Author: Gabriel Shapiro
Source: Lex_Node's Official CryptoLaw Newsletter
foreword
The purpose of this framework is to provide a short functional overview of the DeFi ecosystem functions performed by different people, how they differ, and how they might be regulated. Clarifying all the different “DeFi functions” is crucial, and this is the starting point for a constructive discussion of potential “DeFi regulation”. Personally, I am against all DeFi regulation except notification and disclosure regimes for major players. However, when discussing potential DeFi regulation, we need to agree on some concepts and definitions.
functionalist framework
DeFi users
"DeFi users" are easy to understand - they are the end users of the DeFi smart contract system. They could be traders, liquidity providers, borrowers, lenders, or users of DeFi-enabled consumer apps (e.g., players of the GameFi gaming app).
Certain regulations may apply to DeFi users—for example, a liquidity provider may be considered a security if its liquidity provision forms part of its regular business and the tokens it provides liquidity to are considered part of a security or securities trading scheme. For a securities broker/dealer.
DeFi developers
DeFi smart contract developers (“DeFi developers”) are software engineers who design and write “smart contracts”. They design software code that is stored on a blockchain and executed by miners/validators in the computing environment of that blockchain's peer-to-peer network. Developers can also design auxiliary software, such as DeFi liquidation robots. DeFi developers can be organized into commercial entities or freely associate. The software code written by DeFi developers is usually free and open source, or at least provides usable source code, and lacks traditional proprietary software profit models (eg, selling licenses).
There are two main potential factors for the regulation of DeFi developers:
DeFi developers may be required to comply with specific regulations for smart contract design and creation, for example: laws that impose specific auditing, testing or design requirements for DeFi-related smart contracts. However, no such law currently exists and, if established, would likely face serious First Amendment challenges.
The intellectual property rights of DeFi developers related to smart contracts can be regulated in some way - for example, through laws that impose restrictions on how smart contract code can be licensed. Indeed, smart contract licenses could be treated under their own special product liability/product security regime, or, like cryptography in the 1990s, be subject to special "export" controls or other sanctions.
DeFi deployer
DeFi Smart Contract Deployers (“DeFi Deployers”) leverage their rights as licensees or copyright holders of the smart contract code to “deploy” smart contracts into the blockchain, that is, they broadcast them to the network A transaction and a transaction fee is paid to blockchain miners/validators who create a block storing a copy of that smart contract on the blockchain. Thanks to this deployment, smart contracts can be run as a service by miners/validators and the results of their operations recorded to the blockchain by miners/validators.
There are two main potential factors for regulation of DeFi deployers:
DeFi deployers could be subject to tort liability for the dangerous smart contracts they deploy (this could be similar to the tort liability individuals already face for creating “tempting nuisances” or other dangerous conditions). This would be an ex post system of assigning responsibility rather than a proper system of "regulation", but like regulation would affect ex ante incentives.
DeFi deployers may be subject to specific regulations that clearly define the deployment of smart contracts to blockchain activities, for example, the deployment of smart contracts is used to evade sanctions controls or may be used to trade regulated assets outside of regulated trading venues is a crime. However, it's important to realize that such laws would be fairly novel - they would essentially seek to regulate a specific type of broadcasting, that is, the broadcasting of smart contracts to miners/validators on a blockchain network deployment request. Such regulation could be challenged by free speech if the deployment of smart contracts also constitutes speech. Furthermore, as a broadcast-related regulation, these laws would naturally fall under the authority of the Federal Communications Commission (FCC), rather than traditional financial regulators such as the SEC or CFTC.
DeFi miners
Miners/validators individually or collectively (depending on the consensus design) perform the following activities. Given that the aforementioned activities performed by a given miner/validator are DeFi-related, we can refer to such a miner/validator as a "DeFi miner".
Receive block rewards from the protocol and/or transaction fees from the requester for their proposed block successfully added to the blockchain.
'Enforce the protocol' when performing the above operations (i.e. enforce them according to the protocol rules)
Executing smart contract code (for example, calling certain parameters of certain functions of the smart contract) in order to be able to include the results of their proposed block calculations;
choose which of the transaction requests they receive to include in their proposed block (and sometimes the order in which those requests will be processed in the block);
receive and store broadcast and/or private requests, including certain data or state changes of the blockchain;
Accept or endorse proposed blocks that are added to the blockchain;
Propose blocks to be added to the blockchain;
Miners are not traditional intermediaries or trustees, but are the closest intermediaries or trustees in the DeFi world. Simply put, like brokers or money services businesses, DeFi miners act as for-profit businesses “transacting on behalf of others.” DeFi miners also use smart contract calculations as part of their services, so in a sense they are the real operating "licensees" (users) of most smart contracts. Individually, DeFi miners have significant power to perform arbitrary transaction reordering, and to engage in or facilitate front-running or other manipulation (see MEV literature). Collectively (e.g., having a sufficient majority of block production capacity), DeFi miners have the power to censor specific transactions or users, or halt, rewrite, or otherwise damage the blockchain or its execution environment.
