Polygon Labs, the primary contributors to the blockchain scaling network Polygon, released a research paper on Monday outlining their recommendations for government regulation of the DeFi (Decentralized Finance) sector.
Various governmental entities, including the Treasury Department and the U.S. Senate, have been vocal in their concerns about the potential exploitation of cryptocurrencies for money laundering and terrorist financing, particularly in the context of utilizing smart contracts.
Regulating Cryptocurrency and Blockchain
According to the paper, the existing legislative efforts aimed at safeguarding financial integrity within the DeFi sector miss the mark.
The paper’s summary document points out, “Current laws and regulations concerning financial integrity typically target intermediaries, specifically those designated as ‘financial institutions’ under the Bank Secrecy Act (“BSA”),” and goes on to state, “These current regulations are not well-suited for intermediary-less, blockchain-based software systems like decentralized finance (“DeFi”).”
The authors of the paper include Rebecca Rettig, the Chief Legal Officer of Polygon Labs, Michael Mosier, the former acting director of FinCEN, and Katja Gilman, the Public Policy Lead at Polygon.
This viewpoint aligns with the Treasury Department’s stance, which stated in its Illicit Finance Risk Assessment of Decentralized Finance last year that DeFi services that are sufficiently decentralized “may not be explicitly subject to AML/CFT obligations.”
How Polygon Labs Proposes to Regulate DeFi
Polygon has put forward a three-step solution to address the legal challenges surrounding DeFi regulation. Firstly, they suggest the creation of a legal definition for “System Control Persons” or “SCPs.” These SCPs would be individuals or entities possessing unilateral authority to control third-party value within a blockchain-based software system. Under this proposal, SCPs would be subject to standard Anti-Money Laundering (AML) requirements, even if the system identifies itself as “decentralized.”
Secondly, systems without SCPs, considered “genuine DeFi,” would receive a distinct classification as “critical infrastructure.” Oversight for such systems would be provided by the OCCIP (Office of Critical Cyber Infrastructure Policy).
Lastly, businesses engaging with genuine DeFi, while still obligated to safeguard U.S. national security interests, would not be subjected to regulation as “financial institutions” under the Bank Secrecy Act (BSA).
This approach differs from the suggestions made by Senator Elizabeth Warren, who proposed subjecting crypto firms to the same AML requirements as traditional banks. Senator Warren has also raised concerns about North Korea’s potential use of crypto to fund its nuclear program.
In summary, Polygon’s proposal aims to align the policy goals of the U.S. financial integrity regime with the technological realities of blockchain systems. It seeks to provide answers to questions posed by regulators and policymakers regarding the regulation of DeFi.