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A letter from a16z to regulators: How to properly regulate DeFi?

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Regulators and policy leaders must thoughtfully regulate blockchain technology, as it is crucial.

Original Title: "A16Z's Letter to Regulators: How to Properly Regulate DeFi?"

Translated by Wu Shuo Blockchain

Abstract

This article is a comment letter written by a16z for the Financial Stability Board's (FSB) "International Regulation of Crypto Asset Activities" theme event. It is mainly divided into three parts.

1. Discuss the differences between DeFi & CeFi, and how an appropriate DeFi regulatory framework should involve regulating Web3 applications rather than Web3 protocols (regulating enterprises rather than software);

2. Discussing the importance of privacy while still mitigating illegal financial risks;

3. Remind not to establish overly strict regulations, as these regulations may have the effect of prohibiting the operation of well-functioning and over-collateralized algorithmic stablecoins. Instead, we suggest that the requirements for collateral can be relaxed to mitigate risks, as this may lead to the prohibition of well-functioning and over-collateralized algorithmic stablecoins. We believe that relaxing collateral requirements can mitigate risks.

FSB Financial Stability Board, established in April 2009, is a specialized international organization responsible for regulating and making recommendations for the global financial system. As the successor to the Financial Stability Forum established at the 2009 G20 London Summit, its members naturally include central banks, finance ministries, and financial regulatory agencies from more than 20 countries, as well as major international financial institutions and professional committees.

Decentralized Finance DeFi

CeFi vs DeFi: The Difference

Many people confuse "encrypted CeFi" with DeFi because both are means for customers and users to participate in the encrypted market. However, the operation modes of CeFi and DeFi are fundamentally different. It is precisely because of their unique characteristics that we believe they require different regulatory frameworks.

First of all, CeFi institutions, as the name suggests, operate in a "centralized" manner, with a complete management team and conflicts of interest. Users interact with third-party intermediaries to enter the cryptocurrency market. Intermediaries are usually traditional private enterprises, and users are their clients. Decisions on how to operate the enterprise are made behind closed doors. On the other hand, DeFi consists of software protocols that provide a large number of non-intermediary financial products and services. These software protocols are usually composed of smart contract collections deployed on decentralized blockchains. Users can interact directly with these protocols without intermediaries, trading financial products in peer-to-peer transactions. The rules for managing DeFi protocols are written in computer code and executed through computer code. This is particularly important in jurisdictions where financial regulation is weak or where trust in political, financial, or both institutions is compromised. It also has benefits in avoiding financial contagion risks, as transparent transactions and reduced on-chain risk exposure reduce the likelihood of opaque leverage positions and strengthen risk management through more transparent levels of interconnection.

Because DeFi relies on code rather than intermediaries, DeFi protocols are very transparent. Generally speaking, anyone can inspect and audit the public ledger of a blockchain, and many DeFi protocols are built on these public ledgers, which reflect the smart contracts that govern protocol operations and records of the prices and quantities of each transaction inputted on a given platform. For example, a popular DeFi lending protocol, Compound, has a transparent, immutable, and publicly inspectable ledger of all historical transactions. Importantly, this information is almost real-time.

Compared to CeFi intermediaries, which are opaque, the public can only obtain the necessary information on a limited, sporadic, and retrospective basis. Given the transparency of DeFi systems that use open source code and on-chain tracking, regulatory agencies and users can relatively easily monitor them, while CeFi intermediaries cannot. So far, DeFi protocols have shown significant resilience to market pressures, especially compared to CeFi intermediaries. In the recent months of market volatility, the large-scale bankruptcies in the crypto market have been concentrated in CeFi institutions such as Celsius Network and Voyager Digital, while truly decentralized DeFi protocols such as Compound and Uniswap have been operating normally. This relative success is both a function of the integrity of DeFi protocol smart contracts and the transparency they provide. Given these advantages, we believe that the DeFi ecosystem will continue to grow in terms of usage, practicality, and complexity in the coming years.

DeFi's New Regulatory Framework: Regulatory Applications, Not Regulatory Protocols

As mentioned above, we believe that an appropriate regulatory framework tailored for DeFi involves regulating the on-ramps to centralized/business-owned applications or protocols, rather than the protocols or software themselves. As discussed below, this distinction between business-owned applications and protocols is crucial.

DeFi Protocol

DeFi protocols are software programs composed of smart contracts that provide functionality for peer-to-peer lending and other financial transactions. The protocols are hosted on the blockchain or integrated into blockchains such as Ethereum, and they are open-source, decentralized, autonomous, and censorship-resistant. Among these features, decentralization and censorship resistance have special regulatory and political significance. Decentralization is a broad term that refers to various aspects of the blockchain, including political/legal decentralization (because no one controls the public chain) and architectural decentralization (because there are no central failure points).

