TRM Talks: Abu Dhabi Global Market’s Discussion Paper on DeFi

Decentralized finance – DeFi – has created an entire on-chain Wall Street – a digital financial services industry where users engage with software called smart contracts. With DeFi, you can do most of the things that banks support — earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and more — but at the speed of the internet. Only a handful of regulators globally have weighed in on the power, promise, risks and challenges of DeFi.

This month, Abu Dhabi Global Market’s (ADGM) Financial Services Regulatory Authority (FSRA) published a discussion paper which seeks guidance from the cryptocurrency industry and serves as a starting point for a dialogue on how DeFi may be regulated.

In this TRM Talk, we spoke to one of the paper’s authors, Brian Yeoh, Head of Data Governance and Strategy for ADGM, to discuss the new DeFi paper and how a leading regulator is thinking about the DeFi space.

In its paper, ADGM points to a number of international organizations that have issued reports on DeFi:

• March 2022 — the International Organization of Securities Commissions issued a report providing an overview of the DeFi market.
• February 2022 — the Financial Stability Board issued a report on the risks posed by crypto-assets that noted that DeFi has the potential to increase risks to financial stability, in the absence of appropriate regulation and market oversight.
• January 2022 — the Organization for Economic Cooperation and Development (“OECD”) issued a report on DeFi and its policy implications.
• June 2021 — the World Economic Forum (“WEF”) issued a “toolkit” for policymakers on DeFi’s challenges.

However, ADGM takes one of the most holistic approaches to date on the what, why, who and how of DeFi regulation and the paper essentially goes in that order. The paper sets out the promise of decentralized finance — namely the ability to automate tailored transactions at the speed of the internet — and then seeks to address three main challenges: anonymity, stability, and illicit finance. Specifically, the paper focuses on anonymity as a “common underlying driver” of both stability and illicit finance risks, pointing to the difficulty in associating cryptocurrency addresses with actual persons. ADGM writes, “We believe that preserving the anonymity of DeFi participants will increasingly become untenable in the medium term. We expect that this will be driven both by regulatory intervention as well as market demand for transparency.”

The paper points out that today, DeFi does not present a systemic stability risk to the financial system, given the relatively low activity; however, as the crypto economy continues to grow, FSRA asserts that the risk could increase. In terms of anti-money laundering, the paper points to the fact that, unlike cryptocurrency exchanges, the DeFi space “remains largely unregulated.” Again, pointing to concerns regarding anonymity, ADGM writes, “Ensuring that DeFi participants are able to provide accurate and validated identities is likely to be the key element in any such intervention because anonymity heightens the risk that DeFi will be abused for AML/CFT purposes or allow sanction restrictions to be circumvented.”

Additionally, the discussion paper, which is intended to be a starting point for a dialogue on DeFi regulation, sets forth a number of policy positions, statements and proposals:

DeFi does not change the nature of financial services

While ADGM is of the view that DeFi does not fundamentally change the nature of financial services - that is the reason people consume financial services such as lending, staking and borrowing - DeFi’s “automated nature may change how financial services are consumed, through the use of linked financial services...In this regard, the FSRA sees DeFi as no different from other technological advances in financial services such as digitisation or tokenization.”

Equivalent risk, equivalent rules

"Given that DeFi does not change the underlying nature of financial services, we believe that similar requirements should be placed on DeFi participants as on TradFi participants.”

No anonymous participants - Again, ADGM focuses on the need to remove anonymity from DeFi writing, “Risks from anonymous DeFi activity arising in the areas of fraud and AML/CFT are not and will not be tolerated in ADGM. Similar to our existing regulatory approach to Virtual Assets, the FSRA will only allow DeFi activities where all DeFi participants have been identified and have undergone the necessary due diligence to ensure compliance with AML/CFT obligations.” The paper recognizes that the necessary KYC infrastructure will take time to put in place and states that “FSRA will work with stakeholders to determine what types of public infrastructure would be appropriate and implementable.”

Governance of DeFi protocols

The paper recognizes that “DeFi protocols may have new governance models that do not map to those of TradFi firms,” and suggests that each DeFi protocol should be looked at on a case-by-case basis when it comes to licensing and regulation.

The growing cryptocurrency economy is moving faster than anything we have seen in our lifetime. ADGM acknowledges this in its conclusion, writing “the medium-term trends that the FSRA has identified are subject to disruption and changes in the environment.” However, ADGM, at the forefront of thinking when it comes to regulation in the DeFi space, calls for regulatory frameworks that balance the promise of the technology with potential challenges and reaches out to the private sector to “seek your input on our high-level policy positions so that we can better refine our understanding of the DeFi space and adjust our approach accordingly.”

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