In recent months, the fast-growing pace of the decentralized finance (DeFi) market has captured the attention of regulators looking to fit this new area of crypto into existing regulatory frameworks. Attractive yields and very unique financial instruments are regularly pushing the market to new highs, making the regulatory conversation increasingly relevant.

What makes the topic of DeFi regulation so complex is the very unique nature of DeFi protocols. For decades, financial regulations have evolved around the concept of establishing trusted intermediaries to enable the key building blocks of the financial systems. DeFi challenges that core foundation by replacing those key financial primitives with programmable, autonomous smart contracts. A potential approach to tackle this challenge could be leveraging existing regulatory models while also exploring new frameworks that at least consider the uniqueness of the DeFi space.

Jesus Rodriguez is CEO of IntoTheBlock.

First principles

Without pretending to have an exhaustive list about those first principles, here are a few that are worth discussing:

1. Applying existing regularly models to DeFi: There is an obvious path to apply existing regulatory frameworks to DeFi protocols. Although possible, this approach might be incredibly over simplistic and harm the growth and existing innovation of the DeFi space.
2. Creating DeFi-first regulatory frameworks: Native DeFi regulatory models might alleviate the path to regulation without constraining technological innovation.
3. Quantifying value trade-offs: Imposing regulatory mechanisms in DeFi protocols can certainly hurt the space in the short term but it’s not crazy to think that it will create additional value in the long term.

Traditional approach

The vast majority of the regulated DeFi debate centers around applying frameworks such as know-your-customer (KYC) or anti-money laundering (AML) to DeFi protocols. In that setting, users interacting with lending protocols such as Compound or automated market maker (AMM) protocols like Uniswap would have to pass KYC and AML processes before they are able to trade. This seems reasonable enough but comes with obvious challenges. For starters, KYC-AML restrictions can severely harm the growth and activity in DeFi protocols, at least in the short term. Additionally, a significant percentage of the activity in DeFi protocols is done via smart contracts that adds multiple layers of indirection to any KYC-AML model.

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Getting unorthodox

Approaching the DeFi regulation problem by imposing KYC-AML requirements on DeFi protocols is definitely viable but also quite constraining and potentially harmful to the DeFi space. The decentralized, transparent and programmable nature of DeFi provides a foundation for new types of regulatory frameworks. As a general principle, DeFi introduces groundbreaking innovations in the structure of financial primitives, so why shouldn’t we think about regulatory models that leverage those native innovations? Even though some of these ideas might result insufficient from a regulatory coverage standpoint, their underlying principles might help to provide a better bridge between DeFi and current regulatory frameworks.

A DeFi regulatory score

The activity in DeFi protocols is completely transparent at the blockchain level, so why not to use that information to assess the regulatory compliance of a specific DeFi protocol or artifact. Let’s take the example of a lending protocol like Compound. Imagine if for every Compound market we could develop a regulatory score that quantifies every wallet based on criteria such as the number and frequency of liquidations, the wallets it interacts with, the size of loans and other indicators specific to the Compound protocol. A wallet that interacts with suspicious addresses will score lower than wallets that interact with addresses with a high regulatory score.

Aggregating the scores for the individual wallets should give regulators a statistically significant understanding of the compliance viability of each Compound market. You can extrapolate this concept to other DeFi primitives such as AMMs, decentralized exchanges (DEX) and many others.

The idea of leveraging on-chain data to quantify the regulatory compliance of DeFi protocols is not only viable today but could also be a more effective and certainly a complementary mechanism than traditional KYC-AML frameworks. KYC-AML validations are a validation of past compliance, but it’s hard to refresh regularly.

For instance, suppose a given DeFi protocol imposes KYC-AML requirements. If a bad actor is able to circumvent the validation using fake information, then the actor will be able to act with certain impunity. On the other hand, systematically computing on-chain metrics relative to the bad actor wallet can eventually result in a lower regulatory score.

Continuous incentivized KYC

DeFi protocols regularly rely on incentives and governance votes to adjust the behavior of the protocol. For instance, protocols like Curve regularly assign incentives to different pools to attract liquidity. A similar concept could be applied to regulatory mechanisms like KYC-AML. Imagine that Curve or Aave decides to regularly incentivize pools or markets with a large percentage of identified wallets. It is conceivable that such a mechanism will attract more liquidity into those Curve pools while also incentivizing users to complete KYC-AML processes. Instead of enforcing the KYC-AML requirements, a regulatory framework could use native DeFi incentives to organically increase the compliance of DeFi protocols.

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Trading value today for value tomorrow

There are plenty of challenges about establishing a regulatory framework for DeFi protocols but there are also some interesting opportunities. The most obvious one is the potential of enabling DeFi rails for a new set of regulated asset classes that are not active participants in the ecosystem. Stocks, commodities, bonds and real estate are some of the asset classes that could be traded in DeFi protocols with the right regulatory infrastructure. DeFi today is mostly based on crypto-to-crypto instruments but thoughtful regulation could drastically increase the value locked in DeFi protocols. In a very ambitious world, DeFi doesn’t have to be an alternative financial system but it can replace archaic financial instruments in capital markets.

Overregulating DeFi in a brute-force approach can certainly harm the level of innovation and growth in the sector. However, a thoughtful approach to regulation can unlock the potential of DeFi to all areas of the financial ecosystem. The trade-off is not trivial, but the only way to minimize the potential damage is to have thoughtful dialogs with regulatory bodies and open the door to experimentations. DeFi is novel and different and can open the door to more efficient and innovative forms of regulation.

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