized Finance (DeFi) | Financial applications that are automatically operated by smart contracts or other code |
Smart contract | A collection of code and data (sometimes referred to as functions and state) that is deployed using crypto-graphically signed transactions on the blockchain network. The smart contract is executed by nodes within the blockchain network; all nodes must derive the same results for the execution, and the results of execution are recorded on the blockchain [Source: NIST [33]] |
Appendix B. Abbreviations and Symbols
In this document, the following abbreviations and symbols are used.
AML | Anti Money Laundering |
BGIN | Blockchain Governance Initiative Network |
BIS | Bank of International Settlements |
DeFi | Decentralized Finance |
DAOs | Decentralized autonomous organizations |
FATF | The Financial Action Task Force |
DEX | Decentralized Exchange |
FSB | Financial Stability Board |
IOSCO | International Organization of Securities Commissions |
KYC | Know Your Customer |
SBTs | Soulbound Tokens |
SEC | The U.S. Securities and Exchange Commission |
NIST | National Institute of Standards and Technology |
NOTE: All the abbreviations SHALL appear in this clause.
Appendix C. Summary of Existing DeFi Initiatives
Description | |
---|---|
Lending | By using smart contracts, users can become lenders or borrowers on DeFi platforms. Users typically post crypto-assets as collateral and then can borrow other crypto-assets. The most prominent platform typically requires $150 of collateral for every $100 of lending. Many platforms set interest rates automatically, depending on demand and supply of liquidity. Some of these platforms have characteristics analogous to commercial and/or central banks |
Investment (Asset Management /Derivatives) | Many projects offer a suite of yield-generating crypto-asset products by automatically routing crypto-asset “deposits” to highest-yield opportunities within a set risk-tolerance for particular pools. Other platforms allow derivative products such as synthetic assets, options or perpetual futures as well as crypto-asset tranches |
Decentralised Exchanges (DEXs) | Decentralised Exchanges claim to be peer-to-peer marketplaces based on smart contracts that allow trading in crypto-assets. They use automated liquidity pools, where investors ‘lock’ in their crypto-assets (in exchange for fees) to facilitate trading |
Payments | Many applications focus on increasing interoperability between blockchains, with the aim to increase scaling. Others focus on increasing the safety of existing means of payment (e.g. through the use of QR codes), by using the blockchain to validate transactions in real time |
Insurance | Some DeFi protocols, called discretionary mutuals, allow members to pool and share risks from smart contract failure, or mutualise premiums into smart contracts that trigger payouts when pre-defined risks or events materialise |
(Source) Excerpt from FSB [23].
Appendix D. Proposals by International Organizations and Standard-Setting Bodies
(1) IMF’s considerations for regulatory frameworks
IMF [30] points out the following with respect to considerations for regulatory frameworks across crypto assets.
-
(1)
Monitoring
Authorities should first monitor developments to accurately gauge the size of the market and to identify areas of risk,
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(2)
Prioritization
Authorities should consider the risks of unbacked crypto assets as part of their broader regulatory and supervisory duties and determine whether the crypto asset market presents risks to their mandate that would reflect the considerable resources required to regulate and supervise crypto assets.
-
(3)
Scope
Authorities should determine a clear scope for regulation, that is, which entities, crypto assets, and activities will fall within the regulatory scope
-
(4)
Domestic Collaboration
Regulatory development should be a collaborative effort of financial sector regulators and relevant government departments, taking into account guidance from standard-setting bodies and regulatory approaches in peer countries
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(5)
Continuous Assessment of Risks
Continuous assessment of risks will be needed to identify shifting risks and business models that may require updating regulations to ensure effective protection of markets, consumers, and financial stability
(2) FSB report
FSB [24], “Regulation, Supervision and Oversight of Crypto-Asset Activities and Markets Consultative document”, proposed 9 recommendations for the regulation, supervision and oversight of crypto-asset activities and markets. The summary of the proposals are below. (Excerpt from FSB [24]).
Recommendation 1: Regulatory Powers and Tools. Authorities should have the appropriate powers and tools, and adequate resources, to regulate, supervise, and oversee crypto-asset activities and markets, including crypto-asset issuers and service providers, as appropriate.
Recommendation 2: General Regulatory Framework. Authorities should apply effective regulation, supervision, and oversight to crypto-asset activities and markets – including crypto-asset issuers and service providers – proportionate to the financial stability risk they pose, or potentially pose, in line with the principle “same activity, same risk, same regulation.”
Recommendation 3: Cross-Border Cooperation, Coordination and Information Sharing Authorities. Authorities should cooperate and coordinate with each other, both domestically and internationally, to foster efficient and effective communication, information sharing and consultation in order to support each other as appropriate in fulfilling their respective mandates and to encourage consistency of regulatory and supervisory outcomes.
Recommendation 4: Governance. Authorities, as appropriate, should require that crypto-asset issuers and service providers have in place and disclose a comprehensive governance framework. The governance framework should be proportionate to their risk, size, complexity and systemic importance, and to the financial stability risk that may be posed by the activity or market in which the crypto-asset issuers and service providers are participating. It should provide for clear and direct lines of responsibility and accountability for the functions and activities they are conducting.
Recommendation 5: Risk Management. Authorities, as appropriate, should require crypto-asset service providers to have an effective risk management framework that comprehensively addresses all material risks associated with their activities. The framework should be proportionate to their risk, size, complexity, and systemic importance, and to the financial stability risk that may be posed by the activity or market in which they are participating.
