Technology usage in the financial sector is not a new concept, but its role is limited to facilitating transactions. As conduits of funds transfers, banks operate as intermediaries between payers and payees, subsequently responsible for distributing money issued by the central bank. The financial method now being used has come a long way. However, it is diminishing as DLTs in the financial sector have tested the fundamentals and architectural premises of the present banking system. One of such flourishing paradigms is Decentralized finance or “Defi.” Decentralized finance is a system that allows the availability of financial products on a decentralized blockchain network. In disparity to the current banking system, Defi has no intermediary. The only possible intermediary is the software system. Accordingly, role of Decentralized Finance or DeFi lawyers includes DeFi due diligence and writing DeFi legal opinion letters.
Even though the components of Defi, its similar to the current financial ecosystem, which requires stable currencies and diversity of use-cases, the decentralized and distributed nature of Defi attracts several issues in current financial regulation. This gives the users have more power and authority over their money. However even an intelligent system of finance cannot escape complex environment of legal and regulatory requirements. Listed below are some legal challenges Defi could face in its conception itself. Here’s an overview of legal analysis for FinTech companies.
Blockchain and DeFi Laws
Blockchain has generated several issues regarding regulating laws, particularly the data protection and privacy law. Regarding Defi, challenges prevail in countries that follow the European Union standards of General Data Protection Regulation Directive (GDPR)[1]. Data protection rules do not apply to anonymized data, and one can consider that because decentralized finance practice hashing and encryption techniques to anonymize users. Consequently, if any misconduct happens, the regulatory authority will not enforce it. Similarly, Defi could conflict with the Right to be forgotten or erased[2] as once the data is stored in blockchain, it can never be replaced or reversed.
Cross border Jurisdictions in DeFi
Any decentralized record-keeping makes it more challenging to follow breaches or misconduct. Having that said, Defi provides cross-border services to their users, which could result in difficulty tracking activities occurring beyond boundaries at first and then applying the specific law. Moreover, each jurisdiction will have overlapping laws, giving discrepancies in the enforcement of laws. For example, any misconduct in a country will not have equal enforcement law around potential misconduct, and the offender may take advantage to avoid penalty.
Classification of Digital Assets
Tax treatment or gains from crypto assets depend on those assets’ characterization. Unfortunately, most jurisdictions do not classify crypto assets to determine appropriate tax treatment. In addition to the above, a tendency for the price of crypto assets to fluctuate may affect tax collection. For instance, administrations may collect heavy tax from token holders in a year and refund it in the next. Apart from above, with a distinct feature of tokens, many regulators also have tough time addressing compliance issues under securities law. An incident of theft of 3.6 million Ether prompted the Securities and Exchange Commission in the United States to issue a crypto rule. In addition, in light of crypto rules, SEC has also released the classification of Defi instruments.
DeFi Record-keeping
As regulators start to comprehend how blockchain operates and how secure smart contracts can be, there is still a dichotomy when it comes to rectification of inaccurate entry. If someone enters inaccurate details in the records on the blockchain, such as a user incorrectly recording a deed, the technology accepts and records the entry. However, rectifying errors could be exceedingly tricky because blockchain is anonymous and immutable. It poses a significant risk to the property owner as they might lose the right to their property if the wrong information is stored. In addition, there is no way to verify whether the right buyer receives the title deed. As opposed to above argument, just because an entry cannot be reversed, does not mean it cannot be corrected as the court could obligate the litigant to enter in an opposite transaction on a blockchain network to address the invalid entry[3].
DeFi and Smart Contracts
Smart contracts inherently vary from traditional contracts in terms of advanced computing and its effect. Since smart contracts are executed in computer code, they run automatically if the pre-set conditions are met, thus immutable. Additionally, these contracts effectuate themselves, and for this reason, smart contracts cannot be held accountable for its decision. This creates somewhat of rigidity in the contract.
Another issue surrounding smart contract is that it has inherent nuance and ambiguity because of reduced “if, then” statement. For instance, contracts consist of clauses that are operational and non-operational. The latter cannot be easily expressed in computing language. Moreover, removing all ambiguity may not be favourable in smart contracts as some aspects of contracts are contextual.
In order to have effective compliance, regulators will need to be particular while drafting provisions, cases, and potential room for interpretation in the smart contract. There are measures underway to eradicate the disparity between smart and traditional contracts. For instance, ISDA has published its “common domain model” to establish standard parameters for interoperability[4].
DeFi Investments
Defi let participants obtain assets or loans on decentralized application (dApps) that runs on blockchain. It also offers them to deposit a digital asset. Both products offer direct and indirect returns, opening the door for investment opportunities. Generally, any capital raised in the market is subject to a legal obligation, but since Any regulatory authority does not back Defi, it lacks the legal obligation. This causes hesitance in investors’ minds, making it a risky investment. Many Defi participants recommend that new investors exercise caution, and other experts agree to its significant risk. Furthermore, an unregulated market is prone to corruption, fraud, self-dealing, and cartel activities that reduce investors’ confidence in the Defi market.
[1] https://gdpr-info.eu/recitals/no-26/
[2] Right to be forgotten is a data subject’s right to delete, limit or modify published data, Article 17, GDPR
[3] Werbach, K. & Cornell, N. (2017). “Contracts Ex Machina” Duke Law Journal, 67(313), 224
[4] https://www.isda.org/2019/10/14/isda-common-domain-model/
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