DeFi regulation needs to address liquidity sources

Category: Crypto Fintech Regulatory

The collapse of several major crypto platforms this year has highlighted the need for regulation to restore investor confidence, writes Gil Solomon, one of Israel’s leading emerging tech lawyers. One of the key issues that will need to be tackled is the thorny subject of liquidity and funding sources. 

Liquidity crunch shockwaves

In the past year, the decentralized finance (DeFi) industry experienced an unprecedented shakeup when certain lending platforms found themselves in the precarious situation of not possessing enough liquid assets to pay out dissociating investors.

The resulting shockwaves sent ripples throughout the industry, ultimately reaching even unrelated projects and ventures. The severity of this phenomenon raised many questions, including what steps, if any, could have been preemptively taken.

Simply put, a liquidity issue occurs when an entity can’t provide immediate access to funds, which would have otherwise been eligible for withdrawal, often as a result of cash flow problems from its funding sources. In problematic or unfriendly market conditions, many investors might simultaneously elect to withdraw funds. This amplifies an entity’s cash-flow problems and is referred to as a bank run in traditional markets.

Ratios easily disrupted

A typical stablecoin entity should ideally possess a 1:1 cash to assets ratio (this is not the case always) and even in that scenario it can be easily disrupted with even slight financing complications. Withdrawals only amplify once word of complications spread, with every investor racing to be part of the first group to receive cash back.

As it stands, when it comes to the DeFi sector, most DeFi platforms are structured in a way that negates fiduciary duties to these platforms’ investors, creditors and other relevant stakeholders, along with any relevant obligations towards such stakeholders. Additionally, when a platform overexposes itself, there’s no way to truly guarantee the “house” isn’t playing with money it doesn’t have.

Operation over multiple jurisdictions biggest hurdle to regulation

The largest and most serious obstacle remains the difficulty in regulating across multiple jurisdictions. Current proposed frameworks include organized government bodies aiming to stabilize their regions. For example, the impending European Union’s Markets in Crypto Assets Regulation (MiCA) is expected to drastically unify business proceedings across the continent, potentially setting the standard for other world bodies and bringing stricter enforcement.

At its root, however, blockchain technology affords the ability to store transaction history in numerous nodes worldwide, with compromised server data simply appearing elsewhere.

This means that although a local government could take action to shut down a particular venture or even in practice a server, or a set of local servers, that are instrumental in the performance of unethical or illegal transactions, the data is mostly likely stored and spread over multiple jurisdictions. While supporters of increased regulation agree on a general basis, it’s also acknowledged that true regulatory uniformity is unlikely, or even impossible.

Disclosure vs anonymity

Another issue that is related to this fact is that in any proposed legislation, the disclosure of liquidity sources is paramount. But it is certainly in an enterprise’s best interests to conceal its terms with funding sources, or even the actual engagement with such funding sources, and not necessarily for illegitimate reasons.

This issue is emphasized by the simple fact that the average investor can’t necessarily do effective due diligence into a firm’s liquidity sources or its liquidity processes.

Certain parties hold obvious interest in obstructing, or at least delaying, impending regulation. An obvious example is the DeFi platforms themselves: perpetual regulation efforts may obstruct the goal of revolutionizing the banking system and result in such platforms incurring additional and substantial costs due to regulatory and legal burdens.

However, it is clear that due to the recent market collapse, the provision of liquidity information is crucial. Common denominators amongst failed DeFi ventures include low liquidity, as well as the withdrawal of backing from  financial institutions and venture capital firms, leaving an enterprise and its investors exposed. While the concept of a “bank run” is nothing new, as we recently noticed, the effects in this space differ significantly from traditional markets.

No consumer protection

Unlike government-backed institutions, a lack of regulation and governmental bodies in the cryptocurrency space, means a consumer’s chances of recovering lost funds in a failed blockchain (and more specifically DeFi) enterprise are slim to none.

Lastly, commercial banks feel threatened by the industry’s foray into their business model. A push for a comprehensive regulatory framework certainly exists on their part as they are subject to the limitations applied by extremely burdensome regulatory regimes in most cases. Any proposed framework which would make DeFi compliant and more “mainstream” is likely to either increase or decrease their leverage on financial markets, and their feedback in either case is to be expected.

Various arguments will be brought forward, including making the case that nations need traditional credit to function.

What’s the way forward?

So, what could regulation look like in the near future? Whatever legislation is eventually introduced is likely to address enterprise liquidity sources at its core, with increased pressure to make funding sources, methods, and availability more transparent. Additionally, given that regulating the platforms themselves is proving challenging, we’re likely to see nations implement guidelines for their citizens, much like when the United States enacted the Foreign Account Tax Compliance Act (FATCA).

In my opinion, measured regulation is key in our case. Should lawmakers seek to create a regulatory system that is too burdensome, platforms and service providers may find themselves doing “jurisdiction-shopping” and working from unregulated jurisdictions where there is no protection for investors. Should they be too lenient, future serious liquidity crises such as the one leading to the latest market collapse are inevitable.

One thing is clear, it is imperative that action should be taken sooner rather than later. Lawmakers and regulators need to be responsive and apply their influence on the market in a progressive fashion that will balance the need for protection with the market’s need for progress.

Moreover, regulating enterprises is just one part of the equation: while regulatory bodies are actively attempting to get information on DeFi operations, they equally aspire to gain as much information as possible on the customer.

The advantage of smart contracts

A balance clearly must be found if the technology is to retain consumer privacy. Anonymity has always been one of the blockchain industry’s strongest characteristics. Through over-restricting regulation, the industry could theoretically reach a point where the decentralized nature of the technology essentially reverts to being regulated by central banks or similar bodies.

On the other hand, the concept of smart contracts affords the ability for self-regulation. This, of course, poses its own unique set of questions, such as how different enterprises will ensure uniformity. Overall, by ensuring proper communal measures are in place, individuals can ensure themselves a safe space to conduct business.

Building on a foundation of agreed-upon guidelines and fail-safe code, truly decentralized and safe platforms can be built. The very nature of the technology at hand allows for the leverage of smart contracts to truly revolutionize the way we do business. For this to happen, however, some of the obstacles above have to be faced and solved and investor protection has to be increased.

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