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Crypto and DeFi

Understanding the risk landscape

Increasing adoption

While the digital asset market as a whole is experiencing turbulence, in the past year institutional investors have increasingly embraced crypto and other digital assets in their portfolios. Many mainstream financial institutions, including global, bulge-bracket banks, have started contemplating – and, in some cases, offering – retail and institutional investors access to cryptoasset-linked products and services, such as crypto trading or custody.

An exciting area of development

The decentralised finance (DeFi) space is nascent, and faces challenges to be addressed over time. However, there are many that consider that DeFi structures can be robust and are capable of operating to the high standards expected in the regulated sector. In light of some of the recent disruptive market events and apparent frauds involving arguably trusted, centralised crypto projects and entities, some point to DeFi’s potential for transparency and disclosure as a potential bright spot for the industry. We have also started to see regulated institutions experimenting in this space – indeed it may be that the concept of “regulated DeFi” could be the most exciting area of development over the medium to long term.

The risk landscape in the global digital asset market

However, as with all frontier technologies, crypto and DeFi challenge usual legal and regulatory norms, and the digitising financial markets face novel risks. In this report from our global fintech team, we focus on the risk landscape of three significant jurisdictions in the global digital asset market – the U.S., the EU and the UK. We look at the key legal risks associated with dealing with cryptoassets and decentralised networks and the destabilising impact of key market events including major insolvencies in 2022. These events, which have in part arisen from well-documented issues in the crypto and DeFi markets, have come together to create a situation of heightened risk. We consider how those risks can play out through increased regulatory scrutiny and enforcement and litigation.

Crypto and DeFi – Understanding the risk landscape

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Key topics in our report

Key topics in our report

We look at the key legal risks associated with dealing with cryptoassets and decentralised networks and the destabilising impact of key market events including major insolvencies in 2022.

Click through the key topics on the left for more details on the contents of our report.

Primer on legal risks in crypto and DeFi

The development of cryptocurrencies and their widespread adoption has been one of the defining features of the last decade in digital finance. The rise of crypto adoption, both retail and institutional, has been rapid; and one of the most significant developments in cryptoassets markets in the past two years has been the growth in DeFi. Whilst digitising financial markets herald great promise, there are also novel and material risks to understand. The Crypto Winter of 2022 and the collapse a number of high profile crypto exchanges have complicated the risk landscape. There are key legal risks and uncertainties associated with crypto and the DeFi markets in which they operate; which relate to the functioning of the core technology, and there are also legal issues to be addressed in the insolvency of a cryptoasset related business.

There are myriad of different participants in these markets with exposure to digital assets and DeFi. For example, those who develop and “mine” cryptoassets; those who promote or provide access or “gateways” to crypto; those who invest in digital assets; those who provide banking services to digital native players; those who lend digital assets or related products; and others who can influence the market dynamics. One thing they have in common, however, is exposure to legal risks, many of which are not extensively analysed or well understood, and a need to manage those risks effectively.

DeFi explainer

We provide a visual of the matrix of players, products and services in digitising financial markets comparing relative market sizes and showing the increasing regulation of the emerging financial markets. We also provide a DeFi explainer for those new to the space. We look at the “what”, the “how”, the potential and the risks associated with DeFi, summaries its key features and compare the DeFi system with the more traditional financial system.

How risks manifest: increased regulatory scrutiny and enforcement

The events of the 2022 Crypto Winter have played out against the backdrop of limited investor and consumer protections, which has focused the attention of regulators worldwide on the crypto and DeFi space. Various regulators with reach into these markets are asserting jurisdiction in order to exert their powers to flexibly apply existing laws, regulatory tools and levers with a view to protecting consumers from harm and ensuring market stability. Regulators in many jurisdictions are also tasked with addressing financial stability risks and seeking to limit the exposure of mainstream financial systems to severe corrections in crypto/DeFi markets, and the possibility of contagion into the broader economy.

We provide a regulatory map showing the full spectrum of potentially applicable regulation when dealing in crypto and DeFi, and in a series of case studies examine how enforcement of that regulation can play out. Discussions have also accelerated in many jurisdictions concerning the development of crypto-/DeFi-specific regulation beyond more basic existing requirements for trading platforms and service providers to carry out anti-money laundering checks. We examine how the EU, the UK and the U.S. have all proposed differing regulatory approaches which are at different stages of development, creating a patchwork of regulatory risk and uncertainty to be navigated by those operating in borderless crypto and DeFi markets.

How risks manifest: increased litigation

Even where there is no statutory or regulatory route that allows for consumers and professional crypto investors to be compensated for their losses, there may be the possibility of pursuing private litigation. Since digital assets do not fit neatly into existing legal and regulatory regimes and often therefore do not generally benefit from existing investor protections (for example around securities or consumer compensation), that creates a market which at risk of fraud, scams and financial crime.

Generally speaking, when people lose money, they often look for someone to blame. This is also true in the digital asset space, where the occurrence of fraud and theft is nothing new. What is different now, other than that owning digital assets increasingly has become more mainstream? Some believe that the trend of increased crypto litigation is, in part, being fuelled by the availability to would-be plaintiffs of litigation funding in instances where potential defendants with deep pockets exist. The ensuing losses can give rise to various forms of litigation including criminal enforcement by state authorities, civil action arising from regulatory enforcement and private litigation. We examine these in turn and in a series of case studies explore how litigation is playing out in practice in the crypto and DeFi space.

Tackling the shifting risk landscape

It is clear that participating in crypto and DeFi markets can be a high risk activity regardless of, or in some cases as a result of, the level of market adoption. The types and scale of risk that an organisation may face will depend upon its role within these markets. We consider the perspectives of two broad categories of market participants: investors in digital assets and digital businesses and their investors. However given that any approach to risk management will be highly dependent on both the type of market participant and the nature/structure of their digital asset offering or involvement, we recommend that an approach specifically tailored to that participant’s specific circumstance will be required.

