【AppWorks Selection】Wall Street of the Cryptocurrency World that Muggles Must Understand: DeFi, a New Form of Finance Will Bring About "Regulation 2.0"

The original author, Wang Liying, is the Legal Counsel of AppWorks and the Director of the Innovation and Technology Committee of the Taipei Bar Association. This article is authorized by AppWorks and originally titled "The Next Step for Crypto Wall Street, DeFi Drives 'Regulation 2.0'".

The famous American writer Mark Twain once said, "History doesn’t repeat itself, but it does rhyme."

Comparing the development and impact of blockchain and cryptocurrency in the financial world, it is indeed true that history repeats itself in a similar manner, but at a faster pace of evolution. Two years ago, I wrote an article discussing the rise of Security Token Offering (STO), which resembled the story of "stock exchanges" on Wall Street. A year ago, my another article discussed Facebook's ambition to become the "global super central bank" and Libra's challenge to sovereign currencies in the form of a Stablecoin.

Advertisement - Please scroll down for more content

And this year, as inevitably expected by history, the hottest keywords in the cryptocurrency field are DeFi (Decentralized Finance); decentralized finance officially entering all-round financial services such as banking, securities, and futures, with Total Value Locked (TVL) once surpassing $14 billion. This has alerted traditional financial institutions of the "human Wall Street," suggesting that in the near future, "crypto Wall Street" may become a part of the daily life of Muggles.

Where is DeFi Heading Now?

Let's try to understand what DeFi really is in layman's terms. First, we know that when the Internet "transfers data," it's not actually transferring, but rather copying the data. In contrast, the biggest contribution of blockchain is the adoption of Distributed Ledger Technology (DLT), which allows for "value transfer" where when you add value on one end, I subtract value on the other end. Therefore, blockchain is dubbed as "The Internet of Value," and in its early development, it was most intuitively and tangibly applied with cryptocurrencies, making it easy to understand.

However, the term "cryptocurrency" may represent completely different definitions for different people, as the essence of cryptocurrency is a cryptographic encryption protocol. For example, the Ethereum ERC-20 protocol widely used in the DeFi world allows developers to develop applications with different attributes such as commodities, securities, digital cash, etc., based on the same foundation according to the specific use case requirements. Thus, what may seem unrelated application scenarios in the "traditional Wall Street" can, based on the common feature of "coin-to-coin trading," be designed and developed diversely through a "single" standard protocol. Therefore, we can observe that the global DeFi services are flourishing and have already formed a relatively complete ecosystem.

Take the core role of the DeFi ecosystem, the DEX (Decentralized Exchange) as an example. If the coins used for exchange have the function of digital cash, for instance: using DAI to purchase USDC, then the transaction behavior is similar to a "Currency Exchange" in the Muggle world; and when the coins used for exchange have the attributes of security tokens, for example: if COMP, explained later, is recognized as a security and a user uses ETH to purchase COMP, then the transaction appearance will resemble a "Stock Exchange" for securities trading.

DEX abandons mainstream fiat currencies such as USD or EUR as trading mediums and adopts a "coin-to-coin trading" with trading pairs. Regardless of how the "coin attributes" are legally defined, DEX is most concerned with "coin liquidity." Uniswap, with the largest market share in DEX, currently has over three thousand ERC-20 tokens listed, with nearly 200 listed by Uniswap certification, and a Total Value Locked (TVL) that has exceeded 3 billion USD at one point. Its high liquidity is attributed to the mathematical model of the "Automated Market Maker" designed by smart contracts, achieving real-time dynamic balance of trading volume and price, breaking the traditional order matching mechanism and allowing everyone to become a liquidity provider, earning fees. In other words, Uniswap's successful formula comes from the combination of "diverse features of cryptocurrencies" and "automated smart contracts," enabling everyone to be a market maker.

Furthermore, the active lending service Compound, which resembles doing business as a "bank," operates through a "liquidity pool" model that bypasses the role of a bank as an intermediary and shares services, breaking the limitations of time and geography, allowing prices and interest rates to be directly determined by real-time market operations. When there is oversupply, interest rates are low, and vice versa. All of this is automatically executed by smart contracts.

Where is DeFi Heading Next?

