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Ep 24: DeFi Innovation and Regulation
209 Plays9 months ago
Yesha Yadav (Vanderbilt Law School) delves into the complexities of decentralized finance (DeFi), exploring market structures, regulatory challenges, and the pivotal role of smart contracts in shaping the future of financial landscapes.
Find out more in our explainer:
What is DeFi?
Recommended
Transcript
Introduction and Series Overview
00:00:06
Speaker
Hello and welcome to this Owl Explains Hootenanny, our podcast series where you can wise up on blockchain and web3 as we talk to the people seeking to build a better internet. Owl Explains is powered by Avalabs, a blockchain software company and participant in the avalanche ecosystem. My name is Silvia Sanchez, project manager of Owl Explains and with that I'll hand it over to today's amazing speakers.
Meet the Guest: Professor Yesha Yadav
00:00:33
Speaker
Hi everybody and welcome to the Owl Explains Podcast. I am Silvia Sanchez and I am really excited to be joined today by Professor Yesha Yadav, Professor of Law and Associate Dean at Vanderbilt Law School. Her research focuses on market structure, exchange design, and digital asset regulation.
00:00:51
Speaker
Yesha, we're super glad to have you today. Welcome. Thank you so much, Sylvia. It's such a pleasure to get to be on Owl Explained. I am super excited to get to have this conversation. Great. Awesome. Today, we're going to be talking all about DeFi, DeFi regulation.
Role of Intermediaries in Traditional Finance
00:01:05
Speaker
Let's get started with a very basic question. Can you provide a brief overview of what decentralized finance, of what DeFi is, and how it differs from traditional finance? Yeah. It's the
00:01:19
Speaker
Big question of the day, which is trying to understand what this technology actually does. Now, first thing to start with is what our financial system has traditionally looked like.
00:01:28
Speaker
which is very much based on the concept that you have some key people in the middle that are used to performing a whole bunch of functions that we have come to rely on. So these are intermediaries. They stand in the middle of different kinds of financial interactions. For example, banks are in the middle of you and me, Sylvia, if I want to send you some money.
00:01:51
Speaker
the bank will check that I have the money in my account, it will make sure that I am who I am, and then sends that money to you, and then your bank will do the same thing. So that's intermediation. It makes life, you know, has traditionally just created a way in which we are able to facilitate a lot of our transactions in payments, in banking, in securities trading, commodities trading, and so forth. They stand in the middle, they match people, they check, and they do all these different things.
00:02:19
Speaker
Now that's a world in which we have had, you know, more or less kind of analog interactions in some ways,
Decentralized Networks Explained
00:02:27
Speaker
right? Like that's a world in which we didn't have the supercomputers that we have today, but clearly we have evolved into a world in which algorithmic automated programs can potentially be used to perform a whole bunch of functions that proxy for the kinds of things that intermediaries have traditionally done.
00:02:48
Speaker
So for example, if you look at the Bitcoin blockchain, which is designed to be a blockchain that doesn't function with banks or state governments or anything, the computer software itself looks to perform the different checks. And instead of one person doing it, like a bank, it's all of the different participating nodes or computers that are part of that network that do it. They run this common software, they perform these different checks,
00:03:18
Speaker
to make sure that there's integrity to the transactions that are coming in. The world of DeFi is essentially based on that model, a model in which we don't have intermediaries that are central intermediaries. We're running computerized programs, automated programs that are designed to approximate some of those functions that intermediaries have done, but also bringing new kinds of functionalities as well. But the salient point here is it's automated,
00:03:48
Speaker
you know, using distributed networks of computers working together, running a common protocol, and it's trying to create validation mechanisms that traditionally intermediate users have performed. And so DeFi is this world in which, you know, we are trying to
00:04:05
Speaker
operate without the traditional intermediation structures. Wonderful. Awesome.
DeFi's Legal and Regulatory Challenges
00:04:10
Speaker
And let's switch gears a little bit to talk about the legal and regulation side of DeFi, because I think they provided a great definition, a good distinction between what it is, but with any new technology, or especially when we're involving this financial application, what are the key legal challenges and regulatory considerations surrounding the DeFi space, both at a global and at a local level?
00:04:34
Speaker
Yeah, it's incredibly complex to work out how to apply traditional paradigms to DeFi. So our entire financial markets infrastructure and its regulation has very much been based on the notion of intermediaries. So we have intermediaries, we apply regulation to these intermediaries.