As many regulatory agencies have pointed out, decentralization is a spectrum, and some web3 businesses start from centralization and transition to a decentralized model. We suggest the existence of a "fully" decentralized web3 entity, where (i) information about its operation is transparent and available to everyone (through transparent blockchain ledgers), (ii) no necessary management effort is required (or even possible) to drive the success or failure of the enterprise (through immutable smart contracts, decentralized economies, and DAOs).

Anti-censorship is also a widely used term that describes the ability for almost anyone to use a public blockchain, as well as the fact that no one can be kicked out of a public blockchain. It also describes the fact that no one on the blockchain can be powerful enough to independently stop transactions or prevent others who want to verify blockchain transactions from joining the consensus network.

Due to the lack of control over protocols, they cannot contain subjective decisions that traditional financial regulations sometimes require, and therefore, they cannot comply with or understand specific judicial requirements. For example, product classifications such as securities, commodities, and various derivative instruments may differ between different jurisdictions, and may be highly subjective between countries. Globally accessible software cannot apply factual and environmental tests, nor can it include inconsistencies in its programming. In addition, once deployed, DeFi protocols (such as the Uniswap protocol) will run permanently as originally constructed, regardless of any changes in laws or regulations, as their design parameters typically severely limit functional updates. If the web3 community votes to support updates to new versions of DeFi protocols or launch new versions of protocols, updating their code libraries to point to the new version of smart contracts will provide users with access to earlier versions of applications.

DeFi Applications

DeFi applications are products built on top of DeFi protocols that allow users to access these protocols. Importantly, they often add on-chain or off-chain order databases, as well as a graphical user interface (GUI) or API or both. Unlike the protocol layer, business and developers of web3 applications do not have the same constraints in subjective decision-making. They can comply with different legal regulations and design flexible access points that minimize legal and regulatory risks.

Traditional CeFi regulations should not apply to DeFi

The regulations designed for CeFi should not apply to DeFi because they have not adapted well to the differences between the two types of products and services. In the CeFi field, many regulations aim to eliminate the risks of trust financial intermediaries. The goal is to reduce the potential conflicts of interest or direct fraud that may occur when one person must entrust their money or assets to another. In the world of DeFi, traditional financial services are decentralized and there is no trusted intermediary.

Therefore, in DeFi, the decentralization, transparency, and trustworthiness implemented by blockchain technology eliminate many of the risks that CeFi regulations primarily aim to address. As a result, DeFi can isolate users from many of the old-fashioned malpractices prevalent in CeFi and do better than any "self-regulation" or "public regulation" system in CeFi. Therefore, it is illogical to apply CeFi regulations on decentralized web3 applications that do not provide similar intermediary services.

In addition, any regulatory intervention will backfire because it will hinder the inherent ability of DeFi to achieve many reasonable policy goals pursued by financial regulations, such as transparency, auditability, traceability, responsible risk management, and so on. Imagine the value destruction caused by forcing the SMTP email protocol to comply with various legal systems (from freedom of speech law enforcement to data privacy laws such as GDPR). However, accessing SMTP through applications that communicate with each other, such as Gmail, can comply with various regulatory requirements or respond to regulatory information requests. Traditional regulatory intervention at the protocol level is not feasible.

We also believe that the principle of regulating applications rather than protocols is crucial for ensuring transparency and credibility of DeFi to the international financial system. As mentioned above, since DeFi applications run on blockchain technology, they are open and accessible to anyone around the world, creating unprecedented opportunities for accessing financial services. Since January 2020, the number of DeFi users has skyrocketed from about 91,000 to nearly 5 million, with the benefits of DeFi being most evident in emerging markets where trust in political authorities and financial institutions may be compromised. Latin American countries are leading the world in adopting DeFi, especially in areas where credit facilities are scarce. DeFi is also making progress in African countries such as Nigeria and Kenya.

Using a regulatory framework to capture the software infrastructure that drives the web3 ecosystem, rather than applications running as interface points, could jeopardize the benefits of DeFi for millions of people and push protocol developers towards jurisdictions with particularly lenient regulatory frameworks. If regulators were to impose subjective and potentially globally conflicting regulations on web3 protocols, such as what may or may not be securities, commodities, or their derivatives, decentralization would be unsustainable, undermining the functionality and useful features of DeFi protocols. We believe that international officials and regulators can most effectively address this challenge by promoting responsible development in the DeFi industry, particularly by establishing a clear and feasible legal framework based on standardized DeFi applications.

Privacy and Mitigating Risks of Illegal Finance and National Security

Establishing a clear and consistent global regulatory framework is crucial for the maturity of the digital asset industry, in order to enhance financial integrity and combat money laundering and terrorist financing. We know that such a framework will be most successful if the public and private sectors actively collaborate and share information in real time to reduce the risks of money laundering, terrorist financing, and other illegal activities.