Key topics in our report

We look at the key legal risks associated with dealing with cryptoassets and decentralised networks and the destabilising impact of key market events including major insolvencies in 2022.

Click through the key topics on the left for more details on the contents of our report.

Primer on legal risks in crypto and DeFi

Primer on legal risks in crypto and DeFi

The development of cryptocurrencies and their widespread adoption has been one of the defining features of the last decade in digital finance. The rise of crypto adoption, both retail and institutional, has been rapid; and one of the most significant developments in cryptoassets markets in the past two years has been the growth in DeFi. Whilst digitising financial markets herald great promise, there are also novel and material risks to understand. The Crypto Winter of 2022 and the collapse a number of high profile crypto exchanges have complicated the risk landscape. There are key legal risks and uncertainties associated with crypto and the DeFi markets in which they operate; which relate to the functioning of the core technology, and there are also legal issues to be addressed in the insolvency of a cryptoasset related business.

There are myriad of different participants in these markets with exposure to digital assets and DeFi. For example, those who develop and “mine” cryptoassets; those who promote or provide access or “gateways” to crypto; those who invest in digital assets; those who provide banking services to digital native players; those who lend digital assets or related products; and others who can influence the market dynamics. One thing they have in common, however, is exposure to legal risks, many of which are not extensively analysed or well understood, and a need to manage those risks effectively.

DeFi explainer

DeFi explainer

We provide a visual of the matrix of players, products and services in digitising financial markets comparing relative market sizes and showing the increasing regulation of the emerging financial markets. We also provide a DeFi explainer for those new to the space. We look at the “what”, the “how”, the potential and the risks associated with DeFi, summaries its key features and compare the DeFi system with the more traditional financial system.

How risks manifest increased regulatory scrutiny and enforcement

How risks manifest: increased regulatory scrutiny and enforcement

The events of the 2022 Crypto Winter have played out against the backdrop of limited investor and consumer protections, which has focused the attention of regulators worldwide on the crypto and DeFi space. Various regulators with reach into these markets are asserting jurisdiction in order to exert their powers to flexibly apply existing laws, regulatory tools and levers with a view to protecting consumers from harm and ensuring market stability. Regulators in many jurisdictions are also tasked with addressing financial stability risks and seeking to limit the exposure of mainstream financial systems to severe corrections in crypto/DeFi markets, and the possibility of contagion into the broader economy.

We provide a regulatory map showing the full spectrum of potentially applicable regulation when dealing in crypto and DeFi, and in a series of case studies examine how enforcement of that regulation can play out. Discussions have also accelerated in many jurisdictions concerning the development of crypto-/DeFi-specific regulation beyond more basic existing requirements for trading platforms and service providers to carry out anti-money laundering checks. We examine how the EU, the UK and the U.S. have all proposed differing regulatory approaches which are at different stages of development, creating a patchwork of regulatory risk and uncertainty to be navigated by those operating in borderless crypto and DeFi markets.

How risks manifest increased litigation

How risks manifest: increased litigation

Even where there is no statutory or regulatory route that allows for consumers and professional crypto investors to be compensated for their losses, there may be the possibility of pursuing private litigation. Since digital assets do not fit neatly into existing legal and regulatory regimes and often therefore do not generally benefit from existing investor protections (for example around securities or consumer compensation), that creates a market which at risk of fraud, scams and financial crime.

Generally speaking, when people lose money, they often look for someone to blame. This is also true in the digital asset space, where the occurrence of fraud and theft is nothing new. What is different now, other than that owning digital assets increasingly has become more mainstream? Some believe that the trend of increased crypto litigation is, in part, being fuelled by the availability to would-be plaintiffs of litigation funding in instances where potential defendants with deep pockets exist. The ensuing losses can give rise to various forms of litigation including criminal enforcement by state authorities, civil action arising from regulatory enforcement and private litigation. We examine these in turn and in a series of case studies explore how litigation is playing out in practice in the crypto and DeFi space.

Tackling the shifting risk landscape

Tackling the shifting risk landscape

It is clear that participating in crypto and DeFi markets can be a high risk activity regardless of, or in some cases as a result of, the level of market adoption. The types and scale of risk that an organisation may face will depend upon its role within these markets. We consider the perspectives of two broad categories of market participants: investors in digital assets and digital businesses and their investors. However given that any approach to risk management will be highly dependent on both the type of market participant and the nature/structure of their digital asset offering or involvement, we recommend that an approach specifically tailored to that participant’s specific circumstance will be required.

Richard Hay

“Regardless of their perspectives, all market participants have an interest in reassessing their risk exposure and dealing with the fallout when things go wrong. Understanding risk is key to risk management for all players”

Richard Hay, UK Head of Fintech


Joshua Klayman

“DeFi is a broad term. Essentially, it refers to a category of systems that offer a blockchain-based form of products that resemble regulated financial products – but which aim to operate peer-to-peer, without any intermediary. Some have described Bitcoin itself as a form of DeFi.”

Joshua Ashley Klayman, U.S. Head of Fintech and Head of Blockchain and Digital Assets


Ben Packer

“There is never a legal vacuum, even if there is a regulatory one”

Ben Packer, Dispute Resolution Partner

Further resources

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Fintech Legal Outlook 2023

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Navigating the World of Digital Asset Regulation

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Fintech

Regulating the Digital Economy Series

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AI in financial services

Artificial Intelligence in Financial Services 2.0

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Fintech

FintechLinks blog

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