00:04:57
Speaker
We know that they are the ones that are accountable. So for example, if your payment that we were talking about, Sylvia, if our payment goes wrong, then the bank is ultimately responsible, right? So the law knows that the bank is moving this money, so the bank is going to be responsible for making sure this trade happens. How do we capture that legal accountability structure to defy? That's a question that regulators are really wrestling with. Who's responsible?
00:05:27
Speaker
Right? Who gets to have the liability for making sure that the network is working? When it's distributed and when it's decentralized to various degrees? In that context, can we make all of the different participating computer
00:05:47
Speaker
the folks who are running their computers, do we make them responsible? Do we make the developers responsible? Do we make some kind of other entity that's related to the network responsible? How do we consider responsibility, accountability, liability within that structure? Now, what's interesting, obviously, is that this problem has become incredibly urgent. Because since 2020, the amount of value that's going into DeFi protocols has increased enormously.
00:06:15
Speaker
So DeFi has grown extensively since 2020 with, I believe the latest figures was something like 40 billion in total value locked within DeFi, I believe. That was last time I checked, which is a month or so ago. But clearly there's money on the line here. In addition, obviously we've seen a variety of different risks emerge in DeFi, particularly where
00:06:43
Speaker
Ventures start where they're not properly, where they're not legitimate ventures. There have been a lot of rug pulls, for example, in the context of DeFi, where DeFi applications come forward, try and look legitimate, collect money from folks, and ultimately, the program is just deleted and the person makes off with the money.
00:07:03
Speaker
So it's really important for regulators to get a handle on this, but how they do so is looking to be a very thorny problem because it's not fitting neatly onto our existing paradigms for regulation.
00:07:17
Speaker
Of course. And I love what you mentioned about those key things like responsibility, accountability, market integrity, because just like the Internet, blockchains and crypto assets, DeFi, all of these things are global and they require somewhat of a coordinated regulatory approach.
00:07:35
Speaker
based on these certain first principles like disclosure, market integrity, anti-fraud, privacy. And to follow up on that thought, can you explain the role of smart contracts in DeFi applications and how may they intersect with these legal frameworks?
Smart Contracts in DeFi
00:07:51
Speaker
Yeah, so smart contract theory are a key part of many DeFi applications where they essentially operationalize the function of that particular application. So for example,
00:08:04
Speaker
If you have a trading application, then the smart contract will trigger in the event that your order matches with someone else's, and then that contract triggers to automatically match, and then make sure that the trade becomes final within the application.
00:08:24
Speaker
If you have a lending protocol, for example, the smart contract will be triggered or will play a part in making sure that in the event that the value of the collateral falls below a certain point, that there's a liquidation event that happens. So being able to automate and operationalize certain kinds of processes needs smart contracts. Now, the word smart contracts is an interesting one.
00:08:53
Speaker
It's basically code. It's automated code that triggers in the event that a particular set of conditions arise. So in the event that, for example, you have a flood, then a DeFi insurance application could automatically trigger to ensure that you are paid out. If you have a car sale, to the extent that the title documentations match with what needs to be there, then the title can be transferred. So this is automated code.
00:09:22
Speaker
It's essential to DeFi because it allows for that application to operate in an automated, decentralized way, rely on automated programs to essentially trigger the movement of value provided that certain checks are undertaken by the blockchain. So these are, you know, without so-called smart contracts, otherwise known as automated code, basically DeFi wouldn't really exist. And so they very much are
00:09:47
Speaker
part and parcel of that, the kind of DeFi that we recognize today, obviously Bitcoin and other things it says, but the kind of DeFi that we recognize today is becoming more sophisticated, more financialized, more capable of performing a whole host of functions like lending, trading, insurance, and so forth. That kind of DeFi really depends on smart contracts for its fullest kind of flourishing, as it were.
00:10:11
Speaker
Very nice. And now that we're talking about this role of smart contracts, and as we see them now in the market and in real life, can I give some examples of some DeFi projects that stick out, especially when it comes to navigating these legal challenges? What lessons can we learn from their experiences? Yeah, so there's a number of different types of DeFi that have emerged as being very
00:10:39
Speaker
So, for example, this has been clearly, you know, this has been perhaps most inevitable in the context of lending. So, a number of lending protocols, for example, have garnered enormous amounts of money, actual value that has been put into these protocols. And they've allowed for, I mean, I can certainly name them Compound, for example, it was one.
