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IOSCO's DeFi Report
Securities regulators are getting precise with their language
Last week IOSCO, the International Organization of Securities Commissions, released an important report that adds to the mass of regulatory views on crypto. The DeFi Report deals not just with stablecoins, which were the subject of last year's Stablecoin Report from the US Treasury, but with all of decentralized finance (DeFi).
Coverage has focused on DeFi's hidden centralization, through token issuance, venture funding, and exchanges, all of which can mask conflicts of interest. A deeper reading, which I develop in this post, is also possible: one of the DeFi Report's main moves is to enclose key crypto concepts within established regulatory language.
Regulatory attention: an ambiguous milestone
Crypto has grown to the point where world's securities regulators feel obliged to respond systematically. Surely this is a milestone in the financial technology's development, though one might debate whether that means it has reached adolescence or simply started to crawl. Crypto passed its first decade, in the wake of the 2008 crisis, largely without attracting regulatory attention. During the pandemic, it has grown more explosively. A key indicator has been the rise of stablecoin issuance, especially since early 2021:
This moment of growth has brought crypto projects closer to the core financial activities of capitalism: money issuance, par exchange, market-making. Stablecoins, for example, are a crypto asset built around the guarantee of a stable price. DeFi, more generally, proposes to use distributed databases and distributed computing—that is, ledgers and programmable contracts—to automate lending and exchange.
A phrasebook for visitors to DeFi-land
Until fairly recently, crypto's growth was driven by programmers dabbling in finance, and remained a fringe phenomenon. But DeFi projects' offering bank-like functions caught regulators' attention, while simultaneously opening a legal and political channel allowing their intervention. The DeFi Report should be understood in this light, and deserves particular attention: IOSCO is an influential international body of regulators, and is in a position to guide coordinated agendas in its member institutions, as well as at central banks and other international forums.
What does the report say? In addition to pointing out some of crypto's ironies, an activity in which Soon Parted also delights, the securities regulators are trying to change the language in which crypto is discussed. DeFi was built by programmers, and so the conversation about it has up to now mostly been conducted in a tech vernacular. After the DeFi Report, it is easier to talk about DeFi using a financial vernacular.
For example, a key discussion in the Report describes DeFi as a so-called technology stack. To someone who comes to DeFi from the tech side, this statement and the analysis that follows might seem obvious to the point of being meaningless. How could DeFi be anything other than a technology stack? But a person with such a background might be tempted to skim over the fact that IOSCO's language carefully maps each feature of the software stack into a functional category within the language of finance: blockchain and Layer 2 become settlement; tokens become assets.
Similarly, the DeFi Report has a discussion on the role of bots. To those who think in terms of code, the word immediately evokes spambots (bad) or social network bots (neutral). But the same passage can be read as a discussion of algorithmic trading, quite legible from a TradFi point of view. One bot strategy, for example, exploits token miners' ability to influence the sequencing of transactions. This could be thought of either in terms of miner extractable value and the mempool, or in terms of front-running. IOSCO rather deftly maps the two languages.
Such translations improve the DeFi conversation, along lines that Soon Parted has also sometimes pursued. There are some new ideas in DeFi, to be sure (programmable contracts, for example). But there are also a lot of ancient ideas, and for those it would probably be better to use the names we already have.
“Applicable regulatory frameworks still apply”
But there is more, I think: IOSCO is not a neutral translator, symmetrically explaining each side to the other. Instead, each entry in the glossary brings a DeFi idea into some regulator's purview: a blockchain is just a distributed database, but settlement is a regulated infrastructural financial service. Miner extractable value is an oddity of blockchain algorithms, but front-running is a form of insider trading that comes with stiff penalties. Tokens are a kind of unique identifier, while assets invite the attention of securities regulators.
In other words, the DeFi Report starts from the assumption that financial activities are subject to existing financial regulations, and lays out which regulatory fences go where. Although DeFi has upset some existing categories, it has not made something so completely novel as to defy all financial regulation. As this gets sorted out, we can likely expect regulators to bend a little, and crypto to bend a lot. My baseline view remains that innovations arising from crypto will find permanent homes inside the regulatory perimeter, likely on permissioned blockchains and with a less ostentatious ecosystem.