For DeFi to Flourish, Right-Size the Regulators

Shakespeare wrote in "Henry VI:" “the first thing we do, let’s kill all the lawyers.” If you work in DeFi in 2023, you’ve likely heard similar grumbling directed at regulators. Gary Gensler may as well be the King of France.

This op-ed is part of CoinDesk's State of Crypto Week sponsored by Chainalysis. Matt Luongo is the CEO of Thesis, a venture studio and auditing firm which has built a family of projects across fintech, DeFi, infrastructure, and zero-knowledge cryptography such as Fold, tBTC, Taho, Etcher and Embody.

The fundamental complaint is the same as in the Bard’s day: that “parchment, being scribbled o’er, should undo a man.” Or in this case, an industry.

See also: IRS Proposed Rule on Digital Asset Broker Reporting Could 'Kill' Crypto

I’ve spent years building and developing projects in Web3. This technology can make billions of people’s lives safer, richer and easier to navigate. So I share the frustrations of many at the recent heavy-handedness of regulatory bodies.

This year has already seen a broad assault on crypto, with the U.S. Securities and Exchange Commission (SEC) suing both Binance and Coinbase and refusing to admit defeat in its fight against Ripple. The case against Coinbase is particularly baffling, since the same SEC that’s now accusing the crypto exchange of malfeasance only a few years ago approved its Nasdaq listing.

In the U.S, the approach seems to be to enforce first and figure out the rules second. This must change.

But where does the change start? How can this challenge be overcome?

Tech is about disruption, and some argue that decentralized tech itself will eventually make regulators obsolete. If rules can be written into code, the argument goes, human enforcers and the biases they bring will no longer be needed. Trust me: if it was possible to replace the SEC with code, I would in a heartbeat.

But it’s not possible. The world needs regulators. It just needs to right-size them.

We need to start with a simple question: what is regulation for?

Constructive regulation helps ensure that people do not abuse their positions to cheat, steal or harm others. Enforcement should ensure that everyone is playing by the same rules. At its most basic level, regulation should keep ordinary people safe from bad actors and allow marketplaces to operate as beneficially as possible.

The need for regulation highlights a fundamental truth: technology is amoral. This is true of all tech, from fire to airplanes and AI to DeFi. Its morality is determined by the people who use it. And there are as many motives as there are people.

The stunning unraveling of FTX last year, and the failure of several banks earlier this year, demonstrate the multifaceted nature of risk. FTX was, based on available evidence, a classic Ponzi scheme. Bank failures were caused by a panic that spread through social media. But in each case, a crisis was precipitated by human activity rather than anything inherent to underlying technology.

And since human action is what drives these crises, it’s human behavior that must be regulated.

If crimes are committed, perpetrators must be held accountable. At the same time, honest actors should be allowed to innovate. As a rule, history has shown that adopting and regulating, rather than opposing, new technology benefits society at large. This constructive approach to innovation is a major reason wealth, educational attainment and life expectancy have all risen so quickly over the past century and a half.

Most people get this intuitively. They object not to regulation as such, but to the arbitrary exercise of bureaucratic authority. Excessive regulation is a drag on innovation and economic activity. It’s practically self-evident: who doesn’t know how maddening it is to have your time wasted dealing with an officious employee at the DMV?

Good regulation strengthens the markets by establishing clear rules of the road and enforcing them efficiently and predictably. What does this look like in practice?

See also: Defiant by Default: Why Regulators Must Understand, Not Police, DeFi

First, the scope of regulators’ oversight must be clearly defined. They should not have arbitrary authority to block the march of progress or to favor certain industries while smothering others. They should be empowered to stop bad actors while enabling technology to develop and flourish. And where possible, they should just let the tech work.

Here’s the exciting part: as DeFi matures, this should be an increasingly obvious proposition.

Decentralization and on-chain transparency lend themselves to regulatory efficiency. If a condition is met, a corresponding action is automatically executed; there is no space for manipulation by a human. The more we build out truly decentralized systems, the more the role of regulators will organically shrink. This will take time — the internet wasn’t built in a day. But gradually, the need for humans to regulate technical processes will fade.

Regulators will probably always be necessary to police human activity. But as decentralized technology matures, they should get comfortable letting the machines take care of themselves. Truly helpful regulation means understanding where to step in — and where not to.