Today, the Blockchain Association submitted a response to the Financial Action Task Force’s (FATF) Draft Updated Guidance that seeks to address potential illicit activity in the decentralized financial ecosystem. The Blockchain Association fears that the guidance’s approach to addressing these risks would be ineffective. At the same time, if implemented by FATF member states, the guidance would represent a near de facto ban on the legal participation in and development of decentralized financial systems. A new approach is needed. The Association and its members stand ready to devote their energy and expertise to assist the FATF and other relevant bodies in the critical endeavor of developing a new framework to prevent the illicit exploitation of virtual assets and decentralized finance. To that end, the Association has formed an AML/CFT Working Group led by Jaikumar Ramaswamy, Chief Risk & Compliance Officer at cLabs and former Chief of the Department of Justice’s Asset Forfeiture & Money Laundering Section, and Rebecca Rettig, General Counsel at Aave.
Regulation of decentralized financial systems presents enormous and novel challenges because anyone with an internet connection can deploy, use, experiment with, and participate in the maintenance of decentralized protocols. The inherent features of open source decentralized finance protocols makes their continued development and use inevitable, including by illicit actors. The Draft Updated Guidance represents an attempt to address this challenge by dramatically expanding the perimeter of regulations designed for custodial financial intermediaries to apply to any individual or entity that benefits from the provision of a financial service, “regardless of whether the profits are direct gains or indirect.”
This regulatory approach, aimed at ensuring that “…very few VA arrangements will form and operate without a VASP involved at some stage…,” would not prevent the use of decentralized financial services by illicit actors. while newly created protocols could hypothetically restrict access to known and identified public addresses, the code that powers decentralized finance protocols is open source, which means that it can be copied, edited to exclude such restrictions, and redeployed on a permissionless network in around 30 minutes by any individual with moderate coding skills and an internet connection. In this manner, the open source nature of decentralized financial protocols renders relying on gatekeepers to control access to decentralized financial services unviable because there will always be permissionless alternatives available.
At the same time, the guidance would impose regulatory requirements designed for custodial financial intermediaries on individuals and entities that could not implement or comply with them, such as governance token holders, software developers, autonomous computer programs, and non-custodial entities. The very nature of decentralized governance ensures no single actor or entity can exercise sufficient control over the protocol to function in the way that a custodial financial intermediary does in the traditional financial ecosystem. Moreover, because regulations designed for custodial intermediaries assume the intermediary has custody over the assets, newly captured, non-custodial VASPs would be unable to comply with requirements like asset freezes because users of decentralized financial protocols retain total independent control of their own assets. In turn, compliance would require not participating in or developing decentralized financial protocols whatsoever, an outcome that would prevent society from realizing the benefits of disintermediated financial systems. There is a better way.
To develop an effective regulatory system that effectively addresses ML/FT risks in the decentralized finance ecosystem while preserving the enormous benefits that it offers, regulators and industry stakeholders must develop a new approach that matches the space that is being regulated. If regulators and stakeholders are to truly and effectively mitigate the ML/TF risks associated with this novel ecosystem, they cannot depend on regulating “gatekeepers” in a system designed to function without them.
Instead of trying to regulate an intermediary that does not exist or forcing new projects to function like pre-existing, easily regulatable forms, a more effective approach is to concentrate efforts on the development and consensus-based adoption of new regulatory mechanisms that can be incorporated into decentralized finance protocols. These solutions will require cutting edge work, but we believe that they are technically feasible and can vindicate the core AML/CFT objectives that the FATF safeguards. This way forward will require a partnership between FATF and national authorities, on the one hand, and leaders in the digital assets industry, on the other, to devise standards and solutions that satisfy legal, technical, and commercial needs. The Association commits itself to support this effort fully.
As part of its efforts to facilitate a constructive dialog with regulators, the Association has created an in-house working group to coordinate with domestic and international regulations aimed at (1) exploring these potential solutions, (2) identifying the most promising, and (3) incentivizing the rapid development and implementation of them. The Association believes that no existing AML/CFT regime can effectively mitigate potential ML/FT risks in decentralized finance. Developing a new way is our only viable option and the Association stands ready to marshal the collective contributions of its membership to partner with FATF in meeting this challenge.