A ‘kitchen sink’ approach won’t work if the 118th Congress wants to fix its DeFi problem

December 23, 2022, 12:00 PM UTC
Sen. Chris Van Hollen (D-Md.) and Sen. Elizabeth Warren (D-Mass.) speak during a Senate Banking, Housing, and Urban Affairs Committee nomination hearing on Nov. 30
Sen. Chris Van Hollen (D-Md.) and Sen. Elizabeth Warren (D-Mass.) speak during a Senate Banking, Housing, and Urban Affairs Committee nomination hearing on Nov. 30.
Amanda Andrade-Rhoades/Bloomberg via Getty Images

In 1959, then-Sen. John F. Kennedy remarked on America’s road ahead: “When written in Chinese, the word ‘crisis’ is composed of two characters—one represents danger, and one represents opportunity.” Kennedy’s choice of analogy for his time is perfect for ours when it comes to describing the government’s view on decentralized finance—both the potential threats and its potential for good.

This dynamic was already in place before the cinematic collapse of FTX and the recent arrest of Sam Bankman-Fried. Unfortunately, the fallout from the exchange’s implosion has pushed the previously urgent regulatory debate on DeFi further off screen.

While Congress and relevant agencies are focused on punishing the now-infamous exchange and its founder, the fundamental questions around a workable policy approach to decentralized finance remain unanswered. As the 118th Congress looms and the urge to “do something” about crypto grows, it’s vital that federal authorities bridge their knowledge gap and approach DeFi with fit-for-purpose policies.

Recent hearings in the House Financial Services Committee and the Senate Banking Committee offered a mixed bag as Congress contemplates how to proceed in drafting legislation to regulate crypto. Certain House members, notably Reps. Tom Emmer (R-Minn.) and Patrick McHenry (R-N.C.), differentiated between the traditional corporate fraud perpetrated by Bankman-Fried and the technology that powers crypto networks and exchanges. 

On the other hand, Sens. Elizabeth Warren (D-Mass.) and Roger Marshall (R-Kans.) introduced what is perhaps the most punishing anti-crypto bill yet prior to the subsequent Senate hearing. The headline-grabbing gulf in how each understands the problem revealed by FTX’s collapse is notable, but beyond the public relations there are more fundamental questions that have been overshadowed by this recent blowup.

Prior to FTX’s collapse, one of those big questions was how centralized, custodial exchanges might be regulated, and whether those regulations should apply to decentralized exchanges as well. Figuring out what an effective policy response to decentralized finance looks like is a hard problem to solve, one that certainly can’t be solved by bolting on old definitions to still-evolving protocols.

Applying the same requirements to centralized and decentralized exchanges, intentionally or not, would be akin to applying the same requirements to airplanes and cars because they’re both used for transportation. Just because both modes convey you to a destination does not mean they should be bound to the same set of rules. Legislation that arises in the next Congress must be tailored to treat DeFi uniquely, with an understanding of its benefits, weaknesses, and potential.

The CFTC’s ongoing effort to sue and serve a DAO for the first time ever demonstrates the tricky questions that new forms and technologies of digital coordination raise—questions that our current regulatory regimes are ill-suited to answer. Similarly, the Treasury Department’s decision to sanction immutable smart contracts ignited profound debates about the relationship between code and free speech, and the protections that should be afforded software development.

Our representatives in Congress and the heads of our national regulatory agencies were struggling with the complex questions raised by the rise of DeFi before the collapse of FTX, the suit against Ooki DAO, and the addition of smart contracts to the sanctions list. There is no doubt that a fit-for-purpose policy approach will take time and imagination to develop and refine.

It cannot be that simply because there is a red-hot desire to act in response to the sins of nefarious actors that DeFi gets wrapped up in a “kitchen sink” response. Now is the time to take stock of the core questions, design legislation that provide fitting answers, and create policies that are responsive to DeFi protocols’ unique functionality, risks, and promise.

Miller Whitehouse-Levine is the policy director at the DeFi Education Fund, which explains decentralized finance to global policymakers and advocates for decentralized financial infrastructure. Prior to joining the fund, he led the Blockchain Association’s policy operation and worked at Goldstein Policy Solutions on a range of public policy issues, including crypto. The opinions expressed in commentary pieces are solely the views of their authors and do not reflect the opinions or beliefs of Fortune.

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