The birth of the world's first modern bank was two centuries ago, and the history of "moneylenders" or "pawnshops" is even longer. With the emergence of DeFi, combining the advantages of "diverse cryptocurrencies" and "automated smart contracts" to create a perfect application scenario, it seems that everything "traditional Wall Street" can do, "crypto Wall Street" can do, and perhaps even better. Therefore, one might easily wonder if these DeFi services similar to traditional financial businesses will involve banking, securities, futures, and other related regulations?

If we observe from the perspective of traditional "regulation 1.0," when project tokens fail the "Howey Test" in the U.S. or are deemed as investment contracts according to Taiwan's Financial Supervisory Commission's 2019 ruling, they might be considered illegal issuance or trading of "securities." Especially, as DEX does not have cumbersome listing approval processes, anyone can list any cryptocurrency on the secondary market for speculation, making it even more challenging to distinguish between "utility tokens" and "security tokens." In addition, the exchange and lending in the DeFi world usually do not involve the exchange of fiat and stablecoins through on/off ramps, which are crucial for anti-money laundering and counter-terrorism financing. Currently, transactions using non-global stablecoins for exchange or lending are still mainly considered as "commodity" transactions. However, with the increasing globalization of stablecoins and the participation of Central Bank Digital Currencies (CBDC), regulatory views are likely to be reevaluated and adjusted according to policy goals, potentially leading to crackdowns on what may be seen as "illegal fundraising" or "underground remittance."

Moreover, the inherent advantages of "cryptocurrencies" and "smart contracts" encourage developers to maximize their creativity through "Lego-like combinations," resulting in various "Synthetic Assets" trading. The definition of "futures" in various countries' regulations is usually broad. For instance, Taiwan's "Futures Trading Act" regulates "futures" as contracts or combinations derived from commodities, currencies, securities, interest rates, indices, or other interests; whereas U.S. laws define commodities for futures trading quite broadly, except for prohibiting "onions and motion picture box office receipts." Therefore, DeFi services involving derivative commodity trading may fall under traditional definitions, posing higher legal compliance risks.

Nevertheless, "regulation 1.0" faces a fundamental dilemma, as DeFi services emphasize "decentralized governance," while traditional regulatory frameworks focus on "singular actors," granting licenses and centralized supervision, creating an inherent antithesis. As mentioned earlier, traditional bank transactions follow a Peer-to-Bank-to-Peer model, while lending mechanisms like Compound bypass traditional banks as intermediaries, where transactions are not the traditional "buyer and seller," but rather interactions with smart contracts, eliminating the need for mutual trust or distrust, and relying solely on the automatic execution of software programs. Despite the lack of real-name authentication and credit verification processes, smart contract designs such as over-collateralization and early liquidation can effectively control default and bad debt risks to a certain extent. This exemplifies the essential feature of blockchain, "Trustless," eliminating the need for a trust-based foundation, a critical role assigned in the "crypto Wall Street."

It is worth noting that Compound does not aim to replace banks and become another intermediary. As per the whitepaper design, this open-source project not only emphasizes the transparency of smart contracts but also aims to eventually step back and return to the community. Driving this "decentralization" process is the important catalyst called the Governance Token COMP. Apart from being distributed to the founding team and early investors, the system also combines liquidity mining or similar reward mechanisms to automatically allocate a considerable proportion of COMP back to actively participating users based on their contributions. COMP holders, under specific conditions, can propose and vote to amend the rules of smart contracts. Additionally, in the fine details of the buffering period, Timelock, and executable code attached to proposals, ensure that members, whether opposing or supporting proposals, have a genuinely democratic decision-making space.

Through decentralized governance tokens and accompanying decentralized mechanisms, DeFi achieves a high level of "decentralization," making it impossible for regulatory authorities to apply traditional centralized management models to hold a "non-existent entity" accountable. Instead, they must reconsider the legal implications of "having the right to act if authorized, and no responsibility if unauthorized." On the other hand, the high level of "automation" and "transparency" of smart contracts significantly reduces the most challenging agent risks and information asymmetry risks in the traditional financial industry. In the future, DeFi's ecosystem aims to elevate the weakened position of financial consumers in the past to a more robust position within a sound DeFi ecosystem. The regulatory measures of "traditional Wall Street" are not fitting and are ineffective. What kind of "regulation 2.0" should we expect in the parallel universe of "crypto Wall Street"?

