Regulatory agencies will become stumbling blocks on the road ahead, DeFi has no choice but to help itself.

Many believe that the intervention of regulatory agencies or large institutional entities in the financial markets is a major driver pushing people towards decentralized finance (DeFi). However, based on current market trends, regulatory authorities seem poised to extend their reach into the DeFi space at any time. The current design structure of DeFi also appears to be vulnerable to regulatory risks unless it achieves "true decentralization".

Regulators Increase Scrutiny on Financial Startups

Recently, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) filed a lawsuit against the California-based cryptocurrency wallet provider Abra. The reason cited was that Abra had been offering thousands of derivative contracts through its mobile app since February this year, allowing users (especially in the U.S.) to engage in financial trading with counterparties.

The SEC stated that through the Abra app and services provided by Plutus, users were able to speculate on the price fluctuations of U.S. stock securities and engage in blockchain-based financial transactions, activities that violated existing financial regulations. The lawsuit is currently in the settlement phase, with a fine of around $300,000 to be paid.

On another front, Taiwan's Financial Supervisory Commission issued a warning to the financial product trading platform eToro earlier this month, stating that while eToro claims to have regulatory licenses from the UK's FCA, it does not have business approval in Taiwan:

"eToro is not a legal securities and futures operator in our country and is not allowed to operate securities and futures-related businesses within our borders."

The Financial Supervisory Commission added that if overseas operators engage in illegal securities and futures businesses in Taiwan, they may be in violation of the Criminal Liability under Article 175(1) of the Securities and Exchange Act, Article 112(5)(3) and (5) of the Futures Trading Act, and Article 107(1) of the Securities Investment Trust and Consulting Act. They will be referred to the judicial units for investigation in accordance with the law.

These recent events highlight regulators' growing concerns about financial startups. With such regulatory warnings continuing to emerge in the market, the next target for regulators may be the current hot topic in the cryptocurrency market - decentralized finance (DeFi).

Many DeFi projects currently operate in a regulatory grey area, especially projects like Synthetix and UMA that offer commodity trading markets linked to real assets, raising similar legal concerns as Abra and eToro. Synthetix currently offers synthetic products based on the Nikkei Average Index and the UK FTSE 100 Index, but avoids creating products linked to the S&P 500 Index to mitigate regulatory risks in the U.S.

Money Laundering Concerns Trigger Regulatory Issues

Another issue that DeFi needs to be concerned about is the inflow of illegal funds. Also this month, Centre, the company behind the stablecoin USDC, blacklisted an Ethereum address holding tokens worth $100,000 for the first time. These stablecoin issuers define blacklisting functionality in the token's smart contract to block illegal addresses from receiving tokens or even freeze tokens.

While this feature can prevent the transfer of illegal funds, it may not necessarily be a bad thing. However, it is important to note that many DeFi projects support these centralized stablecoins. If illegal funds flow into these Maker vaults in the form of USDC, forcing the USDC issuer to blacklist the vault address or freeze the tokens, it could lead to a decoupling of Dai from the U.S. dollar and severely impact the protocol's operations.

Additionally, the inflow of illicit funds into DeFi projects is likely to attract regulatory attention. In essence, regardless of the perspective, DeFi will inevitably become the focus of global regulatory bodies at some point in the future.

DeFi Has No Choice But to Save Itself

Currently, the only solution appears to be strengthening the management structure of decentralized governance organizations to further enhance the protocol's decentralization.

In terms of governance, although many projects have issued governance tokens, these tokens only have voting functions in governance matters (e.g., COMP holders can only vote on proposals to add new forms of collateral to the protocol and adjust risk parameters). The execution power of the protocol (administrator key) remains in the hands of the development team, meaning that "most governance tokens decentralize only the decision-making authority of the protocol, not the execution authority." Therefore, if regulators have concerns about DeFi protocols, they can still impact the ecosystem by suing the development team. If the execution authority of the protocol can be distributed to a decentralized governance organization managed by thousands of people through other means, the situation may be different.

Projects known to have administrator keys in their protocols include: bZx, Dharma, Token Sets, Synthetix, PoolTogether, Aave, dYdX, Compound.

Overall, regulators delving into the DeFi field is only a matter of time, and this will have a significant impact on DeFi. Perhaps the only solution to this issue is to enhance the decentralization of protocols.