00:11:01
Speaker
you know avay and others that have been extremely influential impactful in the market and what they've done essentially is allow for borrowing and lending within the application allowing for this borrowing and lending to happen essentially automatically the ways in which there is risk management as it were is through collateralization in other words the application requires the deposit of collateral usually in the form of crypto and
00:11:30
Speaker
The amount of money that you can borrow is then determined by how much collateral you put into the application and then you can borrow some fraction of what you put in as part of the borrowing that you can perform. Obviously, if the collateral falls in value, then the smart contracts are triggered and there's a liquidation event.
00:11:52
Speaker
So these are the basic design of some common lending protocols, but there's also trading protocols. So for example, things like Uniswap has become a very influential market.
00:12:07
Speaker
It's become influential, particularly in the wake of FTX, for example, where a lot of folks became extremely anxious, rightly understandably, that their crypto was not safe on centralized exchanges at that point. And so following FTX, Uniswap saw a whole uptick in the amount of value that was being put into these applications.
00:12:32
Speaker
So clearly there's appeal for this DeFi universe ecosystem for those that are willing to explore the potential of essentially disintermediated finance, self-help, helping themselves, taking care of themselves, relying essentially on potentially cheaper forms of financial services where an intermediary is not involved, potentially cheaper, not always.
00:13:01
Speaker
And one in which I think folks are maybe endorsing a particular vision of finance, which does not involve the traditional Wall Street players. That has seemed to be at least one source of the appeal for many people that it's a little bit different. It's not the traditional Wall Street. It's antithetical to Wall Street in some ways.
00:13:31
Speaker
And so that has appealed to some people that have felt happy with Wall Street for a while. Okay. Okay. Super interesting. Yeah. And I think it's a very dynamic and also diverse ecosystem and ever-changing. And as you were mentioning, it gives opportunity to new players to enter, but that can both be, I think it's a double-edged sword. It's a blessing, a curse depending on how you navigate it.
00:13:56
Speaker
And also as we continue to follow the train of thought, how can DeFi projects work collaboratively with regulators to establish frameworks that balance innovation but also protection?
DeFi and Regulatory Collaboration
00:14:10
Speaker
Like how can we find that sweet spot?
00:14:13
Speaker
Yeah, and I think that sweet spot is extremely necessary, right? There is clearly risks involved here. People's money, people's hopes, people's passions are engaged in this world, in this ecosystem. But we're not fully mature about how we address and handle the risks. And regulators are still trying to understand what those risks should be and how we can try and mitigate them.
00:14:43
Speaker
So, for example, something that has been very much a part of the market structure and regulation is disclosure. This is a big, big way in which folks that are using particular services understand the risks that they take. But how do you do disclosure in the context of DeFi? How do you get information to users in a way that they can understand?
00:15:08
Speaker
appreciate and engage with. How do you do that in the context of DeFi? So we're in a world in which regulators don't have at present a great answer to that. What kind of information do we disclose? Is that information the same as the kind of information we see in traditional marketplaces? So for example, if you look at disclosures that are performed
00:15:34
Speaker
For IPOs, companies that go public, it's a very thick amount of documentation that goes into play. Is that the kind of information we want going out in these applications? When you look at commodities and so forth, there's a ton of disclosure that happens through the exchange structure. How do we make that disclosure work in the context of DeFi? So these are all incredibly difficult questions.
00:16:02
Speaker
At the same time, I think there's a recognition that regulators are not fully, are still kind of wrestling with how to answer it. So for example, in the EU, they have come up with this MICA legislation, which is a very comprehensive framework for oversight of crypto, but there's no DeFi.
00:16:25
Speaker
in it, right? So there's no oversight for DeFi. As far as I understand it, there is no project yet as to how to oversee DeFi, because regulators are still trying to figure out how to get a handle on it. Here, the way in which we've engaged with DeFi is, for example, some of the actions that have come up in the case of tornado cache has been to essentially ban the application as far as possible.
