Most of the conversation about policy in Web3 has centered around what crypto pioneer Nick Szabo calls “wet code” – in this case, the laws that govern human institutions. The world of crypto offers an alternative – “dry code,” or computer code – to protect investors and users, which may be a more efficient approach by literally encoding rules in verifiable, permissionless and self-custodial protocols.
It is an approach that relies on incentives and the transparency of the technology itself.
Why regulations matter
Let’s take a step back and consider the stated reason for financial regulation. Regulations are important because they can promote orderly and efficient markets and protect investors from those who may take advantage of them.
Take the problem of leverage, i.e., when people trade on margin, or borrowing money they have to pay back. Without going into detail, the math behind leverage is such that gains and losses increase linearly while risk increases quadratically. In other words, if you have 5x leverage you only gain or lose 5x against a given price movement, but your risk of being liquidated increases by 25x. Leverage, by its nature via math, sets the house up to win.
Couple this with the fact that exchange operators act as central clearing houses performing the settlement of trades. Historically, large institutions have filled this role, being willing to take the other side of a trade and eat the losses in the case a trader defaults.
To catch up: You have investors with access to leverage taking risks that increase quadratically, and centralized exchanges settling the results of their bets. Exchanges also have access to information regarding liquidation prices that the rest of the market does not have, and an incentive to manipulate the market for their own gain. You can see why regulators are interested in this arrangement and are needed to prevent exchanges from trading against their customers.
See also: DeFi’s Difficult Governance Decisions Lie Ahead | Opinion
Regulations have a defined role and clear mandate to oversee centralized entities that, for the most part, can operate opaquely as far as clients having access to their inner workings.
DeFi is fundamentally different
With decentralized finance (DeFi), you have a completely different paradigm. Not only is there transparency, there is also no need for a centralized entity that controls the order flow of transactions. Funds are self-custodied. DeFi requires an entirely different approach to regulation because – while investor risks still exist – the responsibilities are entirely different, and so are the tools to mitigate risks.
Smart contracts make it simpler to aggregate financial interactions that would otherwise happen in fragmented, siloed and functionally private peer-to-peer (P2P) markets. In DeFi, smart contracts can play the role of an aggregator that was previously exclusive to operators of centralized exchanges.
For instance, an automated market maker protocol algorithmically determines the quote price of various assets and allows anyone to automatically offer these set prices to the rest of the market. Smart contracts then aggregate all the liquidity of the bids and asks together in an aggregated pool by using basic accounting. Similarly, money market protocols aggregate automate peer-to-peer (P2P) secured loans.
However, P2P trading or even private lending are not normally regulated activities, (cold hard cash is a peer-to-peer technology). Why should smart contracts be regulated if the activities they’re replicating are not? That’s putting aside the possibility that crypto can provide people with access to more efficient and transparent financial markets, without the risks inherent to centralized finance.
Code is law
In DeFi, we can use code to automate processes and track accounting data that can be used to drastically improve how these systems operate and manage risks. We can even design tools that protect users from unwanted risks. The idea that “code is law” becomes central. Of course, existing laws already prohibit fraudulent behavior if controllers of smart contracts operate unscrupulously.
The mechanisms that can protect DeFi investors from bad actors are likely to look more like analytics platforms, protective freeware and approval by reputable institutions that users are incentivized to use and seek for. Similar ideas have already been proposed by the European Commission that acknowledged the difficulties in regulating DeFi.
See also: DeFi Is the Way Forward, but It Needs to Evolve | Opinion
Regulators need to consider how technology and science can be used to achieve a desired policy. Perhaps the right step to take in terms of DeFi and Web3 regulation more generally is to focus on the ways in which the technology itself can be leveraged to safeguard investors and drive efficient markets.