"Regulation 2.0" International Trends

In addition to preventing money laundering and counter-terrorism financing, the focus of financial regulation also includes protecting financial consumers and maintaining financial stability. These policy goals should be consistent in both the traditional and crypto worlds. However, faced with the innovations of "crypto Wall Street," the enforcement of "regulation 1.0" will likely result in either superficial actions or complete stifling, driving activities underground. Both scenarios fall into the regulatory blind spots of being "out of touch," potentially thwarting the next paradigm shift in technological innovation. Conversely, if regulatory agencies can view "decentralization" as the greatest advantage of blockchain technology and not an obstacle to regulation and law enforcement, willing to work with private communities to develop a "technology-first" and "self-regulation-first" "regulation 2.0" solution, then the current moment is a transformative opportunity:

1. Technology-First: "Crypto Wall Street" as the Best Showcase for "RegTech"

Over the years, the effectiveness of supervisory technology (SupTech) has been limited, mainly because the true "pain points" and "solutions" for regulation have not been identified. Today, DeFi has chosen the most intuitive and tangible application of cryptocurrencies in the blockchain field, confronting the highest regulatory intensity in the financial industry head-on. On one hand, it aims to break the long-standing high-cost, low-efficiency cycles of "traditional Wall Street" and, on the other hand, leverage the advantages of smart contracts to potentially shape international consensus and prevent regulatory arbitrage. With the shared objectives of "prevention" and "promotion," "crypto Wall Street" has the opportunity to become the best showcase for the development of supervisory technology.

Indeed, as early as September 2019, the Bank for International Settlements (BIS) proposed a policy recommendation for financial businesses using blockchain technology, suggesting an "Embedded Supervision" model with automated transaction monitoring within blockchain systems, replacing traditional centralized information collection, verification, and exchange. This innovative approach affirms the technical advantages of smart contracts in automating regulatory tasks, a potential breakthrough. However, BIS's policy recommendations are based on financial institutions adopting "permissioned DLT" and have not detached from the traditional regulatory framework of a "singular actor," but could serve as a starting point for discussion and contemplation. On the other hand, the Financial Stability Board (FSB) in October 2020, provided policy recommendations for Global Stablecoins, emphasizing the highest guidance principle of "same business, same risks, same rules." Although FSB reiterated that this principle does not change based on the underlying technology used by operators, it acknowledged the challenge of "permissionless DLT" lacking a "responsible singular actor."

Technology's constraints on human behavior are as powerful as legal constraints. "Crypto Wall Street" has demonstrated that laws as external regulations fall short, while smart contracts take on the tasks of "cross-border legislation" and "cross-border enforcement," showcasing their potential to fulfill these roles. This paves the way for the best arena for the development of "regulation 2.0." Taking the example of governance token design, under the judgment criteria of the aforementioned "Howey Test," there is indeed a possibility of being identified as "security tokens." However, the original meaning of a "security token" fragments, commodifies, and allows the free circulation of a company's credit, ownership, or other rights through bonds, stocks, or other certificates of recognition. In contrast, the primary mechanism of governance tokens is to manage smart contracts, ensuring a complete supervisory and balancing framework and automatic execution. While governance tokens may also have secondary market liquidity, their true value lies in transcending the idea of "recognizing certain economic rights" to emphasize "granting governance power." From a technological innovation perspective, this is invaluable. By operating governance tokens, enhancing the incentive for "good deeds" and suppressing the motivation for "misdeeds," perhaps a "regulation 2.0" that balances "prevention" and "promotion" can be achieved sooner.

During the buffering period, regulatory agencies can closely observe industry developments, identify their technical advantages, and have the opportunity to collectively shape a genuinely "grounded" "regulation 2.0" solution through public-private cooperation and international collaboration.

2. Self-Regulation-First: Developing "RegTech" Must be Based on Safeguards

Unlike "traditional Wall Street," accustomed to IPOs and M&A as the sole "exit" options for founding teams and investors, in the daily operations of "crypto Wall Street," there seem to be no boards frequently questioning revenue, nor investors requesting liquidation preferences. All agreements are ingrained on the chain, allowing the community to exercise "power" rather than "rights" through the distribution of governance tokens, enabling a broad community to wield power and responsibility through consensus agreements concluded by smart contracts, automatically executing fair, just, and transparent rewards.

