CFTC report pushes for swift DeFi regulation, highlights risks in the system


The Commodity Futures Trading Commission (CFTC) has urged policymakers to regulate the risks associated with the rapidly expanding realm of Decentralized Finance (DeFi).

Led by CFTC Commissioner Christy Goldsmith Romero, its latest report raises concerns about clear responsibility and accountability in DeFi. This emphasizes both DeFi's potential and risks, urging swift regulatory frameworks to protect the U.S. financial system, consumers and national security.

Titled “Decentralized Finance, the report came following a similar one by the Department of Treasury in April, which addresses illicit finance risks in DeFi and proposes enhanced collaboration between federal regulators and industry stakeholders.

Since the emergence of Bitcoin, blockchain and distributed ledger technologies have experienced rapid growth. These technologies promise increased access to financial services with a more transparent and efficient system. As of writing, the total value locked in the ecosystem has surged to $54.25 billion.

However, numerous systems are still not completely decentralized, making it difficult to establish clear models that ensure decentralization and accountability.

“Most DeFi systems are not completely centralized or decentralized, but instead operate on a spectrum… DeFi remains at the center of illicit finance risks, cyber hacks, and theft,” CFTC Commissioner Christy Goldsmith Romero said.

The CFTC’s report revealed that these gaps present significant risks to both consumers and investors and financial stability and market integrity. They also elevate the sector's susceptibility to illicit activities like cyber and financial crimes.

Without robust regulation and compliance measures, DeFi projects face exposure to fraud, mismanagement and regulatory breaches. The intricate nature of these technologies, combined with market volatility, heightens the risk of substantial losses to investors and stakeholders.

“Fraudsters continue to exploit the rising popularity of crypto assets to lure retail investors into scams," U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler said.

"These investments continue to be replete with/ fraud, bogus coin offerings, Ponzi and pyramid schemes, and outright theft where a project promoter disappears with investors’ money.”

Justin Slaughter, director of policy at Paradigm and a member of the CFTC tech advisory group, calls the report "the first major report on DeFi by a government advisory committee". He believes it is "the most comprehensive review" of the system by the U.S. government so far. Although the committee's proposal lacks legal authority, he hailed the study as a "major step forward for lawmaking on DeFi."

However, Coinbase CEO Brian Armstrong is against the CFTC targeting DeFi platforms, arguing that specific DeFi platforms are not subject to the Commodity Exchange Act. Armstrong cautioned that heightened enforcement measures could prompt the DeFi industry to relocate its operations overseas.

CFTC recommendations

The report stresses the necessity for better monitoring, data collection, compliance assessment and identifying regulatory gaps in the global DeFi space. Collaboration among domestic and international regulatory bodies, standard-setters and DeFi developers is essential to achieve a cohesive approach to governing DeFi globally. The report also provides various recommendations to achieve these objectives.

The first recommendation is strengthening anti-money laundering (AML) and counter-terrorism financing (CFT) measures within DeFi. It emphasizes identifying high-risk projects and highlights the significance of digital identity, know-your-customer (KYC) procedures and refining privacy settings in DeFi.

This includes evaluating the collection of identity information in DeFi systems, identifying compliance deficiencies and needs, and considering methods to regulate and enforce discoverability and verification of identity information.

The report also recommends identifying and assessing various risks in DeFi, including risks posed by information imbalances, conflicts of interest, security weaknesses, liquidity issues, excessive borrowing and potential market manipulation.

The CFTC proposes various policy measures to minimize the risks. These measures could involve disclosure mandates, regulatory reporting, third-party audits, entry limitations, oversight, governance rules, product guidelines, balance sheet controls, activity constraints, structural rules and contingency planning.