On September 7, 2023, the International Organization of Securities Commissions (IOSCO) released its second report [PDF] in accordance with its Crypto Asset Roadmap, Policy Recommendations for Decentralized Finance, this time focusing on decentralized finance. The report builds on a previous report and offers nine additional recommendations to help IOSCO members develop their own decentralized finance (DeFi) regulatory framework. The report also explains how IOSCO’s objectives and principles for securities regulation (IOSCO Standards) apply to DeFi participants.
The release of the IOSCO report coincides with increased regulatory scrutiny of the DeFi sector. Since early 2023, several companies related to DeFi protocols have faced legal challenges, including Commodity Futures Trading Commission lawsuits against Opyn Inc., ZeroEx Inc. and Deridex Inc., as well as New York State’s regulatory lawsuit against Paxos Trust Company regarding its stablecoin BUSD. IOSCO’s organizational mission is to promote regulatory consistency both between and within member states in order to avoid “regulatory arbitrage.” Not surprisingly, due to the cross-border nature of DeFi products between different jurisdictions, IOSCO advocates for uniform DeFi regulation, and within individual jurisdictions IOSCO emphasizes that regulators treat DeFi and traditional finance with “the same activity, the same risk and the same regulatory outcome “should treat. Approach.
The report is notable in that its recommendations are based on the idea that, in essence, DeFi is not much different from traditional finance. Guided by this standpoint, IOSCO aims to extend traditional securities regulation to the DeFi sector, a move that diverges from the preferences of many within the sector.
The recommendations
The report contains nine key recommendations:
- Analyze DeFi products, services, protocols and activities: Regulators should first assess what technical knowledge, data and tools they need to develop a holistic and comprehensive understanding of DeFi products, services, protocols and tools. Regulators must then monitor these activities at (i) a corporate level (i.e. based on material economic reality), (ii) a functional level (i.e. by associating a particular DeFi protocol with its traditional financial counterpart), and (iii) a technical one level (i.e. by analyzing the tech stack, including the settlement layer, consensus mechanism, smart contracts, and on-chain and off-chain processes).
- Identify responsible persons: Regulators should aim to identify the individuals and entities responsible for a particular DeFi protocol. That is, the person(s) who provides or actively facilitates the provision of the product or service. To this end, IOSCO recommends that regulators not rely on labels such as “decentralized” and instead focus on individuals, including developers, foundations and decentralized autonomous organizations, roles and relationships in the DeFi protocol, their level of control over the protocol etc. should focus on their financial incentives.
- Achieve common standards for regulatory outcomes: Regulators must aim for investor and customer protection and market integrity outcomes that are equivalent or consistent with those in traditional financial markets. Regulators should consider attributing DeFi products and protocols to traditional financial markets and consider whether they need to strengthen the applicable framework to avoid regulatory arbitrage.
- Requirement to identify and manage conflicts of interest: Regulators should require providers of DeFi products and services to identify and address conflicts of interest. Conflicts may arise, for example, if a DeFi service provider has a financial interest arising from activities of users or third parties, has an ownership interest in an affiliated third party, has entered into a favorable agreement with a specific affiliate, or is involved in multiple activities vertically integrated matter (e.g. operating a trading platform while simultaneously acting as a counterparty in transactions with users).
- Require identification and management of material risks, including operational and technological risks: Regulators should require DeFi providers to establish and maintain relevant risk management frameworks. Regulators should pay particular attention to the risks posed by the use of technologies other than traditional financial markets and consider whether these can be effectively mitigated. Regulators should hold those with control or sufficient influence over the DeFi product responsible for identifying, managing and mitigating risks. These individuals should be responsible for the risks associated with outsourcing to DeFi service providers such as oracles and cross-chain bridges.
- Require clear, accurate and comprehensive disclosures: Regulators should require DeFi providers to accurately disclose information materials about the products and services they offer to users and investors. Full disclosure helps address the information asymmetries inherent in complex, technologically opaque DeFi markets. The disclosure may take the form of existing traditional financial market disclosure documents, such as prospectuses, and should, where possible, be made in plain language.
