Global Regulators Pursue Stricter Oversight of Decentralized Finance (DeFi)

Global securities regulators are taking their first steps toward establishing a framework to hold participants in the world of "decentralized finance" (DeFi) accountable for their actions, with the aim of safeguarding market stability. DeFi platforms have gained prominence for enabling users to lend, borrow, and save in digital assets while leveraging blockchain technology to bypass traditional financial intermediaries, such as banks and exchanges.

The International Organization of Securities Commissions (IOSCO), the global umbrella body representing securities regulators from various countries, has expressed concern over the increasing influence of DeFi and the potential risks it poses to the financial system. IOSCO highlighted incidents such as the collapse of the crypto exchange FTX and the Terra USD stablecoin in 2022, illustrating how shocks in one segment of the crypto market can trigger massive outflows from DeFi applications.

As a result, the DeFi sector has experienced a significant contraction, with its total value locked plummeting from approximately $180 billion in late 2021 to around $40 billion at present. Furthermore, IOSCO has raised concerns about the misuse of DeFi platforms for money laundering.

Contrary to the common misconception that DeFi operates in a completely decentralized and autonomous manner, IOSCO asserts that there are identifiable "responsible persons" within the DeFi ecosystem, akin to those in traditional finance.

Tuang Lee Lim, Chair of a fintech taskforce at IOSCO, stated, "In reality, regardless of the operating model of the DeFi arrangement, 'responsible persons' can be identified."

One of the key challenges faced by regulators is the lack of standardized data on DeFi, exacerbated by market participants' use of multiple pseudonymous addresses to conceal their activities, making it difficult to track and enforce regulations effectively.

To address these concerns, IOSCO has proposed a regulatory framework for its 130 member jurisdictions to ensure investor protection, maintain market stability, identify and mitigate risks, establish transparent disclosures, and facilitate cross-border cooperation in enforcing applicable laws. The framework calls for regulators to leverage existing laws or introduce new ones when necessary to obtain comprehensive information about DeFi, including the identities of individuals and entities involved.

A public consultation on these proposals, which align with IOSCO's earlier suggestions in May to regulate cryptoassets themselves, is scheduled to run until mid-October. The framework is expected to be finalized by the end of 2023.

IOSCO members have committed to applying the agreed-upon recommendations, and some countries, including the United States, have already initiated discussions on how DeFi fits within their existing securities laws. As DeFi continues to evolve and exert influence in the financial landscape, regulatory bodies worldwide are striving to strike a balance between innovation and risk mitigation to ensure the integrity of financial markets.