00:16:54
Speaker
with Treasury essentially looking to shut that application down in some form because the idea here is that it has been used for a variety of potentially illegal money laundering, terrorist financing, and so forth. And so the response here has been just to completely shut down the technology. Now, clearly that's not going to work in every case, and clearly it's not like
00:17:23
Speaker
something that the industry and others want to have in every case, that every single time there's a problem with the technology, you simply shut down the application. That's just not a very American thing to do. So, you know, trying to understand how to make regulators get comfortable, thinking about new ways in which one can do traditional functions like disclosure. I'm thinking about accountability and how to to operationalize accountability for distributed computer networks.
00:17:51
Speaker
These are all incredibly tough problems. There's no easy answer here. And I think what we have is really to get everyone's brains engaged, industry's brains, regulator's brains, international regulator's brains. Everyone's intelligence has to be pulled to figure out how to deal with this because it's not going away anytime soon. If anything, these applications are becoming much more sophisticated
00:18:18
Speaker
as our understanding of their underlying technology grows over time. Absolutely. Wow. I think it's easier said than done. And I think it's a task that will continue to be refined over the years. But I wanted to also talk about regulatory sandboxes now that you were mentioning these kinds of spaces. So can you discuss the concepts of these sandboxes and how they might be utilized to foster innovation in the DeFi space while also ensuring compliance?
00:18:47
Speaker
Yeah, great. So, regulatory stand boxes are regulatory innovation. So, these are innovations that have been created by regulators to try and understand how technology works. What a sandbox is, is essentially a lab of a sort that regulators have in which they are testing out new kinds of applications, technologies, FinTech, to try and see how it might work in the real world.
00:19:17
Speaker
So a number of different jurisdictions have deployed sandboxes. So the UK, for example, the UK's Financial Conduct Authority has a sandbox where they invite innovators to come and test out their technologies. And so the regulators can see how these might work in real time.
00:19:37
Speaker
And what that does is give regulators information. It gives them some idea of how a brand new technology just to kick the tires in a brand new technology. So for example, if you have a kind of, you know, some kind of new payments app to see how that works.
00:19:53
Speaker
when money is being sent in using new kinds of smartphone interfaces or with certain kinds of add-on features. So that gives regulators information that can help them to think about ways in which some of the risks can be mitigated. For example, should one slow down a particular application? Should one put limits on how much money can go through a particular application?
00:20:19
Speaker
So these are ways in which we can test out ideas. The thing with sandboxes, though, is that they are limited in their usefulness. So they're super useful, but they are limited in their usefulness. Even though we have regulators getting some idea of how a technology works,
00:20:42
Speaker
It's still not the real world. It's still a very stylized setting. It's still a very controlled environment. So for example, certain sandboxes have limits as to how many users you can have. I believe in Australia, the limit was something like 100 users that can be included within the sandbox's technology that's being tested. That's not the real world. There's always going to be more than 100 people. The way people use it might not be how the sandbox
00:21:09
Speaker
how the sandbox sees them using it. So people might use the technology in a very different way. So these are things that we have to be mindful of, that even though regulators are experimenting, even though they're trying to
00:21:25
Speaker
be open to innovation, have these sandboxes where these innovations can be tested out, there's limits in how useful these regulatory innovations can be. Now here in the US, both the CFTC and the SEC have little sandboxes of their own. So lab CFTC is an awesome, is a really awesome part of the CFTC, which is dedicated to understanding new kinds of innovations in the market as a way to inform regulation
00:21:53
Speaker
as a whole. So clearly we're trying things out, but we have to think bigger and deeper and more collaboratively about what the fullest permutations of new technologies are likely to be. And that really involves us getting messy and talking and kicking the tires, workshopping, and just being patient with each other to figure out how to get this regulation right.
00:22:23
Speaker
Well, fantastic summary, great description. And I also wanted to hear from you, how do you see the regulatory landscape for DeFi evolving in the coming years?
Future of DeFi Regulation and Advice
00:22:34
Speaker
And what advice do you have for DeFi projects navigating this ecosystem? Yeah, you know, the question of evolution is a really interesting one. I think it's going to be fascinating to see what happens because different jurisdictions are responding to DeFi in different ways.
