Pavel Kulikov - Regulatory Taxonomy for DeFi: Global Technology Risk and Beyond

Transcript

hello good afternoon I see a lot of people are coming from the other room possibly we will be having another 51 participants of uh this presentation in the next 5 to 10 minutes we're going to speak about an interesting topic of uh regulatory expectations about State as a risk manager about compliance practices about the regulatory approaches to regulate the things that it's really hot and technically uh not always possible to predict and uh regulate and uh just a second technical is on I think it's on yeah so

this one no no my apologies no yes yeah so not not not um everything would be that clear cut uh subject for regulation decentralized Finance or open finance is one of those you know topics where uh most of the people most of the professionals most of the Regulators would find difficult to regulate sometimes it's not even possible to regulate the things that uh go through uh continents uh in regulatory C

coverage and this should be taken into account when we speak about the compliance and risk management practices for decentralized finance so after a quick introduction we go um and discuss in in in uh more details um those values at risks the agress from the legal systems potentially that defi uh has here to offer um abuse on Market abuse on financial markets um and possible approaches for regulation as well as the issues of complexity and an interesting topic of whether decentralized Finance might constitute an elementary subsystem in

finance or is that beyond the complexity that we can see initially uh so the first uh example of um Finch technology which is you can see here on the screen it's uh it was invented in 1850s 50s pan telegraph was invented by Jaan Celli considered as the first uh example of uh fintech technology uh just to give you an idea uh 25 words to transmit it was over 1 minute about 1 minute and a half to transmit 25 words that's how it worked in the in the 19th century in 1850 consequently um in 196 60s the the

things uh get a little bit better with an introduction of quatron uh you see here on the screen this is the this is one of the First Data Centers for trading in 1971 organized by nasdu National Association of security Securities dealers automated quotations NASDAQ so it was absolutely revolutionary as uh it's emphasized the transition from uh trades from physical tra TR to electronic trades so the 1971 possibly was the first solution closely at least uh reminding us of their current Financial systems and how

they work including fex um and and um Tech fi and re teexs we will speak about these categories a little bit later come on come on in am I waiting for you guys thanks works oh great it works um since that time since the first examples of fintech uh on the markets um the role of Technologies and Innovations has been constantly increasing in uh parallel to the computational power growth um this is was a very revolutionary uh M law introduced in 1965 by one of the co-founders of uh Intel company and if

you are interested in in the topic I do strongly recommend you to attend a session um of our conference tomorrow discussing uh the limitations of application of the Moors law uh the session is taking place I think at about 2:00 it's called dancing with the Moors law so um the role of Technologies is is increasing 1965 the Mo's law is introduced and currently uh over the years we're coming to to definitive framework which could be concluded and named as something easy to remember as an ABCD framework of

Technologies within the three categories of fex tech fs and directex so a goes for artificial intelligence B uh for blockchain c for cloud and D for data plus uh machine learning and Biometrics this is basically these Technologies are the cross cutting enabling Technologies used by most of u tech fin fintech or rech companies so what is uh Finch and what's the difference between fintech and Tech and re tech companies everywhere you could use one of those cross cutting

enabling remember ABCD right Technologies so fintech companies using technology to provide financial services and products in other words technologically enabling Innovation uh such as uh possibly coinbase um it's one of the examples Tech F companies initially Technologic technological technology companies um expanding into the sector of finance and re tech companies um within this classification those companies providing and using information technology in the context of regulatory monitoring reporting and uh performing other functions we will be speaking about the the St treack chair of monitors and some

other approaches to regulation of dii a little bit later here and during this presentation this is for the reading so um defy um and values at risk uh decentral Iz Finance is uh generally uh aiming at um elimination of traditional Concepts at elimination of traditional Finance financial institutions in the traditional sense of this word should be ruled out as as a as an as an Institutional uh cause due to the wider adoption of decentralized Finance so

possibly um in the next next 5 years to come we will see defy at about 10% uh of the global cryptocurrency market this would be the rate market cap in 2023 it was Circa 4% of the global cryptocurrency market uh Regulators lawyers uh philosophers uh freedom of speech activists um all concerned about decentralized Finance being able to to facilitate agress from the legal system so basically there will be no laws applicable to the new systems of uh doing business on the market and taking into account the main aim of defy uh elimination of traditional

