CFTC Issues DeFi Report | Practical Law

CFTC Issues DeFi Report | Practical Law

The CFTC issued a report on decentralized finance (DeFi), outlining a conceptual framework for taking steps to address the opportunities and risks associated with DeFi.

CFTC Issues DeFi Report

Practical Law Legal Update w-041-9805 (Approx. 6 pages)

CFTC Issues DeFi Report

by Practical Law Finance
Published on 16 Jan 2024USA (National/Federal)
The CFTC issued a report on decentralized finance (DeFi), outlining a conceptual framework for taking steps to address the opportunities and risks associated with DeFi.
On January 8, 2024, the CFTC's Digital Assets and Blockchain Technological Subcommittee of Technology Advisory Committee's (TAC) issued a report on decentralized finance (DeFi), outlining a conceptual framework for taking steps to address the opportunities and risks associated with DeFi. According to the report, since the launch of bitcoin, applications leveraging blockchain and other distributed ledger technologies (DLT) have grown exponentially, and while these technologies hold promise for greater transparency and efficiency, expanded access to basic financial products and services, and a more resilient financial system, they also comes with very significant risks.
According to the report, in the absence of effective regulation, enforcement, and compliance, many DeFi projects, enterprises, and ecosystems have been vulnerable to fraud, mismanagement, and serious regulatory violations, compounded by periods of extremely high market volatility, exposing investors, customers, and other stakeholders to significant losses.
According to the report, a central concern relating to DeFi systems is the lack of clear lines of responsibility and accountability, which may be intentionally designed. The central message of the report is that both government and industry should take timely action to work together, across regulatory and other strategic initiatives, to better understand DeFi and advance its responsible and compliant development.
The report provides the following key findings:
  • The defining feature of DeFi enterprises, projects, and ecosystems is that they are characterized by highly automated financial networks that have no single point of failure, do not rely on a single source of information, and are not governed by a central authority that is capable of altering or censoring this information in order to perform tasks central to delivery of one or more financial services.
  • Understanding DeFi systems is extremely complex, requiring an examination of features of decentralization in enterprises, projects, and ecosystems across several dimensions:
    • access;
    • development;
    • governance;
    • finances; and
    • operations.
  • Most DeFi systems are not completely decentralized or centralized, but instead fit on a multi-level spectrum of (de)centralization, varying along each of the above functional and technical dimensions.
  • The architecture of DeFi involves key components across mutually supporting layers of technology and functionality critical to the delivery of financial products and services, specifically the physical/hardware protocol, network, data, application, user, asset and market, and governance layers, all working to support operations and communications across networks with varying degrees of core characteristics of programmability and composability, automation, transparency, openness, and immutability and censorship resistance.
  • Policymakers should align regulatory strategies in pursuit of a balance across what the report deems to be core regulatory objectives or outcomes in DeFi innovation, including:
    • customer and investor protection;
    • promoting market integrity;
    • ensuring microprudential safety and soundness;
    • financial stability and mitigating systemic risk;
    • combating illicit finance and protecting national security;
    • reinforcing and securing US competitiveness and leadership; and
    • expanding access to safe and affordable financial services.
  • Decentralized networks and technologies operating largely on public, un-obfuscated ledgers present opportunities to leverage efficiency improvements in payments and financial markets, more transparent and auditable financial services, enhanced financial sector resilience, dismantled barriers to access to financial services, promotion of innovation and competition, and reinforced US leadership in technology and finance.
  • Policymakers should understand the type, nature, sources, probability, and potential impact of identified risks presented by DeFi, including seeking to identify the persons and entities behind DeFi projects, enterprises, and ecosystems.
  • Industry players also hold distinct responsibility and capability to shape responsible development in DeFi, especially through integration of compliance and security measures that will likely enhance the sector's success with wider adoption and trust across enterprises and consumers.
The report notes the following key recommendations for policymakers:
  • Resource assessment, data gathering, and mapping.
  • Survey the existing regulatory perimeter.
  • Risk identification, assessment, and prioritization.
  • Identifying and evaluating the range of potential policy responses.
  • Fostering greater engagement and collaboration with domestic and international standard setters, regulatory efforts, and DeFi builders.
  • Apply recommended framework to drive near-term, prioritized progress on digital identity, know-your-customer and anti-money laundering regimes, and calibration on privacy in DeFi.
The report highlights current and potential future use cases of DeFi, including:
  • Digital wallets.
  • Decentralized exchanges.
  • Consumer lending and credit platforms.
  • Cross-border payments and remittance networks.
  • "RegTech," which the report defines as software designed to enable DeFi projects, enterprises, and ecosystems to comply with their ongoing regulatory compliance obligations while simultaneously protecting the privacy and in some cases anonymity of their users to the fullest extent permitted by applicable law.
  • Life, property, health, and other types of insurance.