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Policymakers Chase Central Framework for Decentralized Finance Oversight

You don’t know what you don’t know.

And what you don’t know you can’t leverage or interact with, much less hope to regulate. That is the realization that governmental bodies and organizations around the world are coming to, at least as it relates to the digital asset and decentralized finance (DeFi) sectors.

With the release of a report entitled “Decentralized Finance,” the Commodity Futures Trading Commission’s (CFTC) Technology Advisory Committee (TAC) looked to narrow lawmakers’ knowledge gap about the Web3 space’s makeup; the Financial Stability Board (FSB) on Monday (Feb. 26) made public a statement that they are looking to standardize a format for incident reporting exchange (FIRE) for the digital and tokenized asset landscape.

“The first priority for policymakers should be to increase their capacity to understand DeFi, including by identifying what they do and do not know yet about DeFi,” the CFTC report stated.

The U.S. lawmakers behind the report noted that their intent is not to “advance a definitive definition of DeFi that might one day provide the basis for a new or expanded regulatory perimeter,” and they go on to caution against designing regulatory frameworks around a singular technology, emphasizing — and identifying — the different risk layers endemic to DeFi’s technology stack.

Rather, just like the FSB’s standardization of incident reporting, which the international body explains will hopefully establish “common information requirements and reduce fragmentation in incident reporting requirements,” the CFTC’s advisory committee’s publication of a DeFI report is being viewed by some observers as a potential beginning to a dialogue between regulators and industry.

Read more: Financial Blockchain Technology Gains Ground While Crypto’s Future Remains Uncertain

Centralizing Definitions in a DeFi World

At a high level, DeFi refers to a set of financial services and applications built on blockchain technology. These services aim to re-create traditional financial systems, such as lending, borrowing, trading, and asset management, without the need for traditional intermediaries like banks.

The lawmakers on the CFTC TAC “functionally” define DeFi as “enterprises, projects and ecosystems characterized by highly automated financial networks that have no single point of failure, do not rely on a single source of information, and are not governed by a central authority that is capable of altering or censoring this information in order to perform tasks central to delivery of one or more financial services.”

“[The report] finds that the benefits and risks of DeFi depend significantly on the design and features of specific DeFi systems. However, most DeFi systems are not completely centralized or decentralized, but instead operate on a spectrum,” said CFTC Commissioner Christy Goldsmith Romero in a statement. “I hope that this report can serve as a first step to facilitate a dialogue between policymakers and industry particularly because DeFi remains at the center of illicit finance risks, cyber hacks and theft.”

Various regulatory agencies, including the Securities and Exchange Commission (SEC), the CFTC, and the Financial Crimes Enforcement Network (FinCEN), have shown interest in overseeing aspects of the DeFi space.

But not everyone on the CTFC’s TAC agreed or found footing with the subcommittee’s DeFi recommendations.

“I cannot support this report’s recommendations. I am concerned that the report stops short of engaging with why much of DeFi’s hyped potential is, in fact, impossible — often because of the realities of economic incentives. At least, it is impossible without DeFi becoming so much like the existing financial system that all the added technological complexity is pointless,” wrote committee member Hilary J. Allen in a prepared dissenting statement.

Read moreDeFi Gets Defanged as Investor Doubts and Regulatory Scrutiny Grow

DeFi’s Dynamic Financial Landscape

DeFi services have come under scrutiny from lawmakers as being ripe for abuse by bad actors due to the capabilities for anonymity and the ability for end users to skirt know your customer (KYC) and know your business (KYB) controls while transacting.

Per a U.S. Treasury Department report from last April, “illicit actors, including criminals, scammers and North Korean cyber actors, are using DeFi services in the process of laundering illicit funds.”

Against that backdrop, the CFTC lists seven policy objectives in its report related to DeFi: first, protecting investors and consumers; second and third are promoting market integrity and ensuring microprudential safety and soundness (the adjustment of capital based on individual institutions’ risks); fourth is maintaining U.S. and global financial stability and mitigating systemic risks; fifth, expanding access to safe and affordable financial products and services; sixth, combating illicit finance; and seventh, strengthening U.S. leadership and competitiveness in finance and technology.

“This technology is actually better than the existing [centralized] infrastructures from a security perspective,” Yan Zhang, co-founder of Web3-native payment aggregator Pelago, told PYMNTS last April.

But as the lawmakers’ report noted, despite the “underlying transparency of blockchain networks much of the raw data cannot be effectively used by investors, consumers or regulators without first devoting significant time and effort to building the core technological competency and capacity necessary to collect, manipulate and analyze it.”

And those are the obstacles that blockchain-based financial technology will have to overcome in order to enjoy scalable adoption: a lack of foundational infrastructure across crucial opportunity areas, and the regulatory environment.