Decentralised Finance: navigating the rugged regulatory landscape
The Decentralised Finance movement is growing rapidly, with DeFi apps now being used to facilitate a wide range of activities. Many players in this space are operating on the assumption that they are unregulated. Yet the regulatory analysis in relation to these business models can be highly complex and often sophisticated multi-jurisdictional legal advice is needed to understand and respond to it. Below, we highlight some of the issues in this space and the importance of precise structuring.
The growth of DeFi
Over the last year, the economic value of cryptoassets locked into DeFi applications has grown exponentially. These are applications that seek to deliver services through a decentralised platform which closely resemble regulated financial services. They typically employ open protocols and smart contracts to create trust and manage risks, in lieu of traditional intermediaries. Often this involves the use of automated collateral or escrow mechanisms.
There is a perception that such activities fall outside the regulatory perimeter by virtue of the use of unregulated cryptoassets as collateral and exchange of value tools and the lack of a central operator. Indeed, most regulatory frameworks were not designed with DeFi arrangements in mind and do not always readily map on to them.
As the technology has developed and profile increased, so too has the market. Today, DeFi apps are used to facilitate a wide range of quasi-financial activities, including stablecoin networks, decentralised exchanges, crypto-lending, collateral management platforms and yield farming services. This is attracting growing interest from sophisticated institutional investors and regulators alike.
The regulatory perimeter: a fine and moving line
DeFi ecosystems have often sought to operate outside the regulatory perimeter. In certain areas it can be relatively simple to determine whether an asset or activity falls outside that perimeter. In other areas, however, the regulatory analysis can be extremely complex and nuanced.
Understanding the regulatory landscape across all applicable jurisdictions and structuring arrangements accordingly is an essential step for anyone involved in DeFi activities – whether they intend to operate on a regulated or unregulated basis. Getting it wrong can have not just financial implications but also criminal ones. Founders, developers, issuers, promoters, operators, providers and users all bear these risks, which may arise regardless of whether operation and/or governance is centralised or decentralised.
What’s more, regulators are paying close attention to this area, with both the FSB and IOSCOhaving highlighted their concerns over the last year. Notably, the European Commission has recently proposed a comprehensive new framework for the regulation of markets in cryptoassets, which is likely to have significant implications for the DeFi market.
The need for a multi-jurisdictional approach
One of the challenges in navigating the regulatory pitfalls is the multijurisdictional nature of decentralised platforms.
Obligations can arise in any of the jurisdictions in which the tokens are available. Yet, often founders and participants only consider the jurisdictions in which they are located, and perhaps a few select others that immediately spring to mind.
Regulatory characterisations can also differ dramatically between jurisdictions. Surveys reveal that even in areas of regulatory harmonisation within the EU, national authorities can reach very different conclusions as to regulatory characterisation – for example, whether a particular token qualifies as a “financial instrument” or a “transferable security”.
These matters are further complicated by issues around conflicts-of-laws. For example, there are uncertainties as to which national law should prevail in the context of assets and arrangements which are not located in or constituted under the laws of any one jurisdiction. The need for a comprehensive multi-jurisdictional approach is thus all the more important.
The complexity of the regulatory landscape
In each applicable jurisdiction, there will be a number of regulatory issues to consider. This will include the regulatory characterisation of the platform, each token on the platform and the activities conducted in respect of such tokens. Certain obligations, particularly around anti-money laundering and counter-terrorism financing, may apply even in the context of otherwise unregulated DeFis. Other cross-sectoral rules, such as consumer protection, data protection and tax requirements, may also be relevant.
In relation to characterisation, most jurisdictions have a wide array of regulated investments and regulated activities, and a considerable degree of overlap. For example, in the UK, depending on its precise structuring, a stablecoin could potentially qualify as any or all of a deposit, an instrument creating or acknowledging indebtedness, a collective investment scheme, e-money, a transferable security, a derivative or an alternative investment fund. Activities like yield farming, liquidity pooling and crypto-lending could also be regulated, depending on how the arrangements are structured.
In other jurisdictions, such as France, specific new regimes have been introduced in relation to the issuance and provision of services around tokens, yet there remains considerable subtlety in determining which regulatory frameworks and rules apply. This is likely to be equally true under the European Commission’s proposed framework.
The importance of precise structuring
In many cases we have found that actions that may appear innocuous to the uninitiated can lead to unintended regulatory consequences.
- The act of tokenisation itself can sometimes bring an otherwise unregulated asset within the regulatory perimeter.
- The nature of communications used to promote a token may change its regulatory character.
- Promotions in respect of a token may be regulated even if the token is not.
- Seemingly similar governance arrangements may fall either side of the regulatory perimeter, depending on a variety of factors such as the degree of control and whether or not income is pooled.
- The legal character of the smart contracts can be an important determinant of the regulatory characterisation of the arrangements.
Precise legal and regulatory structuring can thus make all the difference.
The regulatory appetite of a DeFi, or anyone involved with one, may also vary in the course of their journey from nascency to maturity, necessitating further structural changes. However, significant efficiencies may be gained through initial structuring decisions designed to facilitate a future transition to a regulated (or more highly regulated) environment.
Should you need any advice regarding your DeFi arrangements, please do not hesitate to get in touch.