Regulating DeFi
Released earlier this month by the US Treasury, the FDIC and the Comptroller of the Currency, the Stablecoin Report begins to establish an approach to regulating crypto assets. I have written already about some of the specific actions the report calls for—stablecoins should become banks, wallet providers should be regulated, and banks should think about a permissioned blockchain. The report also discusses, without making recommendations, issues raised by so-called decentralized finance (DeFi) arrangements.
The report's perspective is that DeFi projects' claims of decentralization are frequently misleading. It rightly observes that DeFi is frequently a misnomer: in some cases DeFi arrangements are in fact highly concentrated. The recent debacle at Poly Networks, in which a hacker found a bug in the project's code and used it to redirect $600 million worth of tokens to their own accounts, shows that there is if anything quite a lot of centralization, with attendant risks.
But it is not that there is nothing new in DeFi. In fact these projects have made significant steps in bringing ideas from the world of computer science to the world of finance. The Stablecoin Report, in my reading, recognizes this fact but takes only some initial steps toward responding to it.
Aave: automated lending
To fix ideas, it may be helpful to focus on the complexities raised by one specific DeFi project, the unattended lending platform Aave. Aave offers automated deposit and lending services on the Ethereum blockchain. Anyone who holds assets on Ethereum can deposit them into the Aave pool, entitling them to receive interest payments. Deposits can also serve as collateral for loans of tokens, taken out at interest from the pool.
The following T accounts illustrate, using the example of a deposit of ETH tokens, which are then borrowed, with the stablecoin USDC as collateral. The holder of ETH tokens deposits them into the pool in return for aTokens, which represent the deposit and which entitle the depositor to receive interest payments. The prospective borrower first deposits their USDC collateral, which is just another deposit; then they can borrow the ETH deposited by other users.
Done by a brick-and-mortar financial business, this would be quite typical financial activity. But Aave is not a brick-and-mortar financial business, it is an open-source computer program stored on the Ethereum blockchain. Interest rates for depositors and borrowers are determined by algorithms that seek to match supply and demand; haircuts (levels of overcollateralization) are likewise determined by the program; transfers are carried out automatically on request; collateral can be liquidated automatically in the event of default.
Uniswap: automated market-making
Another example is provided by Uniswap, which provides automated market-making for crypto tokens. Operating on the Ethereum blockchain, Uniswap pools accept deposits of asset pairs into liquidity pools. Funded in this way, the pools allow other users to exchange between the two assets. Transaction fees are paid to the depositors.
The T accounts below illustrate. A liquidity provider deposits ETH and USDT tokens into the Uniswap unattended pool, receiving liquidity provider (LP) tokens in return. Other users can then transact with the pool, for example exchanging ETH for USDT as shown. The depositor can later redeem their LP tokens. They receive ETH and USDT in return, though the proportions will have changed since the deposit was made.
As with Aave, the Uniswap pool operates without manual intervention. Taking deposits, setting relative prices, compensating liquidity providers, and managing redemptions are all managed by an open-source computer program that exists on the Ethereum blockchain.
Regulating automated finance
Aave and Uniswap each represent a class of DeFi arrangements—similar projects with different nuances. Programmable contracts, not decentralization, are their key innovation. This aspect of DeFi has already piqued the interest of the incumbent financial sector, and so the Stablecoin Report can be understood as preparing for a future in which DeFi is mostly taking place within formal financial institutions.
DeFi may not always be decentralized but, the report argues, it is most definitely finance: DeFi arrangements often offer familiar financial products or services, and so raise the same concerns—security of deposits, transparency of investments, etc. The regulators, in other words, are asserting their jurisdiction over DeFi. Whatever structure the projects have, they are facilitating borrowing, lending, market-making and so on, activities which fall under the purview of existing regulators.
But who is it exactly that should be regulated? Assets that are deposited in automated pools, as with Aave or Uniswap above, are in a murky legal state. The report notes "risks resulting from unique aspects of distributed ledger-based arrangements," and from "novel custody and settlement processes." In regulators' conceptual framework, assets cannot be unowned. Elsewhere in the document, the regulators point to the idea of a permissioned ledger, one which controls access and which presumably clarifies such legal issues.
The Stablecoin Report is only a beginning, and we shall have to wait to see what comes next. DeFi has avoided regulation for now, but perhaps not for too much longer.