Mapping out policy challenges and opportunities for Maker

@jacek This sounds like a fairly plausible idea, which does open up a road for integrations focusing on the “permissioned” aspect of the Maker product. In a way this is not entirely different from entire portions of existing banking software e.g. used for InfoSec. The underlying protocol (e.g. UDP, RSA, Linux kernel…) is opensource and maintained by open communities. But it’s used within the systems of a “permissioned” entity, behind firewalls etc. The entity may either utilise the opensource software directly and maintain integral its libraries/bin/versions/dependencies or contract a 3rd party intermediary that does that maintenance on its behalf (e.g. many companies like IBM etc do this).

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Hey El Pro – you have a link to the observation? The thing I find interesting is how the community may be expected to govern these pools but will the Aave token (or COMP with Compound’s “Treasury Pool”) accrue fees and value as a result?

Another issue that I’m sure Aave has discussed, but I’m curious if their community was involved in bringing about the “permissioned pools”. If not, and Aave holders are relying on the efforts of Aave Labs’ small team to build out this new functionality…and if Aave governance is simply decentralized theatre…wonder when they will launch the Howey pools.

Hey Tosh–it was a Crypto Briefing Article based on an email from a recent webinar for the AAVE Pro + Fireblocks (KYC/AML provider) partnership: Aave to Launch Institutional Lending Markets This Month | Crypto Briefing

Here’s the webinar:

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IMO, the positive here is that there is ample opportunity for “permissioned” vaults, institutional involvement (with KYC) and Dai that trades freely in the markets (i.e., non-permissioned Dai). It strikes me that an ambitious core unit or units could establish entities properly registered as money service businesses or VASPs in the countries where they offer services. These entities would be the go-between for institutional users who want access to the Maker suite of smart contracts. For their efforts and the onerous burden of running a VASP along with the concomitant costs, expenses and risk exposure, the Maker MSB/VASPs could take a small percentage of the stability fees. Presumably, having these “closed gardens” would generate so much volume that the arrangement would make economic sense for the DAO, the Maker MSB/VASPs and the institutional users.

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I like that the key observation of your fever dream is that DAI is our product. Leveraged vaults, PSM, RWA, etc are all just ways to mint and expand DAI.

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Like what linux distros are to kernel or what databricks is to spark or cloudera to hadoop etc… By having this, these VASPs have an interest in that the underlying code is well maintained too. Their businesses depend on it.

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Yes, ser. Exactly right.

Modest fever dreams, I suppose. But that’s the central crux and always had been in humble opinion, Dai fungible and everywhere.

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Take a look at what we are doing here.

First, we have recognized the AML/KYC risks for the Maker Protocol:

Second, we want to look for solutions which would not negate the core value propositions of the open and permissionless Maker Protocol. There seems to be rough consensus that while “vault intermediaries” which plug into the Protocol on pre-negotiated terms may act as regulated gateways with KYC measures (a.k.a. walled gardens), Dai should remain permissionless and fungible:

In order to make sure that this is a viable strategy, we need a bit of the third ingredient here:

Of course, this specific discussion is primarily driven by the fact that we see some segments of the market demanding some features (in this case KYC), and Growth et al. have already looked into it. One thing to underline is that in the future we may see cases in which commercially viable projects will bear some regulatory risks, which just have to be taken into account and overall assessment.

Let me provide two examples of regulatory challenges which are more sophisticated (less obvious) than the permissioned vaults / permissionless Dai discussion:

  • We can see a regulatory trend that the mere fact that a given stablecoin refers to a fiat currency (even if via a soft peg like Dai) is a reason for a much more strict regulatory framework. While a soft peg to USD is a good idea for market adoption purposes, over time it may accrue a hidden regulatory cost when even soft-pegged stablecoins are subject to more rigid regulation (not to mention that “hardening” the peg e.g. via introducing direct redeemability of Dai as proposed on forums some time ago would make things even more complicated).

  • Another trend that can be identified is the approach among some of the policymakers who even understand Bitcoin, decentralization, etc., but are having hard time understanding why the mere fact that there are multiple and anonymous governors of a system like Maker (as opposed to e.g. having just 1 MKR holder—an interesting thought experiment) would be enough for not applying the entire regulatory framework. They understand the transparency, non-custodial nature, etc. and even have no problem with no-governance or almost-no-governance systems, but they are wondering why a system which is actively governed by a somehow decentralized crowd would be treated differently than the same system with just a single operator.

Just to make clear: in my view the above challenges, and many other ones, are solvable, and I am simply advocating for (1) discussions on these and similar topics, (2) making sure that MakerDAO can act in all three policy and regulatory streams: Monitoring, Advocacy, Product Strategy, in an efficient manner.