As the most powerful and important DeFi ecosystem participants, DeFi miners are "lowest cost avoiders" because they bear the burden of "DeFi regulation". These potential regulations could extend, or have many similarities to, the TradFi regulations pertaining to broker-dealers, money services businesses, securities/futures exchanges, and similar intermediaries. Such regulation is unlikely to be constrained by First Amendment principles, as most DeFi miners run for-profit businesses rather than engage in their own free speech.
On the other hand, the design of the blockchain has anticipated and tried to limit the possibility of bad actors or government authorities of any given nation-state seizing mining operations. Blockchain design achieves this by making the block production process expensive, decentralizing incentives, and allowing anonymity. This could mean that DeFi miners will adapt to regulation, move their operations to mining-friendly jurisdictions, and possibly limit their “counterparties” on p2p blockchain networks to those known to be in friendly jurisdictions people. For example, DeFi miners may refuse to accept transaction requests from DeFi relayers in the United States.
DeFi Repeater
"DeFi relayers" send DeFi-related transaction requests to DeFi miners on behalf of others. This includes any nodes in the blockchain network that typically propagate transaction requests in order to enter the "mempool", whether or not they are also mining nodes. DeFi relayers are usually commercial "nodes as a service" that receive and transmit DeFi-related requests from encrypted wallets to DeFi miners. For example, Infura is a major DeFi relayer on Ethereum. Some DeFi relayers are in the relaying business (such as Infura), while others may perform relaying assistance for other businesses (for example, a CEX may run a relayer to facilitate withdrawals). Some DeFi relayers are run by amateurs. Relays may include narrowcast, broadcast, or both.
DeFi relayers, when performing relaying on behalf of clients as part of their business, are essentially business service providers. Such business services can be regulated in various ways - for example, a DeFi relayer could be considered similar to a broker/dealer or money services business and thus require its users to register with government agencies, KYC, and monitor, block and report suspicious transactions. Because DeFi relayers transmit information on behalf of other people rather than themselves, freedom of speech protections are not too implicated in relayers, and users can always choose to run their own nodes instead of using DeFi relayers. So even if DeFi relayers are regulated, their freedom of speech rights will be preserved. On the other hand, DeFi relayers that are not transmitting as part of a business (perhaps amateur nodes or nodes primarily used to connect with a different business) may again use First Amendment defenses and otherwise logically cannot be targeted by regulation .
DeFi Function Packager
"DeFi Function Pack" is an application designed to help users generate broadcastable DeFi-related transaction request messages from a set of inputs describing DeFi transactions that users may wish to perform. Users can then broadcast transaction messages to DeFi relayers or DeFi miners through DeFi wallets.
Most “DeFi websites” or “DeFi frontends” are packages of DeFi functionality. They provide the state information of the blockchain related to a specific set of DeFi smart contracts and the functions of these smart contracts, and provide users with an intuitive GUI to indicate which operations they want to perform through smart contracts. DeFi function packs take this high-level GUI input and translate it into lower-level function calls. This "function package" is bundled into a data object, which can be input into a separate DeFi wallet application, and if the user wishes, can also be transmitted by the DeFi wallet to the DeFi miner for execution through the DeFi repeater. Importantly, DeFi function packs do not perform relay or mining functions per se, but simply translate user intent into hypothetical function calls in hypothetical mining requests.
Apps that we think of as “dev tools” (like Brownie, Truffle, and Hardhat), “block explorers” (like Etherscan), and “wallets” (like Metamask) may also have DeFi feature packs.
DeFi feature packs are similar to many other types of software tools in that they abstract away some of the details to make the software easier to interact with. In theory, they could be subject to specific product liability or product stewardship regimes, but there is no equivalent within TradeFi, which would set a new precedent. To a certain extent, DeFi function packs may be seen as merely providing information on how to interact with software, but they may also attract the attention of the First Amendment.
DeFi browser
The "DeFi Browser" enables users to view DeFi-related blockchain data in a convenient format. Most "DeFi sites" combine a DeFi browser with a DeFi feature pack. Block explorers like Etherscan can also be considered more general blockchain explorers and therefore DeFi explorers. Some "wallet apps" also include DeFi browser functionality.
A DeFi browser is similar to any other type of web browser or web browser. In theory, they could be subject to a specific product liability regulatory regime, but this has no equivalent in TradeFi regulation today. Even "stock market browsers" like the Bloomberg Terminal are not subject to the specific financial regulatory regime of the TradFi world - they are tools, not intermediaries.