00:22:53
Speaker
So, for example, when one looks at the EU, there's a recognition that some kind of framework is needed, but exactly what that framework is going to be is anybody's guess. At the same time, I think there's a certain openness to seeing what happens with DeFi. I think the idea here is not to ban DeFi, certainly, but just to see how it evolves and what kind of status and market impact is likely to
00:23:23
Speaker
get as a result. I think here in the US we are you know we are at the initial stages of trying to figure this out. As you know Sylvia we do not have a regulatory framework for crypto. We are still struggling with centralized finance let alone getting to defy decentralized finance. And yet of course
00:23:44
Speaker
As you pointed out, Sylvia, there are applications that are underway, developers that are building these applications. But I think there's also a fear that the absence of a regulatory framework, a lot of enforcement that has happened lately, that that might result in applications potentially being shut down, say, for example, tornado cache. So there is a sense potentially that developers are not sure
00:24:13
Speaker
as to the risks they face in this environment. Could there be liability that faces them in this environment? That's something that they have to also deal with. Now, there was one interesting case that happened recently, which related to Uniswap. It was a kind of class action that was brought in that context. And in that case, the judge did say that you can't hold developers responsible.
00:24:39
Speaker
At the same time, there have been some CFTC cases, for example, concerning a DeFi application called Open, O-P-Y-N, I think that's how it's spelled, where developers were held liable. And so there's a lot of regulatory uncertainty here, and that certainly can play to the incentives of developers when thinking about potentially where to launch their applications or where to think about how to
00:25:08
Speaker
come up with new applications because the oversight framework that we have in the US is very much in its initial stages and we're still grappling with how best to get a handle on it. Of course, we definitely have a long way to go. I just wanted to conclude in what can individuals and organizations in the DeFi space do to stay informed about these evolving legal and regulatory developments?
00:25:36
Speaker
Listen to this podcast. That's a good one to start with. I think you guys are doing an incredible service to disseminate information and ideas and research to everyday people. So I think one of the best things about crypto and DeFi in some ways is the fact that there's a lot of people willing to share knowledge and information and
00:26:00
Speaker
to talk about these technologies. So I think keeping abreast of that is super useful. In addition, I think it's worthwhile also paying attention to what regulators are saying. So increasingly, there are white papers that regulators are producing about DeFi. For example, in the EU, there's been research papers, white papers that speak to DeFi. The Bank of International Settlements, for example, is another one, are set up where
00:26:31
Speaker
We might see regulators provide some kind of guidance or thoughts about DeFi. So these are all publicly available sources for folks just to learn about the new kinds of technologies that are coming up, but also just how regulators are responding to what they see as being emerging trends in this technology. And that is a really interesting
00:26:54
Speaker
a way to get into the brains of some really smart people who are doing informed work, but to try and get a sense of how regulators are positioning themselves to deal with this technology that essentially doesn't map onto the traditional kinds of paradigms that they have been used to handling. So definitely pay attention to that because that tells you a lot about where regulation and arguably market structure in our
00:27:21
Speaker
national ecosystem might be going as well as obviously internationally with the BIS, Bank of International Settlements, the EU and others.
00:27:29
Speaker
Wonderful. Thank you so much, Isha. It was fascinating to talk to you. Do you have any concluding remarks, anything else you would like to add before we wrap this recording? Yeah, I think one of the things that I would like to just highlight is just how exciting this is. I think for many of us as legal academics or as people who are
00:27:52
Speaker
into the technology and just trying to understand it. This is a fascinating time to be alive, to see a lot of innovation development in new kinds of protocols, to see existing protocols that have been in the market for a while become much more sophisticated and usable, to see these use cases start to expand in their reach.
00:28:15
Speaker
These are exciting times, and for those of us who do regulation in this space, I think it's an incredibly important moment for us to try and figure out how to bring the traditional legal system, our paradigms, our new ways, new innovations in law, new ways of thinking about regulation to bring that to bear to this field. So that's a very exciting thing for us to get to do, and I'm so glad that
00:28:43
Speaker
You guys are very much at the forefront of trying to encourage us to do it.
Conclusion: Innovations in DeFi
00:28:47
Speaker
Thank you. Love that. And I also love how you ended this on a very positive note, and it is a very exciting industry and a very special time indeed. So thank you so much, Isha. Once again, we loved having you on the Owl Explains podcast. And thank you everybody for listening. We'll see you next time at another one of our Hutu Nannies.
00:29:08
Speaker
We hope you enjoyed our Hootenanny. Thank you for listening. For more Hootful and hype-free resources, visit www.owlexplanes.com. There, you will find articles, quizzes, practical explainers, suggested reading materials, and lots more. Also, follow us on Twitter and LinkedIn to continue wising up on blockchain and Web3. That's all for now on Owl Explains. Until next time!