- Enforce applicable laws: Regulators should apply their existing inspection, investigation, monitoring and enforcement authorizations to DeFi providers. Regulators should keep in mind the “same activity, same risk, same regulatory outcome” approach. However, regulators must first assess whether they have the appropriate powers, tools and resources.
- Promoting cross-border cooperation and information exchange: Given the cross-border nature of DeFi, regulators should collaborate with authorities in other jurisdictions. This may take the form of ad hoc arrangements to address urgent matters, as well as ongoing supervisory colleges or networks. Cooperation should include the exchange of information on emerging risks, registration and authorization information for market participants and ongoing supervision. Regulators should also leverage IOSCO’s Multilateral Memorandum of Understanding and Enhanced Multilateral Memorandum of Understanding, which capture information requests related to DeFi.
- Understand and evaluate the connections between the DeFi market, the broader crypto asset market and traditional financial markets: Stablecoin purchases from centralized exchanges are often the gateway to DeFi participation and are critical to DeFi protocols such as liquidity or collateral pools. Traditional financial firms such as issuers, funds, banks, registered companies and professionals can provide services for DeFi protocols. Regulators should consider these relationships and assess how their regulatory touchpoints can be used to gather information and provide investor and market protection.
Mapping DeFi activities to IOSCO standards
The report provides insight into how IOSCO understands DeFi protocol participants and service providers to align them with IOSCO standards.
Issuers
The aim of IOSCO is to ensure that securities issuers disclose their financial results and risks fully, accurately and in a timely manner and treat security holders fairly. IOSCO suggests that the following activities constitute the issuance of securities and could therefore trigger disclosure requirements: Aggregators and decentralized exchanges (DEXs) that offer their own crypto assets or crypto assets of other issuers, such as: B. Governance tokens; Lending/borrowing products or services that offer and sell shares in their pools in exchange for crypto assets or that offer other crypto assets, such as. B. Sell governance tokens; Automated Market Makers (AMMs) or other liquidity pools that offer and sell shares in the pool of crypto assets; and issuing derivatives such as cross-chain bridges, wrapped tokens or liquid staking.
Auditors, rating agencies or other information service providers
Service providers such as auditors and rating agencies that offer services for DeFi projects fall within the scope of IOSCO’s recommendations. This means that the results produced by these companies are subject to standards of oversight and independence. Importantly, this also includes “oracles” that provide off-chain price information essential to DeFi projects; This information is expected to comply with IOSCO standards.
Collective investment instruments
DeFi activities may also fall within the scope of collective investment schemes, hedge funds and other private investment vehicles subject to IOSCO standards for authorization, governance, organization and operational conduct. For example, lending and borrowing protocols and AMMs – pools of crypto assets deposited by holders in exchange for another token representing stake in the pool – can be considered collective investment systems.
Market intermediaries, markets and clearing and settlement
Many DeFi activities fall within the definition of market intermediaries, including exchanges, brokers, dealers, investment advisors, custodians, clearinghouses and transfer agents, all of which are subject to IOSCO standards. For example, aggregators and DEXs facilitate the exchange of crypto assets and offer functions typical of exchanges. AMMs can act as liquidity providers or market makers, such as brokers and dealers; Loan/loan products are likely to require broker or dealer activity if the crypto assets in the pool are financial instruments. and both AMMs and lending/lending products can act as custodians of crypto assets, depending on how the assets are transferred. This custody function, even if anchored in smart contracts, also implies IOSCO standards related to clearing and settlement, securities depositories, trade repositories and central counterparties. Additionally, aggregators that allow users to search for the most favorable terms across protocols are likely to include exchange, broker or dealer activity, or investment advisor activity.
Next Steps
IOSCO is inviting feedback on the report from stakeholders by October 19, 2023, with the aim of finalizing its policy recommendations by the end of the year. Since the DeFi Working Group behind this report consists of staff from the Ontario Securities Commission, the Alberta Securities Commission and Québec’s Autorité des Marchés Financiers, the final policy recommendations are expected to have a significant impact on the development of Canadian securities regulation, particularly with respect to this a cornerstone of the cryptocurrency industry – decentralization.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
Comments are closed.