DeFi advisor
A "DeFi advisor" provides advice on how to use DeFi to achieve a given goal or execute a transaction. Advice can be tailored through a personal service, or rendered algorithmically through a “robo-suggestion” — either way, it’s still an advisory service. Examples of DeFi advisors include Metamask’s “swap” service (recommendation of the best DeFi protocol or combination of DeFi protocols for an ideal exchange) and Uniswap’s “routing” service (recommendation of Uniswap v2 or Uniswap v3 for an ideal exchange) .
Similar to traditional securities or other financial advisors, DeFi advisors can be regulated and properly tuned for DeFi.
DeFi Broker
A "DeFi broker" is a person who uses or manages digital assets within DeFi on behalf of or for the benefit of depositors, on a discretionary or semi-discretionary basis. Examples include Celsius, Voyager, as well as Coinbase, Kraken, and other CEXs (in terms of their staking services). Certain hedge funds are also DeFi brokers.
Brokers could be regulated in a similar way to traditional securities or commodities brokers, with appropriate adjustments for DeFi.
DeFi investor
A "DeFi investor" invests money, blood, or both to gain token ownership of all or part of the value of one or more DeFi systems. “Governance tokens” are currently the most popular investment vehicle for DeFi investors. In the category of DeFi investors, not only venture capitalists or open market token buyers, but also DeFi developers who build tokenization methods into smart contracts to capture value and allocate some of these tokens to themselves.
DeFi investors may participate in “investment contract schemes” and are subject to securities laws. In addition, DeFi investors may also manage smart contract systems in an open partnership that is not regulated by securities laws, and may be subject to regulations related to the liability of partners in such enterprises.
DeFi manager
"DeFi Governance" participates in the formal governance of the DeFi smart contract system or DeFi infrastructure. This is often done through governance tokens, so DeFi governance is often also a DeFi investor. Alternatively, DeFi governance can also be non-investors who receive voting rights from DeFi investors.
DeFi governors may have tort liability or other types of liability for the results of their governance decisions. The FATF suggests that DeFi regulators may be regulated as virtual asset service providers (VASPs)/money service businesses, depending on their level of power over the relevant DeFi system and the relevant attributes of the DeFi system.
DeFi Promoter
"DeFi Evangelists" publicly promote, promote and publicize the availability and usefulness of DeFi. They may be held liable under existing Consumer Advertising Code (FTC) or Consumer Financial Protection (CFPB). Regardless of the extent to which DeFi may involve regulated financial products, DeFi promoters may also be liable for their promotional activities under existing financial regulations (e.g., securities “tipping” rules). Alternatively, new laws could be passed to specifically regulate DeFi promoters. Due to free speech protections, any such DeFi marketing laws may only cover those DeFi promoters engaged in marketing as businesses, rather than those who merely express their opinions and enthusiasm for a particular DeFi system.
Portfolio roles and suggested regulatory priorities
Most DeFi players do not strictly limit themselves to a single "DeFi function", but take on multiple functions, some of which are synergistic. For example:
Many DeFi "teams" include DeFi developers, DeFi deployers, DeFi managers, and DeFi investors.
A centralized service might want to be both a DeFi broker and a DeFi advisor in order to serve multiple types of clients.
A DeFi "front end" is not really "user friendly" unless it combines a DeFi browser with a DeFi feature pack. Some DeFi "front ends" are also DeFi advisors (for example, because they provide routing recommendation engines).
For a typical "crypto wallet" app, the best monetization strategy might be an app that combines a DeFi browser, DeFi feature pack, and DeFi advisor all in one.
An open question is whether regulations that by themselves may not be appropriate or practicable for a particular function become appropriate or practicable when the combination of a particular function is performed by a single person or group. Certain combinations of functions — such as a single person or group running DeFi explorers, DeFi relayers, DeFi miners, and DeFi advisors as a whole — can raise significant conflicts of interest that require proactive regulation.
We recommend that initial regulatory discussions focus on centralized functions—such as DeFi brokers—and individuals or groups that vertically integrate many DeFi functions in ways that create systemic risks or conflicts of interest. A beneficial side effect of this focus could be to promote greater decentralization: If centralizing or vertically integrating different DeFi functions under one person or group creates a heavier regulatory burden, then there will be greater The incentive to remain decentralized.
in conclusion
Any discussion of "DeFi regulation" must begin with a solid understanding of the functions within the DeFi ecosystem, their unique risks, and their similarities to regulated Tradefi activities. I hope this will clear up many misconceptions and allow people to focus on discussing which regulation makes sense for which functions, being as specific and precise as possible.
Aaron
YouQuan
Alex
Hui Xin
Brian