Decentralized Finance (DeFi) Policy-Maker Toolkit

Decentralized Finance (DeFi) Policy-Maker Toolkit in Collaboration with the Wharton Blockchain and Digital Asset Project

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I. Decentralized Finance (DeFi) Policy-Maker Toolkit In Collaboration with the Wharton Blockchain and Digital Asset Project

Decentralized finance (DeFi) is an emerging and rapidly evolving area in the blockchain environment. Although examples of DeFi have existed for several years, a sudden upsurge of activity in 2020 has simulated interest from the private and public sectors.

Over the past year, MME Legal partner Dr. Andreas Glarner has been working with the World Economic Forum, the Wharton University and 50+ other legal, policy making and industry experts to create a DeFi Policy-Maker Toolkit. The Toolkit has been published 8 June 2021 and highlights DeFi’s distinguishing characteristics and opportunities, while also calling attention to the new and existing risks. As well as providing an overview of the DeFi space generally, it maps out the potential legal and regulatory responses. The result of an international collaboration among academics, legal practitioners, DeFi entrepreneurs, technologists and regulatory experts, the report provides a solid foundation for understanding the major factors that should drive policy-making decisions.

This article provides an overview on the key topics addressed by the DeFi Policy-Maker Toolkit. Interested in more details? The Toolkit as well as the highly recommended accompanying publication “DeFi Beyond the Hype” are open and free to anyone and can be downloaded here:

Download Toolkit

Read “DeFI Beyond the Hype"

Visit WEF Landing Page

 

A. What is the Goal of the DeFi-Toolkit?

The Toolkit aims to be a clear, concise, and neutral guide for policy-makers and regulators interested in the quickly-evolving decentralized finance space. Thereby, it:

  • Provides an overview of the DeFi space generally, and the major classes of DeFi protocols, with tools to help understand the implications of new services
  • Explores the potential benefits of the DeFi approach, along with the challenges that DeFi businesses will face
  • Offers a detailed breakdown of the risks that DeFi may pose. Many of these are familiar concerns (although sometimes manifested differently), while others are unique to the decentralized, programmable and composable structure of DeFi
  • Maps out potential legal and regulatory responses to DeFi

To achieve these goals, the Toolkit in particular includes the following Policy-Maker Tools:

  • DeFi Distinguishing Characteristics,
  • Architecture, Service Categories
  • Case Studies
  • Decision Tree
  • Background Assessment
  • Stakeholder Mapping Tool
  • Decentralization Spectrum
  • DeFi Policy-Maker Canvas


B. What is DeFi?

While the space is evolving quickly, the Toolkit offers a functional description to distinguish DeFi from traditional financial services and auxiliary services. A DeFi protocol, service or business model has the following four characteristics:

  • Financial services or products
  • Trust-minimized operation and Settlement
  • Non-custodial design
  • Programmable, open and composable architecture

Thereby, the DeFi “stack” includes:

  • Base-layer blockchain system
  • Assets (digital assets, stablecoins, etc)
  • Optional Gateway (wallets)
  • Application layer (decentralized exchanges, credit, derivatives, insurance)
  • Aggregation layer (DEX aggregators, asset and yield management)
  • Auxiliary services (oracles, indexing and query, storage)

 

C. What are Risk related to DeFi?

The toolkit provides a risk mapping framework covering 17 risks divided into five categories:

  • Financial Risk: Depletion of funds due to the transactional behaviour of fellow users concerning the digital assets in the DeFi service.

       a) Market risk

       b) Counterparty risk

       c) Liquidity risk

  • Technical Risks: Failures of the software systems supporting transaction execution, pricing and integrity.

       a) Transaction risk

       b) Smart contract risk

       c) Miner risk

       d) Oracle risk

  • Operational Risks: Failures of the human systems for key management, protocol development or governance.

       a) Routine maintenance and upgrades

       b) Forks

       c) Key management

       d) Governance mechanisms

       e) Redress of disputes

  • Legal Compliance Risks: Use of DeFi to engage in illicit activity or to evade regulatory obligations.

       a) Financial crime

       b) Fraud and market manipulation

       c) Regulatory arbitrage

  • Emergent Risks: Macro-scale crashes or undermining of the financial system due to the interaction, scaling and integration of DeFi components.

       a) Dynamic interactions

       b) Flash crashes or price cascades

 

D. What are possible Policy Approaches to DeFi?

The Toolkit provides a range of policy actions may be adopted for DeFi, including:

  • Forbearance: decision that no new regulations are needed
  • Warnings: issuance of warning to users/ consumers
  • Enforcement: determinations that existing rules already cover the relevant actors and activities and have not been complied with
  • Opt-in: provide the option to become subject to regulations in return for certain protections, even though there is no legal requirement
  • Pruning regulations: eliminate regulatory requirements that are no longer essential in a DeFi context
  • Limited licence frameworks: the possibility of obtaining licences of limited scope or under size thresholds, with light-touch requirements
  • Prohibitive measures: prohibit certain activities in the DeFi sector
  • New licence types: address risks with new categories designed for DeFi
  • Issuing guidance or expectations: craft new frameworks, often with a public comment or consultation included before its official release

 

E. What are available policy tools for DeFi?

The Toolkit specifies various policy tools that are available to address DeFi and associated risks.

  • Transitional mechanisms: While not entirely analogous, policy approaches may be informed by how digital assets were initially addressed. In the 2017 initial coin offerings (ICOs) boom, few regulators had structures or expertise fit for purpose as – seemingly out of nowhere – significant capital was flowing into new platforms that claimed to be outside the regulatory perimeter. Some of the initial responses may prove useful in the context of DeFi.

       a) Specialized regulatory units

       b) Incentivizing information flow

       c) Regulatory sandboxes

       d) Clarifying easy cases

       e) Coordinating government action

  • Regulation throughout the life cycle: Where there is no inherent distinctive risk, regulation typically occurs later in the life cycle of a product or service, when the harms that rigger liability or regulatory enforcement are more likely to occur. Early on, regulators are more likely to adopt a "do no harm" approach, given the relatively small scale and innovative potential of nascent technologies. For products with clearly known dangers or misuses, such as poppy flowers and weapons, the industry is strictly regulated and all stages are carefully supervised and controlled. Technological systems tend to fall somewhere in the middle.

Juni 2021 | Autor: Andreas Glarner

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