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As I was saying…I would love to see us get ahead of this, and perhaps respond to it using the new Marketing team that’s up for a vote.

Marketing or perhaps a Maker lobbying CU would be appropriate (and no, I do not think something like the Uniswap puppet DeFi Education Fund adequately represents our interests).

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Building relations with the policymakers and regulators is something the Strategic Marcomms has experience of. Jacek had already highlighted the approach and some key points that I believe we need to tackle and won’t repeat here.

Suppose the Strategic Marcomms CU has the opportunity to serve the MakerDAO community. In that case, we will approach it by becoming more involved in participating in organizations such as BGIN that some regulators support. Such activity tends to bring speaking opportunities, further strengthening our reputation and building trust.

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The work conducted by the FSB, BIS, FATF, IOSCO and other international standard setters clearly show that they have been monitoring the space closely and are well aware of the latest developments.

Looking at the latest report from the FATF, it becomes clear that the standard setters want to apply the same set of rules that currently apply to traditional finance. These legacy rules still require a legal entity or some person that can be held accountable. In DeFi, this person does not necessarily exist. The MakerDAO is one of the best examples.

That being said, I am not convinced that DeFi should play according to the playbook of global standard setters. Instead, the industry should take a more proactive approach and develop new solutions that are acceptable to the international standard setters. The MakerDAO advocacy efforts and the WEF DeFi Policy-Making Toolkit you mentioned in your post are a very good starting point.

Based on some ideas from the DeFi Policy-Making Toolkit, I am currently working on a new regulatory approach, and I would be more than happy to share some thoughts with you. I am not sure whether this is the right place to discuss it as it does not specifically deal with Maker.

For DeFi, the way to mass adoption is not compliance with legacy rules but with a new set of rules that cater to the specifics of the DeFi space.

Complying with legacy rules inevitably means more centralization.

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Yessss, please share your work (it’s all relevant) – this current forum thread works, or please start a new Forum Post. Either way, thank you for joining the Maker community! Looking forward to hearing/reading your thoughts.

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Thanks, @YouguS and we’d be very interested in learning about your new regulatory approach, even if the suggestion is not Maker-specific. I’m sure if you’re focused on DeFi, there will be some positive overlap.

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I have been doing legal research in the crypto space for more than four years now and got increasingly unhappy with the overall direction. I don’t think that regulation is necessarily bad. In fact, it is good if applied properly.

At the same time, I don’t think it is necessary to regulate everything as this inevitably stifles innovation and results in suboptimal outcomes.

What I suggest is an opt-in approach – not only for the DeFi space but for crypto overall. To ensure that investors and consumers are sufficiently protected, this scheme would be combined with a certification scheme that allows investors and consumers to identify the regulated projects easily.

I have written the following summary over the last few weeks and would appreciate your input.

Please note that the summary only deals with the opt-in approach. It does not mention any details on the regulation of DeFi and should therefore only be considered a starting point for further discussions.

I chose Japan as an example because Japan, as one of the first countries, introduced crypto regulations in 2017. I am also based in Japan and work for a Japanese law firm specializing in crypto. The following summary is my personal opinion and is not necessarily in line with my firm’s opinion.

I’m looking forward to hearing your input and hope that together we can expand our research and efforts on it.


A New Regulatory Approach for the Crypto Industry

The crypto industry has come under increasing regulatory pressure. Whether it is the mining ban in China, the new crypto regulations in the EU, or the updated FATF guidance on virtual assets and virtual asset service providers, the direction is clear – more rather than less regulation.

Regulation is not necessarily bad as it allows institutional players to enter the space more easily. Yet, it inevitably increases compliance costs for projects in the crypto space and, in some cases, prevents companies from entering the space altogether.

What is needed is a more balanced approach. An approach that sufficiently considers the benefits but also the costs of regulation – in other words, a new regulatory approach, an opt-in approach.

Before taking a closer look at the opt-in approach, it is worth looking at the objectives of capital and financial markets regulation, the current regulatory approach and its shortcomings.

1. Objectives of Capital and Financial Markets Regulation

Capital and financial markets regulations aim to protect the integrity and efficiency of capital and financial markets, consumers and investors, and financial stability.

A new regulatory approach that does not sufficiently consider these objectives is condemned to fail.

2. Current Regulatory Approach

At a very basic level, capital and financial markets regulation generally involves a three-step approach:

  1. Analysis of whether an activity is a regulated activity.

  2. Assessment of which person provides the regulated activity.

  3. License and registration requirements with ongoing compliance.

In the past, the second step has not played a crucial role in the analysis. This has changed, however, with the emergence of DeFi. Today, much of the analysis is concerned with the question of whether there is a person engaging in regulated activities or not.

