On March 24, 2022, the International Organization of Securities Commissions ("IOSCO") published a detailed 45-page public Report ("Report") asserting that decentralized finance ("DeFi") is quickly evolving to mirror conventional financial markets. Notably, in a press release about the Report, Ashley Adler, Chair of IOSCO and CEO of the Hong Kong Securities and Futures Commission, noted that while DeFi services replicate more traditional financial services and activities, they have weaker regulation and increased risks for investors. The Report also casts doubt that DeFi services are a decentralized peer-to-peer network with no centralized insiders in control.
IOSCO is an international body of securities regulators and includes the U.S. SEC and U.S. CFTC in its membership and on its Board, which sets global standards for securities regulators. This Report welcomes input from the public, including crypto or DeFi entities or market participants. Because IOSCO's work often gets incorporated into policy or law, including in the United States, it can be very useful for members of the industry to provide comments.
As for the substance of the Report, in the introduction, it generally states that DeFi products are often analogues for traditional financial products. It then provides various and significantly detailed information about how DeFi works, providing explanations about several topics, including:
- Technical aspects of blockchain technology, noting that In DeFi, blockchains are used as a settlement layer for recording transactions. It also mentions particular blockchains that are used in DeFi, such as Ethereum, Binance Smart Chain, Solana, Polygon, and Avalanche.
- DeFi products and services, which it states are open-source, decentralized, non-custodial, and enable investors and consumers to engage in crypto-asset transactions on a peer-to-peer or peer-to-contract basis. It discusses that many DeFi products resemble traditional financial products and notes that there are also entirely new financial products and services, such as flash loans.
- Decentralization, discussing that DeFi products and services may have the potential to become more decentralized over the course of their development as they often start out as centralized projects but have a goal of decentralization, which they move towards incrementally.
- Lending and borrowing, noting that these are two of the primary DeFi products currently available. Lending protocols allow holders of crypto-assets, often stablecoins, to earn a fixed or variable return on those assets by depositing them in a smart contract or lending pool that simultaneously allows other participants to borrow those assets.
- Derivatives/synthetics, explaining that DeFi protocols have enabled the growth of blockchain or smart contract-based derivatives and synthetic exposures. A large portion of derivative DeFi protocols currently available allows participants to create synthetic crypto-assets whose value derives from the performance of an underlying reference asset or the outcome or occurrence of some event.
- Insurance and risk protection, explaining that although investors may have a strong interest in hedging their exposures and protecting against certain risks, in DeFi, traditional insurance is significantly limited.
- Custody services, comparing those to traditional retail custody services.
- DeFi investors, discussing several types, including institutional, venture capital, and retail.
The Report also discusses the enormous growth of DeFi in detail, and finally explains key risks and considerations for DeFi.
Moving forward, IOSCO is likely to issue additional reports or even guidance or principles on DeFi that may influence future U.S. legislation and regulation. Our team will be closely monitoring all upcoming developments, and we have experience with the work of IOSCO and the expertise to advise clients in working with them to provide comments. Please reach out to us if you would like to further discuss the Report and its potential impacts.
DISCLAIMER: This article was originally published by McGonigle PC prior to their combination with Davis Wright Tremaine LLP. The article is published here with permission.