The discussion paper Policy Considerations For Decentralised Finance presents the United Arab Emirates’ Financial Services Regulatory Authority (FSRA) of the Abu Dhabi Global Market’s (ADGM) view on the direction of DeFi – their proposed regulatory approach to DeFi, the predicted growth, high level policy positions on how FSRA might consider adopting, and implications for future DeFi regulatory framework. Market participants are encouraged to provide feedback by 30th June 2022.
Whilst in November of last year the Financial Action Task Force updated its recommendations to encompass DeFi and in June 2021, the World Economic Forum issued its white paper on DeFi, detailing the myriad of risks in the space and potential policy approaches, apart from the UAE, there are few jurisdictions that have specifically looked into DeFi regulatory frameworks.
However, some jurisdictions have begun exploring regulations regarding self-hosted wallets – the typical type of wallets that interact with Dapps. In 2020, the US’ FinCEN introduced a proposal to make unhosted crypto wallets comply with Travel Rule guidelines, whilst most recently the European Parliament’s Committee on Economic and Monetary Affairs (ECON) voted to revise the Transfer of Funds Regulation, concerning the verification of unhosted wallets.
Here Coinfirm’s Regulatory Affairs takes a look into the UAE’s FSRA regulatory approach considerations to the decentralised finance space.
Direction of DeFi
The FSRA anticipates that DeFi will continue to grow over the next 5-10 years due to 2 main drivers: automation/cost (i.e. increased automation leading to lower costs of services) and returns (i.e. potential to provider higher returns). The anticipated growth rate is slower than what has been observed from the emergence of DeFi. Additionally, FSRA foresees consolidation of DeFi protocols as well as change growing number of traditional finance (TradFi) engaging in DeFi activities on behalf of their clients.
The predicted growth of DeFi is likely to create greater need for regulatory intervention, FSRA notes, highlighting that the likelihood of such intervention is proportionate to the growth rate. Anti-Money Laundering (AML)/Counter-Financing of Terrorism (CTF) and sanctions are believed to be the priority areas of the upcoming regulatory focus on DeFi. With that in mind, FSRA expects DeFi controllers to be faced with the choice between embracing the regulation or pushback, noting that the ‘pushback’ option seems more likely.
At the same time, the emergence of new compliant-by-design DeFi controllers is believed to drive the further adoption of DeFi in a regulated environment.
FSRA Regulatory Approach
High level policy positions:
FSRA highlights that DeFi does not change the underlying nature of financial services, therefore they believe that similar requirements should be placed on DeFi participants as on TradFi participants. DeFi addresses the same financial services needs in different ways than TradFi and hence the regulations may impose different obligations on a DeFi activity to achieve the same outcomes as those obligations placed on a TradFi.
- Falling into FSRA regulation: case by case analysis of each DeFi protocol would be required to understand whether they provide services akin to currently regulated financial services
- Anonimity: FSRA will only allow DeFi activities where all DeFi participants have been identified and subject to customer due diligence
- Governance/controllers: individuals who are DeFi controllers and therefore exercise significant control over a DeFi protocol are to be treated in a similar way as individuals playing an equivalent role in a TradFi firm and have personal obligations placed upon them (*this relates to the concept of ‘Approved Persons’ who in traditional finance are the main contact with the regulator and are responsible for compliance)
Illustrative regulatory framework:
FSRA may choose to require that firms only be allowed to engage in DeFi activities if they use specific DeFi protocols that the FSRA has designated as acceptable through FRSA ‘recognition’ or ‘approval’.
The following factors are likely to be considered in recognizing whether DeFi protocol is acceptable:
- Ability to identify DeFi participants
- Track record of DeFi controller
- Level of transparency
- Explanation of how the protocol functions and is governed
- Technology underpinning the protocol
Approved DeFi protocols would be held to a higher standard than recognized DeFi protocols, such as:
– at least one DeFi controller to be based in ADGM
– DeFi protocols that have a longer and demonstrable track record
– specific regulatory framework for approving DeFi controllers e.g.:
- At least one DeFi controller be incorporated in ADGM
- personal obligations be placed on the controllers
- DeFi controller may need to demonstrate how it would be able to conduct an orderly exit if the DeFi protocol intends to cease operation
- DeFi controller could be obliged to make information accessible to the FSRA and DeFi participants concerning who is allowed to modify the DeFi protocol and under what circumstances and give undertakings that they have taken due care to manage the DeFi protocol
There may be different conditions on exposure to DeFi protocols, depending on whether they are recognized or approved, e.g.:
- Both Retail and Professional Clients would be allowed to use approved DeFi protocols
- FSRA may choose to impose conditions or prohibit retail clients’ exposure for recognised protocols