Clarity, please

With the ongoing crypto drama of 2022, most recently the spectacular blow-up of Bahamas-based crypto exchange FTX, the financial world is screaming for regulators to do "something." Experts say tighter rules are inevitable, not just for exchanges but also for other parts of the digital asset world. This includes decentralized finance (DeFi), peer-to-peer financial services transacting on public blockchains.

"A lot of investors will probably now decide to stay away from this space until there are very clear regulations," says Rick Moscone, a partner at Fogler Rubinoff in Toronto.

The problem is that no one is quite sure what DeFi regulations will look like and whether new laws are needed. While some crypto exchanges in Ontario are now registered, DeFi projects are much harder to monitor. That's because they have less identifiable central players to oversee and fit less easily into current legal systems.

On the whole, "it's not always clear what falls within the jurisdictional perimeter of the securities regulator, and what is outside of that remit," says Ryan Clements, a law professor at University of Calgary, who writes extensively on crypto regulation. "In many situations, DeFi and crypto may require new legislative solutions because the product, service or function doesn't fit within an existing regulatory framework."

Canadian regulators so far say the framework is adequate. Using the existing securities legislation to guide them, they're maintaining a "same risk, same regulation" stance, though some say this is not enough. "The problem is that in many DeFi applications, we have a situation where there is "'more risk/no regulation,'" says Clements.

DeFi is a parallel banking system that uses distributed ledgers, tokens and smart contracts to replicate the existing centralized system of lending, borrowing and trading. In theory, DeFi allows individuals to participate directly with the market, thereby removing costly third-party infrastructure. In contrast to centralized elements of the crypto universe like FTX, which provided custody solutions, DeFi "clients" connect with automated protocols using self-custody. 

Proponents of this technology hope DeFi can transform the financial system and unleash a wave of increased productivity. 

At the moment, DeFi projects, which encompass lenders, decentralized exchanges, and interest-earning platforms, are almost entirely unregulated, making them risky to both individuals and the wider economy. Investors and regulators have little visibility in terms of the health of balance sheets and vulnerability of the underlying codes. However, there are possible remedies for policymakers to explore. These could include the inspection of DeFi codes before they are released and greater supervision through blockchains when projects are live. Targeting the entry points into the DeFi ecosystems (i.e the more regulated exchanges) is also an option.

As shown by the recent crypto implosion, self-regulation of this space is not working out. Removing third parties has left investors exposed to a multitude of hacks, scams and bankruptcies over the last few years. Losses are counted in the billions.

"Why have we had regulations for hundreds of years? Because they work," says Fogler's Moscone. "Over time, people have realized that [risks] need to be contained."

There's also ample evidence that digital assets have been used to facilitate crime. From the very beginning, there have been know-your-customer (KYC) and anti-money laundering (AML) concerns. "Crypto was born in a libertarian environment where the objective was precisely to get away from scrutiny," says Annie Lecompte, a professor at Université du Québec a Montreal. "That's part of the reason why it's so hard to regulate."

Creating a workable framework for DeFi won't be easy. The European Union earlier this year purposefully excluded DeFi in its sweeping agreement for regulating the cryptocurrency industry, Markets in Crypto Assets, or MiCA. However, it has commissioned a study to develop "embedded supervision" of DeFi on the Ethereum network. In theory, this could enable regulators to monitor compliance automatically by reading public blockchain data.

Despite recent setbacks, it's unlikely that this sector will disappear. The value of DeFi projects, which jumped from 18 billion dollars in January 2021 to about 250 billion by the end of December 2021, was still estimated at around a hefty 60 billion before the latest ructions. 

Some are skeptical that crypto programmers will go along with supervision given their core mission: get rid of third parties. "I have seen a fair amount of resistance in parts of the DeFi ecosystem to this," added Clements.

There could also be pushback from other quarters: policymakers who are looking at crypto for growth. Indeed, regulators around the world have been handed a seemingly impossible task: protect the public and capital markets from blockchain blow-ups, but avoid stifling the environment for innovators.

In Canada, regulators have come under pressure from some politicians who hope the country will become a leader in the blockchain technology. They had been calling for light-touch regulation, though it's unclear whether they will maintain this stance given the recent rout. Crypto has often re-invented itself — Lazarus-like — following crises.

This month, bitcoin plunged about 20% following the implosion of FTX - a prominent centralized (and offshore) crypto-asset trading platform, which provided a custody function to clients. But this is only the latest crypto firm to crater. This summer Celsius, a multibillion-dollar crypto lender, collapsed, leaving thousands of investors holding the bag. That came after Terra Luna cryptocurrency imploded, losing investors $40 billion.

Thanks to economic headwinds and various crypto scandals, bellwether bitcoin and ether have lost about two-thirds of their value in a year. Ethereum is the main blockchain for DeFi protocols. The world's leading watchdogs, including the Financial Stability Board and the Basel Committee on Banking Supervision, have warned about digital assets' systemic risks to the real world.

While the recent rout may curb enthusiasm for all things crypto, getting to grips with regulation is imperative, given public enthusiasm, particularly from young people. Before the recent plunge, the OSC estimated that 30% of Canadians plan to buy crypto assets in the next year.  

While there are skeptics, many believe that blockchain technology will eventually make financial arrangements more efficient and more inclusive, though it will take time and experimentation to work out solutions to today's thorny issues. The problems are mainly with implementing the technology rather than the fundamental ideas, they say.

"Blockchain is still largely nascent," says Jeremy Clark, a professor at Concordia Institute for Information Systems Engineering. "The most successful use-cases have not been examples of blockchain doing the same thing as existing technology, but rather inventing new categories of technologies."

In any case, a wholesale prohibition of blockchain applications is likely futile.

"You'd have to effectively ban the internet," says Clements. "It would also create a tremendous enforcement challenge, and major public backlash given the many people interested in the sector."