House Republicans are pushing their newly-released draft crypto bill as a major inflection point. They argue that it provides long-overdue regulatory clarity to the digital asset space. However, buried underneath its seemingly benevolent provisions is a dangerous loophole. This loophole would by accident kill the decentralized finance (DeFi) industry as we know it. Are we really that hungry for regulatory certainty that we would trade it away to eliminate the one thing that breathes innovation and creativity into this space, the unknown?
DeFi's Definition Problem
The bill’s intent is to create a workable definition of key terms like “digital commodity” and “decentralized governance.” The devil’s in those details and that’s where the real challenges lie. Even something that seems simple, like defining what “decentralized governance” means, could be construed to disproportionately exclude most of the current DeFi protocols out there. What if a protocol that at first truly appears decentralized changes or develops in such a manner that doesn’t fit the bill’s definition any longer? Does it now in some way become subject to a new and different set of regulations, likely choking its innovation and creative growth in the crib? This is akin to putting a very dynamic living thing into an ironclad container.
Consider pioneering days of our modern internet. Just think how crazy and misguided Congress would have been if they tried to define “website” or “online forum” back in 1995. Without improvements like those, we’d still be on Geocities 2.0. Otherwise, we never would’ve had the incredible consumer experiment of Web 2.0 or the democratic possibilities that Web3 holds. The same danger exists here. The bill’s definitions are noble in intention, but might inadvertently codify ivory tower definitions that uphold the status quo. This could negatively affect investment in building highly innovative DeFi apps.
"End User" Exception? Or End of Innovation?
The bill carves out an exemption for “end user distributions” produced by mining, staking or user rewards. On its face, this seems like a positive development, providing regulatory clarity that these activities should not necessarily be treated as securities offerings. This exemption would directly lead to a two-tiered system. How do we consider all the new, novel distribution models that are not easily classified into “mining,” “staking,” or “user rewards”?
They sell governance tokens and airdrop them to users in sophisticated ways including contribution-based airdrops and varying liquidity mining programs with complicated vesting schedules. If these mechanisms are not included under the “end user distribution” exemption, they are subject to harsher securities regulations. This not only places them on an uneven playing field, but stifles their ability to experiment. Are we inadvertently privileging the well established proof-of-stake blockchains at the expense of the more radical, experimental DAOs that might actually reshape governance?
This is what the early music industry used to be like. Think back to the days that Napster was exterminated because it was labeled as a danger to existing record labels. Even as we acknowledged the value of copyright protection, this crackdown on Napster, even if legally justified, killed off innovation in digital music distribution for a decade. We should avoid making the same mistake with DeFi.
Self-Custody Safe? For Now, At Least
As it currently reads, there are provisions of the bill that would work to protect self-custody. Second, it prevents the Treasury Department and FinCEN from preventing Americans from controlling their own crypto. This sounds great on the surface. Let's dig a little deeper.
The bill as currently written does not explicitly refer to or clarify the tools that individuals may use for self-custody. What if future regulations begin to regulate certain kinds of wallets or dictate that certain self-custodial actions must be KYC/AML compliant? The bill does little beyond preventing outright bans. It does open the door to more targeted forms of regulation that would nevertheless make self-custody far more difficult and less private.
Take, for example, the debate on privacy-enhancing technologies such as coin mixers. Although some consider them vital to shielding financial information, some just as strongly believe they exacerbate our country’s criminal activity. If regulators push or require broad action against all coin mixers, they will make it much more difficult for Americans to meaningfully protect their crypto. Second, this would undermine much of the privacy and security that self-custody provides. The road to regulation is indeed paved with good intentions, yet we must be careful to avoid unintended consequences. Are we really making changes to protect self-custody, or are we just moving the goalposts?
The crypto bill moves us significant steps closer to that clarity. We need to take a much harder look at its details and possible loopholes before it goes to law. Otherwise, we will all, unfortunately, run the risk of unintentionally undermining the one DeFi sector it is supposed to be regulating. The future of finance depends on it.
