The World Economic Forum, a bastion of the global establishment and ultra-exclusive club for heads of state, billionaires, and policymakers, is embracing DeFi. Well, sort of.
In another sign that decentralized finance has spurred serious study in influential think tanks, the Geneva-based WEF issued a “Policy-Maker Toolkit.” The 38-page white paper explores DeFi’s benefits and opportunities, as well as its risks. It also unpacks the potential policy and regulatory responses states might take as decentralized finance protocols are adopted. Given the WEF’s clout — the organization hosts the prestigious Davos confab every January — it’s bound to influence the thinking of lawmakers and regulators coming to grips with DeFi.
“Understanding DeFi’s business models and the full set of relationships underlying DeFi is crucial for an accurate risk assessment and nuanced policymaking,” the white paper’s authors write.
One of the report’s most important sections analyzes five categories of risk: financial, technical, operational, legal compliance and emergent risks. For instance, the authors highlight a Ciphertrace study which found that half of the digital asset hacks in 2020 targeted DeFi services; in 2019 the number was “negligible.”.
The report was well-versed in major hacks across the DeFi spectrum, including Compound’s November 2020 oracle exploit, the flash loan used to vote on a MakerDAO governance proposal, as well as contentious dynamics like miner extracted value.
The report even addressed “rug pulls,” DeFi shorthand for a preordained scam by developers, as potentially addressable issues of fraud and market manipulation.
“An effective regulatory response to DeFi is likely to involve a combination of existing regulation, retrofitted regulation and new, bespoke regulation,” the paper said.
In what might be a preview of future rulemaking, the report said “imposing regulatory obligations may be easier earlier in the life cycle, where there may be clearly identifiable access points and more room to influence the long-term trajectory.”
Translation: Regulators should work with DeFi entrepreneurs as they develop their platforms to ensure compliance with the law.
Indeed, the authors emphasized the wisdom of using “tools that incentivize rather than mandate action at early stages, including sandboxes, safe harbours, and no-action letters.” This is consistent with the approach authorities have taken with other fintech innovations, such as digital banks and payment apps. The U.K. Financial Conduct Authority, for instance, set up a sandbox in London to foster better communications between startups and regulators several years ago. That approach has become a template for other regulatory regimes, and it’s noteworthy that the WEF is highlighting its utility for DeFi.
With all the capital and entrepreneurial activity flowing into DeFi, it was only a matter of time before regulators and policymakers started seriously evaluating what action might be needed. The WEF’s white paper may spur fears in the DeFi community that this process will result in hardline rules that strangle open finance.
Yet the WEF sought to assuage such concerns. Contributors to the “toolkit” included representatives from major projects like Uniswap, Compound, and Aave. And the authors stressed that they get it — DeFi offers breakthroughs for a global system struggling to improve financial inclusion, transparency, and robustness.
“What is clear is that DeFi represents a distinct and potentially significant development, both within the landscape of blockchain and financial services more generally,” the white paper said.