A16z warns UK on lumping DeFi into broader crypto laws

Don’t conflate CeFi with decentralised finance.

Crypto industry players, investors and lawyers made that plea to the UK government as His Majesty’s Treasury closed its consultation into how to regulate the sector in Blighty.

Launched in early February, the consultation marked the start of Prime Minister Rishi Sunak’s stated aim to transform Britain into a crypto hotbed. The proposals are intended, along with the Financial Services and Markets Bill, to create conditions where crypto asset service providers and investors can thrive.

The industry embraced the initiative with cautious enthusiasm, but some warned against making sweeping decisions on DeFi based on the consultation.

The Treasury sought public comment on a range of measures to regulate crypto exchanges and other businesses offering services like crypto custody, bringing them into the fold of traditional financial services.

NOW READ: UK floats DeFi oversight to mitigate crypto ‘regulatory arbitrage’

While it focused on centralised finance, it also asked for input about DeFi. The consultation said in its DeFi chapter that the objectives described in the rest of the proposal relating to CeFi — such as investor protection, liability for misleading statements, and transparent disclosures — would apply to DeFi regardless of the underlying technology, infrastructure, or governance mechanisms.

Market participants responding to that aspect said the government’s approach could run the risk of lumping together CeFi and DeFi — stifling innovation in the process.

“Traditional frameworks do not take into consideration the radical transparency of blockchains, the reduced barriers to entry provided by open source code, and the advantages of decentralisation provided by permissionless systems,” venture capital fund a16z crypto wrote in its response.

UK startup Aztec echoed that sentiment. Aztec, which has built a zero-knowledge protocol on top of Ethereum, also responded to HMT’s consultation.

“Some of the biggest failures in the crypto industry resulted from CeFi entities’ misconduct,” Aztec tweeted.

“DeFi offers a different approach to custody, trust and permissioning,” Aztec said. “We urge HMT to create a bespoke, progressive regulatory regime that acknowledges DeFi’s unique benefits for consumers.”

NOW READ: UK as major crypto hub? ‘I don’t see that happening,’ Coinpass CEO says

Thorny challenge

DeFi presents a thorny challenge for regulators generally. Financial markets regulation inherently assumes the existence of a centralised intermediary, but DeFi, as a suite of permissionless financial protocols on blockchains like Ethereum, doesn’t present an obvious locus of oversight.

Proponents of DeFi say that if a protocol is truly decentralised, it operates with complete transparency and trustlessness, unlike traditional finance, where investors rely on regulation to keep intermediaries honest.

Even if it were possible to regulate people or companies along the DeFi value chain — some approaches have mulled regulating developers creating the underlying code or even decentralised autonomous organisations — shoehorning traditional regulation into DeFi could suffocate what makes DeFi special, they say.

NOW READ: SEC reopens dark pools rule proposal that would regulate DeFi

These kinds of arguments were evident in several consultation responses.

“TradFi systems typically depend on, and are only able to function as a result of, various rights and obligations that are enforced by extrinsic legal contracts and laws,” LeXpunK, a collective of DeFi lawyers and developers, said in its response to the consultation.

“In contrast, DeFi systems function pursuant to various intrinsic powers and incentives that are enforced via deterministic smart contracts.”

DeFi, then, gives rise to different risks, and regulation should take that into account, LeXpunK said. It said the UK should consider a custom DeFi regulation, but acknowledged that it was unlikely, given the rest of the consultation, that this would be the route the government takes.

The UK could, however, also consider a system where DeFi projects will report their activities to the government if they fell within regulators’ ambit, rather than having to get authorised.

Cautious praise

More generally, the proposal met with cautious praise from commenters.

Kraken managing director Blair Halliday said in a LinkedIn post that many of the proposals “are pragmatic in both substance and scope’, though he added that their technical implementation will be the true test.

Trade association CryptoUK broadly welcomed the proposal, and urged the government to consider wider, related issues in designing its framework, such as the de-banking of the crypto industry, and tax policy.

Ripple said the Treasury proposal and the recent markets bill are encouraging, and that when it’s passed, the legislation will provide the necessary route to put the proposals into effect.