3. Shortcomings of the Current Regulatory Approach

The current regulatory approach has various shortcomings, both in design and execution. These shortcomings do not only negatively affect projects in the crypto space but also national regulators, investors and consumers, as well as the overall market.

3.1 Regulator

From a design perspective, the current approach provides a one size fits all solution. As a result, entities engaging in regulated activities must comply with the same regulations irrespective of their size. This is meant to level the playing field and to ensure that only entities with sufficient resources provide regulated services.

As regulators do not only deal with registered or licensed entities but also with entities providing regulated services without being authorized to do so, the current approach means that they must deal with a rapidly increasing number of new market participants. While FinTech has already posed a challenge to regulators, it is fully integrated into the existing infrastructure and run by profit-seeking companies. Crypto, on the other hand, does not necessarily have these ties with traditional finance and is typically run by open-source software on the blockchain. As anyone can fork the code and integrate it into their own projects, the number of regulated services provided via smart contracts is likely to grow exponentially. At the same time, the resources of financial regulators are only expected to grow modestly – if at all. Similar findings were made by the Blockchain Governance Initiative Network (BGIN) and presented to the Financial Action Task Force (FATF) in 2021.
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According to data from Dune Analytics, the number of newly deployed smart contracts on Ethereum reached 2,702,142 in June 2021 alone. Assuming that most of these contracts can be used to provide regulated services, the supervision of the crypto space would bind a tremendous amount of resources. These resources would then be missing elsewhere, for example, the supervision of regulated entities. If this happens, regulators can no longer fulfill their mission to protect the integrity and efficiency of markets, consumers and investors, and financial stability, and the system becomes dysfunctional.

The increasing scope and increasing decentralization add further complexity to the one size fit all approach. As can be seen from the communication of various regulators, already today, they act increasingly helpless. Without being able to enforce regulations outside their jurisdiction, they follow a name and shame policy and issue warnings. Even in the US, DeFi projects have not been the target of a probe by the Securities and Exchange Commission (SEC) so far.

The regulators’ problems at a glance:

  • exponential growth of crypto space
  • international scope
  • increasing decentralization

3.2 Projects and Companies

Despite the problems outlined in the previous section, teams without sufficient resources may still decide not to proceed with their project because they do not have sufficient resources to comply with the regulations.

Compared with international projects targeting their home market, they are at a disadvantage as enforcement against them is easily possible.

3.3 Investors and Consumers

Investors and consumers are not necessarily the winners of regulation. While they are protected against certain failures, they are also likely to get access to less products and services.

A good example is the Japanese market. As one of the first countries, Japan introduced crypto regulations in 2017. The regulations were updated in 2020 and provide market participants a clear picture of what activities are regulated. Because of the strict regulations and a lack of resources on the regulator’s side, the Japanese market has not seen any innovation over the last few years. Only 24 tokens are currently listed on the 31 registered exchanges. None of them is a DeFi token. Staking services do not exist except for very few projects. Other forms of passive income are not available.

Investors seeking yield or access to certain products and services are therefore forced to go offshore. The strict regulatory environment therefore achieves exactly the opposite of what it aimed to achieve – less protection for Japanese investors.

3.4 Market

At the moment, regulations benefit those who can afford to comply with them. These are not necessarily the best, but the best-funded projects. Innovation, however, in particular in the crypto space, does not necessarily happen within these projects. More happens outside.

If the primary concern of all projects in the space would have been regulation, the crypto industry would not be where it is today. This applies even more if one considers that the regulations in all 195 countries vary to a certain degree.

4. New Regulatory Approach

Because of the shortcomings outlined in the previous section, a new regulatory approach is urgently needed. Ideally, the approach should not only overcome the outlined shortcomings but also promote innovation and the free flow of capital.

Stated differently, what we need is a fundamentally new regulatory approach – an opt-in approach.

Under the opt-in approach, crypto projects would not be regulated unless they explicitly opt in. A certification scheme would ensure that consumers and investors can easily identify regulated projects and are sufficiently protected.

While the approach sounds rather disruptive, it is not as radical as one might first think. In fact, the situation is similar to today, where consumers and investors can opt out from the protection granted under their national laws. If a consumer, for example, wants to use an offshore exchange, he might simply open an account with the exchange, well-knowing that he is not protected under the laws of his home country. The opt-in approach on the other side, would require a user actively look for certified projects.

5. Benefits of the New Approach

The opt-in approach has benefits for regulators, consumers and investors, market participants, and the market overall.

5.1 Regulators

Currently, regulators do not have sufficient resources to police the crypto space properly. Overall, this makes approval procedures slow and enforcement actions random.