Take COMP as an example. Although the whitepaper had long declared a move towards "decentralization," it is undeniable that "where there are people, there is a world." The distribution of governance tokens, including recipients, quantities, times, proportions, methods, is, in itself, a test of "human nature," requiring extensive planning, trial and error, and corrections over a considerable period to achieve genuine "decentralization." At that time, all rules will not be dictated by any single entity, but will rely on the collective wisdom and joint decisions of the community, making the founding team and early investors part of the broader community, devoid of substantial control over the project. In other words, the growth of a DeFi project is inevitably a transition from a "centralized team" to a "decentralized community." By empowering the community, true "exit" is achieved.

Since any "decentralization" goal must start with efforts from a "centralized" team and must undergo an extended period, if regulatory agencies only focus on the apparent "centralization" facade of projects in the early stages and fear the results of "decentralization," hindering regulation and law enforcement, directly applying ill-fitting existing regulations could potentially stifle projects before they reach the mature stage of "decentralization." Given this scenario, the U.S. SEC Commissioner Hester Peirce, known as "Crypto Mom," proposed the "Token Safe Harbor Proposal," suggesting a grace period, such as three years, for these innovative technologies and business models to help founding teams progress step by step from "centralization" to "decentralization."

The "safe harbor" mechanism ensures continuous innovation by teams while the entire industry gradually forms unique best practices based on the principles of "self-regulation-first." Beyond the open-source design of smart contracts and decentralized governance token mechanisms, there are service providers offering smart contract integrity and security audits to mitigate cybersecurity and software vulnerability risks, such as Quantstamp. To reduce agent risks and information asymmetry risks, there are also rating services for comprehensive evaluations, such as ConsenSys. Additionally, due to the DeFi's financial trading characteristics, there are service providers offering real-time behavioral detection and testing and simulation for predicting black swan events, preventing systematic risks, such as Gauntlet. Most importantly, during this buffering period, regulatory agencies can delve into industry developments, identify their respective technical advantages, and collaborate to shape a genuinely "grounded" "regulation 2.0" solution.

Conclusion

Two years ago, in an article discussing STOs, I wrote in the conclusion: "Blockchain's consensus algorithm is fundamentally a form of political operation, choosing the more challenging but potentially more long-term decentralized path in the various methods of 'managing the affairs of the public.'... The revolutionary technology and applications of Crypto are about to lead us to construct 'Wall Street Finance 2.0,' where this Wall Street does not belong to any country or city but exists virtually, equally, and decentralized within the entire community."

DeFi is more of a social movement experiment rather than an innovative technology or business model. DeFi transactions largely replicate traditional financial operations, but what's crucial is that the transformation from "centralized" to "decentralized" completely upends our understanding of the existing world. "Crypto Wall Street" reveals a spirit of cross-border, open-source, community, consensus, and sustainability through the implementation of blockchain technology. It allows us to witness how smart contracts can express inner thoughts through code and execute them automatically, truly embodying the beauty and power of "Code is law."

Through continuous efforts of the community, we have now arrived at today. It's clear to us that the faith of "crypto Wall Street" is not about turning into "traditional Wall Street" but making Wall Street ubiquitous. Whether this next step can successfully move forward depends on whether regulatory agencies can smoothly upgrade their systems, bravely break the limitations of centuries-old financial charter operations, and consider how to develop a "regulation 2.0" era eagerly awaited through the viewpoints of "technology-first" and "self-regulation-first," contemplating public-private cooperation and international collaboration to combat crimes, protect financial consumers, maintain financial stability, and jointly move towards the anticipated "regulation 2.0" era.

About the Author:

Author: Lily Wang, Legal Counsel at AppWorks / Chairperson of the Innovation and Technology Committee at the Taipei Bar Association

Leading a team of professional lawyers to establish TomorrowTech Legal Firm, providing comprehensive legal advice on enterprise operations, contract negotiations, dispute resolutions, and more. Concurrently serving as the Chairperson of the Innovation and Technology Committee at the Taipei Bar Association, dedicated to promoting dialogue between industry, government, academia, and research institutions, and advancing regulatory adaptations for emerging technologies. Previously served as the Senior Legal Manager of Global Operations at HTC, a lawyer at the Technology Legal Department of Universal Law Firm, as well as served at the Shilin District Court and the Taipei High Administrative Court. Holds a Master of Laws degree from Northwestern University, and is licensed in both New York, USA, and Taiwan.