We appreciate the Financial Action Task Force's (FATF) proposals and guidance on anti-money laundering (AML) and countering the financing of terrorism (CFT) in the field of digital assets. As this sector continues to innovate, FATF should continue to engage with the private sector and its members should participate in practical testing of technology to develop policies that effectively achieve necessary goals while avoiding overly broad or unforeseen consequences. In addition, local regulatory authorities should also engage with the digital asset industry when implementing FATF's virtual asset standards.

In the United States, many cryptocurrency businesses are protected by the US Bank Secrecy Act, and these protected entities have successfully benefited from traditional financial institutions' "anti-money laundering" programs, while also developing additional elements that reflect the unique situation of cryptocurrency. In addition, the Financial Crimes Enforcement Network (FinCEN) in the United States works closely with cryptocurrency asset service providers to leverage their advanced information and threat detection capabilities. However, in applicable cases, the "know your customer" (KYC) rules should apply for the purpose of using blockchain technology's technical capabilities. KYC processes that collect the minimum amount of identifiable user data should be encouraged, and technology and processes should be tested through exceptions and regulatory sandboxes. This flexible approach can promote the development of native cryptographic tools and effectively combat illegal finance using blockchain technology and transparency.

Despite the important compliance obligations of the entities involved, privacy is a fundamental human right and social good. Privacy protection technology allows for data computation and targeted analysis while maintaining encryption for those who perform the computation and malicious actors who may attempt to steal or compromise the information. Zero-knowledge proofs and configurable privacy blockchains are emerging forms of privacy protection technology that can balance individual privacy interests with broader public policy and social needs, such as effective compliance, transparency, and security.

Governments around the world should adopt laws and policies that allow for the development and use of privacy-protecting technologies, while also making compliance with these technologies possible. For example, regulatory bodies can establish processes to assess new mechanisms for creating and maintaining digital identity records, including the use of digital identity verification technologies, which can be combined with decentralized blockchain technology and secure off-chain data repositories. In addition, zero-knowledge proof technology can be used for sanction screening.

At the same time, the government itself should also respect personal privacy, and should only access or use personal data when it is necessary to achieve specific, narrow, and legitimate government goals. For example, the US Treasury Department is considering collecting, verifying, and retaining the names and physical addresses of all counterparties involved in transactions exceeding $3,000 between cryptocurrency trading platforms and non-custodial wallets, which poses serious privacy and security concerns. In addition, these proposals may harm law enforcement investigations, prosecutions, and asset recovery capabilities, as they would drive self-custodial wallet users away from well-regulated and compliant trading platforms and financial intermediaries to entities that are non-compliant or poorly regulated, thereby reducing the amount of valuable information available to law enforcement and national security agencies.

Finally, we suggest that FSB clarify the statement in recommendation 5 of the GSC report, which states that "authorities should ensure that the GSC arranges for the implementation of appropriate anti-money laundering/counter-terrorism financing measures, in line with FATF standards, including compliance with the FATF travel rule requirements", specifically considering whether the GSC arrangement allows for peer-to-peer transactions through non-custodial wallets, only applicable to covered entities with travel rule obligations. Typically not aimed at non-custodial or non-custodial wallet providers, users, or non-VASP entities.

Algorithmic Stablecoin

FSB's recommendation on stablecoins is that the reserve assets should be "at least equal to" the amount of stablecoins issued by the issuer, and should only consist of "conservative" assets. Stablecoins should not "derive" their value from algorithms, as this would have negative unintended consequences for the blockchain ecosystem. More specifically, we are concerned that the framework based on this recommendation will effectively prohibit algorithmic stablecoins, where the best algorithmic stablecoins operate through over-collateralization with external collateral, and show hostility towards web3 applications that rely on algorithmic development for their products and services. While we wholeheartedly support regulation that prevents stablecoin issuers from taking unreasonable risks, we believe that legislators can protect users without such a broad ban. They can do so by enacting strict, tailored collateral requirements that allow for the development of secure software code, but prevent excessively risky projects.

Algorithm is not the problem

Stablecoin is a type of cryptocurrency whose value is pegged to the value of external assets such as the US dollar or gold. Stablecoins can be maintained through centralized custody of collateral and reserve assets, or through the use of algorithmic clearing mechanisms and a combination of different cryptocurrencies or other assets as collateral. Generally, legislators and regulators are concerned about algorithmic stablecoins, which use algorithms to maintain stability, and consider them a risk area. However, this overly broad concern is largely misplaced, as it focuses on algorithms as an unstable source rather than the real problem of insufficient collateral.

