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Thoughts on DeFi Policymaking and Regulation

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By Benjamin Melnicki, Chief Compliance Officer, Grayscale Investments and Craig Salm, Vice President of Legal, Grayscale Investments

 

History holds the key for the future of crypto regulation

 

As the crypto industry continues to grow and mature, regulation can no longer predominantly be done through enforcement actions. It’s time for oversight of this industry to move beyond enforcement toward the creation of a regulatory and legislative framework that recognizes the potential and importance of digital currencies and, more broadly, decentralized finance (DeFi), an umbrella term used to describe a variety of blockchain-based financial applications that provide traditional financial services using smart contracts.

 

This moment in financial history is an opportunity to take a fresh look at both historical precedent and  crypto regulation, with appreciation for the sophisticated financial regulatory framework that has ensured adequate investor protections for decades. 

 

The fact is DeFi is not just disrupting our current legacy financial system. DeFi, as a concept, is an effort to make finance better. It’s a bridge to a more inclusive, accessible financial services ecosystem for all. Today, over 2.3 billion people are excluded from the traditional financial system, and even more lack access to sophisticated services such as borrowing, lending and asset management. DeFi provides a solution for this inequitable challenge. But to achieve increased inclusivity, we need a refreshed framework that brings together legislators, policymakers, and regulators who recognize this potential for positive change.

 

Policymakers vs regulators – or policymakers and regulators?

 

While at times it appears as though the roles of legislators, policymakers, and regulators may blur – there are important differences we all must keep in mind.

 

Legislators and policymakers define and set the fundamentals within which regulators determine specific regulations. They must outline the policies and ‘rules of the road.’ As one paper stated, legislation can be thought of as ‘macro policy’ vs. regulation as ‘micro policy.’ No legislator or policymaker can predict exactly how a policy might need to be enforced or enacted and so legislation cannot be overly prescriptive. Not only is the work of these groups not mutually exclusive as some believe, but their work should — and often does — work in tandem. The true value of collaboration between policymakers and regulators can be clearly seen during periods of extraordinary and necessary market change.

 

However, in crypto, regulators have been the primary drivers of our current ‘regulation by enforcement’ environment. Policymakers have used these regulatory actions to inform policy creation, which is the opposite of how other industries are regulated. We’re creating policy from enforcement instead of policy from the most common use cases.

 

Why it’s time

 

The digital currency industry has evolved so rapidly that its treatment by both regulators and legislators is well-intentioned but dispersed. There is not a singular or holistic approach to how digital assets are treated. Is it a currency? Property? Security? Commodity? There are even differences as to how digital assets are treated at a state versus federal level. 

 

Perhaps there was nothing wrong with these conflicting messages yesterday. The hodgepodge global regulatory approach ten years ago was understandable, maybe even appropriate, considering that blockchain and digital currencies were nascent technologies. At the time, crypto was so new and so little understood that there was not a clear path to implementing a holistic approach to regulation. In a very real way, the regulatory tool box was empty.

 

But we understand crypto more today and our regulatory tool box’s inventory has increased significantly. A growing number of investors are moving into this asset class, and they deserve the same protections that exist in other aspects of finance. To not look at our existing regulatory policies with fresh eyes would not only be a disservice to investors across the country, but it could also hobble the innovation that DeFi and digital currencies are currently inspiring. We should look to the ‘do no harm’ approach of the Internet era when considering a more consistent approach today.

 

Smart regulation leads to better innovation

 

During the internet’s infancy, the U.S. government under the Clinton administration published its landmark Global Framework for Electronic Commerce, which set in action an age of ‘do no harm’ policies aimed at supporting — not stifling — this new technology’s potential. The framework consisted of a series of specific recommendations for not taxing, regulating, or restricting the then nascent and key promise of the Internet: global electronic commerce. It was not only an important framework, but an inspiring call to action for other global regulatory bodies in light of the global cooperation needed to realize the internet’s full potential.

 

Had it not been for this philosophy of regulation by support, not by enforcement, the period of American economic growth driven by the applications and infrastructure of the internet would have been crippled.  It’s vital to recognize that  this type of supportive regulatory framework helped the US further solidify its  ‘economic superpower’ status.

 

Effective regulation solidifies U.S. leadership

 

Shifting over from technology to finance, the aftermath of the Global Financial Crisis provides helpful analogies for crypto regulation too. 2007-2009 was a time during which credit default swaps and other complicated derivatives were considered by some to be ‘weapons of mass destruction.’ Banks were going under and the entire financial system experienced the most severe economic recession since the Great Depression of the 1930s.

 

During an unprecedented crisis, American policymakers and regulators came together to establish an entirely new legislative framework: Dodd-Frank. This legislation was followed by extensive rulemaking across multiple regulatory agencies and constituencies. 

 

Dodd-Frank gave birth to SEFs, SDRs, SDs and SBS, an entirely new set of market intermediaries, market participants, rules and practices – stretching across regulatory authorities and varying levels of Congressional oversight.

 

Yet again, the U.S. led, and the world followed.

 

The Global Financial Crisis serves as an example, albeit a dystopian one, of how we’ve used regulation to navigate a challenging financial quandary before. If the U.S. was able to bring policymakers and regulators together during the throes of a dire crisis to create a hugely beneficial framework that continues to live on today – can we not work together to create the legislative framework the crypto industry so sorely needs right now?

 

The path forward

 

The supposed tension between crypto and the existing financial system is a story from an earlier time. It’s a story that today’s reality does not support. The truth is that there is so much these two financial systems can learn from one another. And perhaps the most important lesson to learn is that we all want the same thing: A more equitable financial system that works for everyone, not just a small few.

 

DeFi and digital currencies have the potential to achieve the financial inclusion goals that so many constituents – politicians, legislators, market participants, voters, institutions, consumers – are so desperately seeking. If we are able to come together to develop the overarching policy and associated regulations that can govern and encourage the digital currency ecosystem, we can affect the type of positive change the finance industry has not seen in over a decade.

DeFi and digital currencies are here. While it’s still a nascent technology, it has the ability to revolutionize the global financial services industry and pave the way for a more accessible and efficient financial system. Like the internet, DeFi can spur on a new age of democratized innovation  – but only if we let it.

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