Authorities should, to the extent necessary to achieve regulatory outcomes comparable to those in traditional finance, require crypto-asset issuers to address the financial stability risk that may be posed by the activity or market in which they are participating.
Recommendation 6: Data Collection, Recording and Reporting. Authorities, as appropriate, should require that crypto-asset issuers and service providers have in place robust frameworks for collecting, storing, safeguarding, and the timely and accurate reporting of data, including relevant policies, procedures and infrastructures needed, in each case proportionate to their risk, size, complexity and systemic importance. Authorities should have access to the data as necessary and appropriate to fulfill their regulatory, supervisory and oversight mandates.
Recommendation 7: Disclosures. Authorities should require that crypto-asset issuers and service providers disclose to users and relevant stakeholders comprehensive, clear and transparent information regarding their operations, risk profiles and financial conditions, as well as the products they provide and activities they conduct.
Recommendation 8: Addressing Financial Stability Risks Arising from Interconnections and Inter-dependencies. Authorities should identify and monitor the relevant interconnections, both within the crypto-asset ecosystem, as well as between the crypto-asset ecosystem and the wider financial system. Authorities should address financial stability risks that arise from these interconnections and inter-dependencies.
Recommendation 9: Comprehensive Regulation of Crypto-Asset Service Providers with Multiple Functions. Authorities should ensure that crypto-asset service providers that combine multiple functions and activities, for example crypto-asset trading platforms, are subject to regulation, supervision and oversight that comprehensively address the risks associated with individual functions as well as the risks arising from the combination of functions, including requirements to separate certain functions and activities, as appropriate.
(3) IOSCO report
IOSCO [31], “Decentralized Finance Report” point out that financial innovation may lead to benefits for investors and others, but it may also present risks. Then it point out that DeFi appears to present many similar risks to investors, market integrity and financial stability as do other financial products and services, and it also poses specific and unique risks and challenges for regulators to consider. Potential regulatory concerns raised by IOSCO [31], are below.
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Asymmetry and fraud risks
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Market integrity risks
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Front-running (or similar frauds)
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Flash loans
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Market dependencies
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Use of leverage
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Illicit activity risks
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Operational and technology-based risks (Blockchain, Smart Contracts, Oracles)
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Cybersecurity
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Nascent stage of development (Comprehensibility, Scalability, Supportability, Reliability)
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Governance risks
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Spillover of risks to centralized/traditional markets
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Centralized Crypto-asset Trading Platforms
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Traditional Financial Institutions
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(4) FSOC Recommendations
In the U.S., the FSOC (Financial Stability Oversight Council) suggests the following as recommendations for building regulations on crypto-graphic assets.(FSOC [25])
(Recommendation 1). Member agencies (Treasury department, SEC, OCC, FRB, FDIC, etc.) consider these general principles in their deliberations about the applicability of current authorities: Same activity, same risk, same regulatory outcome;
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Technological neutrality;
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Leveraging existing authorities where appropriate;
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Transparency in technology, including through potential future adoption and implementation of federal agency SBOM requirements by industry;
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Addressing financial stability risks before they impair the economy;
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Monitoring mechanisms through which crypto-assets could become more interconnected with the traditional financial system or increase in overall scale;
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Bringing transparency to opaque areas, including through disclosures and documentation of key issues such as inter-connectedness;
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Prioritizing timely and orderly transaction processing and legally binding settlement;
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Facilitating price discovery and fostering market integrity; and
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Obtaining, and sharing with other agencies, relevant market data from the crypto-asset market.
(Recommendation 2). Continued enforcement are needed.
(Recommendation 3). Congress pass legislation that provides for explicit rule-making authority for federal financial regulators over the spot market for crypto-assets that are not securities.
(Recommendation 4). Regulators continue to coordinate with each other in the supervision of crypto-asset entities, such as stablecoins issuers or crypto-asset platforms, particularly in cases where different entities with similar activities may be subject to different regulatory regimes or when no one regulator has visibility across all affiliates, subsidiaries, and service providers of an entity.
(Recommendation 5). Congress pass legislation that would create a comprehensive federal prudential framework for stablecoin issuers that also addresses the associated market integrity, investor and consumer protection, and payment system risks, including for entities that perform services critical to the functioning of the stablecoin arrangement.
(Recommendation 6). Congress develop legislation that would create authority for regulators to have visibility into, and otherwise supervise, the activities of all of the affiliates and subsidiaries of crypto-asset entities, in cases in which regulators do not already possess such authority.
(Recommendation 7). FDIC, FRB, OCC, and state bank regulators use their existing authorities, as appropriate, to review services provided to banks by crypto-asset service providers and other entities in the crypto-asset arena.
(Recommendation 8). Member agencies assess the impact of vertical integration (i.e., direct access to markets by retail customers) on conflicts of interest and market volatility, and whether vertically integrated market structures can or should be accommodated under existing laws and regulations.
(Recommendation 9). Coordinated government-wide approach to data and to the analysis, monitoring, supervision, and regulation of crypto-asset activities.
(Recommendation 10). Council members continue to build their capacity to analyze and monitor crypto-asset activities and allocate sufficient resources to do so.
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Yuyama, T., Katayama, K., Brigner, P. (2024). Proposal of Principles of DeFi Disclosure and Regulation. In: Essex, A., et al. Financial Cryptography and Data Security. FC 2023 International Workshops. FC 2023. Lecture Notes in Computer Science, vol 13953. Springer, Cham. https://doi.org/10.1007/978-3-031-48806-1_10
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