In the past year of market volatility, we now know that the vast majority of algorithmic stablecoin projects have performed very well, while a very small number of poorly performing projects have severe collateral shortages, relying on collateral created by the issuer themselves. Importantly, the relative safety of algorithmic stablecoins is due to the programmability of blockchain, which creates certain key risk controls typical of traditional clearing infrastructure, including collateral liquidation, which protects the security and robustness of investors and protocols, and is far more transparent and effective than manual processes.

One example of the programmability of blockchain involves stablecoins, which require users to deposit ETH as collateral. These protocols require the value of the ETH collateral to be between 135% and 150% of the value of the stablecoins the user intends to mint on such protocols (the "collateralization ratio"). Although these stablecoins are unsecured, if the price of ETH falls and the value of the user's collateral falls below the collateralization ratio of the protocol, the user's collateral will be automatically liquidated and their ETH will be sold to close the stablecoins borrowed by the user. All of this happens automatically and autonomously, ensuring that the protocol's collateral is never worth less than the value of the outstanding stablecoins.

Given the success of over-collateralized stablecoins during periods of significant volatility, this programmable security mechanism should be praised rather than discouraged.

Regulatory Algorithm Stablecoin

FSB has a great opportunity to recommend a properly tailored regulatory framework for algorithmic stablecoins that recognizes the importance of algorithms and digital assets. However, the currently proposed recommendations almost explicitly call for the effective prohibition of algorithmic stablecoins, as they typically require all stablecoins to be backed 1:1 by conservative and highly liquid assets, suggest restrictions on the use of cryptocurrencies as reserves, and note that stablecoins should not "derive value from algorithms".

More carefully tailored requirements will more effectively protect the blockchain ecosystem and users. The FSB should conduct a study analyzing the relative safety of over-collateralized stablecoins to evaluate which collateral and collateral ratios may be sufficient to allow for continued use of such collateral. For example, a regulatory proposal may effectively suggest that only digital assets with a market value above a certain threshold can be used as collateral to ensure that bad actors cannot easily manipulate collateral assets. In addition, collateral ratios of 125% or more have been proven effective in recent volatility and are worth further exploration.

On the other hand, a widespread ban on algorithmic stablecoins may harm the international financial system. Firstly, stablecoins, whether custodial or algorithmic, provide stability in countries where centralized monetary policies have failed. As more countries face increasing inflationary pressures, we expect the use of stablecoins to increase. Additionally, algorithms are not only important for the development of stablecoins, but they are also critical for other aspects of the blockchain ecosystem, including DeFi and other digital asset markets. If regulatory bodies view algorithms as a source of instability, web3 developers may perceive this as a threat to their projects and exit the market. With appropriate regulations, we can prevent this outcome.

In short, our high-level principle regarding algorithmic stablecoins is:

Prohibiting algorithmic stablecoins is simply blindly assimilating all algorithmic stablecoins, when in fact they are very different. The system risks brought by stablecoins are more of a product of their collateral design rather than the use of algorithms. Banning all algorithmic stablecoins is like using a sledgehammer to crack a nut (note: meaning that excessive force can be counterproductive).

Prohibiting algorithmic stablecoins would disrupt the current DeFi market and lead to significant customer losses. From the perspectives of investor protection and software development, such bans are destructive and counterproductive, potentially causing billions of dollars in losses for the users that policymakers are trying to protect.

The ban will have unforeseeable negative impacts on the entire DeFi and broader web3 industry. The algorithmic mechanisms used in algorithmic stablecoin protocols are widely present in DeFi and web3. The blockchain ecosystem may perceive a comprehensive ban on algorithmic stablecoins as an attack on these mechanisms, which could inadvertently hinder widespread web3 innovation.

The ban will be extremely difficult to enforce. Jurisdictions around the world that choose to implement the FSB-approved ban will not be able to remove all stablecoins from their markets, which may encourage regulatory arbitrage and expose users to greater risks of harm.

The ban will push innovation towards regions with particularly lenient regulatory frameworks and harm large developed economies with good regulation. The ban may accelerate the decline of the web3 developer market share in developed countries and hinder their ability to influence the development of web3 and the wider industry.

The ban is unnecessary, as other restrictive measures will be more effective in reducing systemic risk. Regulatory agencies could use existing regulatory provisions to prevent most recent systemic harm, and new precise regulatory provisions can eliminate the risk of such systemic harm recurrence without impeding innovation.

Summary

It is crucial for regulatory agencies and policy leaders to thoughtfully regulate blockchain technology, as it is rapidly becoming a key pillar of the financial system. We appreciate the opportunity to comment on these important matters. We view this comment letter as part of an ongoing dialogue between the public and private sectors and look forward to continued engagement on these issues.

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