The opt-in approach would allow regulators to focus on the projects that have decided to opt in. The number of regulated entities would there-fore be much smaller than it is at the moment. Being able to allocate their resources more efficiently would also mean better services and stricter law enforcement, and as such, more products and a higher level of protection across regulated projects.

5.2 Projects and Companies

The opt-in approach would further allow projects to decide freely whether they want to be regulated or whether they want to innovate freely.

In many cases, projects might start in the unregulated space and migrate to the regulated space once they have sufficient traction and resources to comply with the regulations.

The opt-in might also be considered as a good way to signal quality to the market and attract investments from entities that cannot interact with unregulated projects.

5.3 Investors and Consumers

Having both regulated and unregulated products and services at the same time allows investors and consumers to choose freely from a large variety of products and services. For those who prefer to remain in the regulated space, it is possible to identify and verify regulated projects through the certification scheme easily. Investors who want to earn higher yields can easily access unregulated services without necessarily leaving their home jurisdiction. This is important, as it allows them to sue the teams behind those projects more easily. Just because a project is not regulated, this does not mean that investors and consumers are unprotected. In case of negligence or willful misconduct, the teams can still be held liable. Criminal sanctions in cases of fraud and other financial crimes also apply and offer a minimum level of protection. This disciplines the market and ensures a better quality of projects in the mid to long term. Despite being unregulated, the level of protection would, therefore, naturally increase.

To prevent consumers from being exposed to unregulated projects, it should be considered to restrict financial intermediaries from promoting unregulated products and services to consumers.

5.4 Market

The market would significantly benefit from the rapid innovation driven by unregulated projects. As indicated further above, much of the innovation would not have happened – or at least not at the same pace – if projects were primarily concerned about regulation from the very beginning.

What is built in the DeFi space today can be used in a different context tomorrow. The unregulated space should be considered an excellent opportunity and driver for further innovation in the financial markets and elsewhere. Central Bank Digital Currencies (CBDCs) or programmable money, as they are sometimes called, may be one of the biggest beneficiaries of free innovation.

6. Conclusion

Much of today’s research focuses on AML/CFT regulations only. Yet, a more holistic approach is needed to ensure that the funds can flow freely from the traditional regulated space into the crypto space. Proper risk weights, liquidity requirements and other measures must be implemented for financial institutions to ensure financial stability in stress scenarios. The requirements may be different for regulated and unregulated projects. More research is needed here. The same applies to market efficiency and integrity considerations.

The approach outlined here should also ensure that projects and funds can move freely between the regulated and unregulated space.

Finally, the opt-in approach should not be misunderstood as an approach where existing regulations are applied blindly to regulated projects. In fact, many of the regulations are still unclear and require further updates. Clarity by case law must be avoided at all costs.

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Wowzers that is quite the statistic. I have to believe that over 50% of those smart contract deployments were for either upgrades, and/or maintenance. Also, I personally don’t believe regulations should and can inspect every single contract that gets deployed, before, or after—nor should they be looking to place a barrier to the growth of innovative tech.

It’s extremely difficult for current government agencies to keep up—it’s hard enough for someone like me to keep up—but I do admire the effort of trying to provide guidance by Japanese regulators. That’s cool.

All in all nice write-up, very informative—and thank you for putting in the work. The DeFi community appreciates it :slight_smile:

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Thanks a lot for your feedback @ElProgreso.

I don’t expect government agencies to inspect every single smart contract. This would be unreasonable. The number shown here is for illustrative purposes only as each of these contracts might be deployed for the provision of financial services - globally. Even if the number is much smaller, dealing with all the projects that utilize these smart contracts would bind a lot of resources. Composability adds another layer of complexity.

It is indeed difficult to keep up with the developments in the space. From my experience I can tell, however, that the regulations are not necessarily benefiting retail investors and consumers, and as far as I can tell, institutional investment in Japan is lagging behind other markets as well. Tax laws are another reason.

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New legislation proposed this week in the US.

Big takeaways

  1. Proposed stablecoin regulation that illegalizes not only issuance, but also use of fiat pegged, or collateralized stables which are not registered and brought into compliance w a number of rules. Seems like the focus is primarily on centralized stables like usdt, although based on my read, dai could fall under proposed regulations.

  2. A possible classification system to determine if a digital asset is a security. The proposed system includes voting rights, claim to collateral, and access to equity or revenue some of the characteristics which would qualify a token as a security, but interestingly, there is an exception for voting rights related to updating and modifying protocols.

  3. Agencies and regulators would be mandated to come up with a report on possible new regulations specifically for Defi, as well as possible application of preexisting regulations and the aforementioned proposed regulations.

This is just my interpretation. Unsure what the broad sentiment among legislators is about this legislation