Regulating DeFi Platforms

Traditional financial systems rely on a dense network of intermediaries—banks, brokers, exchanges, and clearinghouses—that not only facilitate transactions but also serve as compliance gatekeepers. These intermediaries protect the financial markets by implementing capital adequacy rules; disclosure requirements; and anti-money laundering and know-your-customer protocols. In doing so, these intermediaries constrain opportunism by actors within the financial markets, enable protocols that ensure reliable recordkeeping, and facilitate the information sources regulators need to monitor systemic risk. Decentralized finance (DeFi) disrupts this model by replacing traditional intermediaries with smart contracts: self-executing digital agreements that automatically perform transactions on blockchain or other encrypted computer code. While proponents tout DeFi as a more efficient and “purer” form of finance, its disintermediation eliminates the purposeful chokepoints that historically enabled the oversight necessary to ensure the legitimacy of financial transactions, as well as to protect consumers from potential harms. This disintermediation creates opportunities for  DeFi to magnify classic types of market and financial risks; risks that are quite similar to those that fueled the Great Depression and the 2008 Global Financial Crisis. DeFi is novel in that it layers upon those traditional risks a range of new vulnerabilities tied to new uses of computer code and cross-border anonymity.

This Article argues that DeFi platforms’ disaggregation of traditional intermediary functions requires the adoption of regulatory requirements that focus on (1) embedding compliance safeguards directly into platform design and (2) holding accountable the actors who build, operate, and maintain those platforms. Policymakers should prioritize the development of regulations that require DeFi platforms to incorporate technological and governance tools that replicate the critical compliance and risk-management functions historically supplied by intermediaries. The development of more robust safeguards are essential to preserve market integrity, mitigate systemic risk, and protect investors. Constructing such a regulatory regime will require substantial multijurisdictional coordination, both in harmonizing regulatory expectations and in building cross-border enforcement capacity. Fortunately, a range of existing international coordination mechanisms can be leveraged to facilitate this effort. DeFi—like many types of financial innovation—has both benefits and costs; it is time for governmental actors to constrain those costs through formal interventions.