financial institutions this is quite alarming isn't it so that's why a lot of attention all over the world by Regulators on both sides of the Atlantic is paid to uh regulation of um decentralized finance and also um the the main difference here is that um existing code based rules traditional finex they should be regulated differently and not all the time supervisors and Regulators are really aware what would be the best way and how they could effectively regulate decentralized Finance because decentralized Finance relies on Lex cryptograph which is absolutely

different uh and it's very difficult to regulate uh if you speak about fintech we all know about regulatory Arbitrage okay I launched the company uh with a license on the on the in the offshore jurisdiction or somewhere in Gibralter and we provide services to the American residents living in in Europe only etc etc uh different tactics are used to evade the application of laws and to achieve a license and to to play with different Regulatory regimes and rules soal regulatory Arbitrage and this is traditional fintech companies and if we speak about decentralized Finance of course the opportunities are enormous so

most of the authorities most of the Regulators they would be thinking how we can uh what would be the solutions and how we can achieve the regulatory equilibrium trying to catch uh the decentralized finance Technologies as a subject um for regulation and that's why the necessary risk assessment practices usually um implemented and and developed as a help for Regulators to to to develop a regulatory approach so um the main questions would be how to regulate decentralized Finance to prevent Market abuse including insider trading in Market manipulation uh if you remember

maybe who knows the who who who've been a victim of the uh Celsius CL glowback Sal everybody knows the company salus right so inside of trading and Market manipulation um and how to protect those values at risk so uh Lawrence uh leic uh considered that there are four uh technological advances uh four excuse me four values which are at risk due to technological advances intellectual property uh had to protect had to who had to monitor uh violations of trademarks patents uh and and similar

abusive practices on the market privacy free speech and uh also sovereignity um yesterday one of my friends from the big from the big uh Banks um was uh was complaining that he couldn't he couldn't get um a free speaking slot at one of the side um events of the conference um but which is like reason reasonable to to expect from a big bank because usually they are paying when they're participating in this or another event and I told him that U you know Free Speech uh doesn't apply the right to speak for free he was laughing his guts off so um free speech is still one of those values which is um at risk due

to technological advances in accordance to leic and uh of course here uh we have to mention scale without mass limits so there is no clear identification for particular um projects using decentralized Technologies and it's very difficult to impose uh tax on those companies it's very difficult to impose um uh an efficient tax policy on decentralized finance projects it all affects the global tonomy for decentralized finance uh at the same time making us closer to the question can a true state really exist if we couldn't tax some of the commercial

activities which in in theory should be taxed of course because this is this is commercial activity and if you're using a defi protocol uh or layer to earn money you have to you have to pay taxes otherwise a state could not exist so um for Defi and how to regulate defi generally is a question of if there should be one regulatory Authority established let's say in or in Geneva which would be entrusted with the tasks of regulating uh decentralized Finance all over the globe technically is it possible what do you think so uh like in

the same manner we see the weather forecast you know so just this this is this data is accumulated and then you can you can watch it on on CNN on Swiss channels uh Swiss TV channels you know whatever so possibly we we we have one um organization uh similar to the Past proposal of the Global Tax organization and it monitors Financial flows spillovers all the correlations and similar so and I was thinking how how this uh cockpit of this financial regulator Global Financial regulator might look like so I think this is this is a very realistic picture so this is the cockpit of the Global

Financial regulator and it it goes like okay I see another FTX Scandal coming here there's not enough liquidity there's like there's some turbulence here on the market you know in in U in Hong Kong so let's take some action and and uh and and proceed but this is unrealistic of course so this is more realistic this is concept and this is quite revolutionary It's A New Concept it's called embedded super Vision so embedded supervision is basically um here there are two layers uh two blockchains this is non-financial ledger this is financial industry Ledger uh all the information is getting accumulated together so and uh classification

includes transaction level internal risk modeling and institution to institution Ledger bank to bank Consolidated exposures as well and other risk rated bases so after in information after these ledgers non-financial and financial uh read the thata access management uh provides Regulators the possibility to to access the data and to adapt this in another decision uh regulator intervention or or similar um possibly um another way to do it is to implement a smart contract for The Regulators here

to implement a solution for regulation of uh of any particular transaction involving uh non-financial institution and financial institution why a smart contract also a very reasonable Prospect so this is much more realistic than establishing a Go Global you know Star Trek uh chair of um regulator technically uh regulation is about a adopting one of one of the tools and methods and here most likely the three methods the three uh tools um come to attention the first one is using

existing regulatory mechanisms such as uh the recent recent sack um last month in March 2024 uh there was a sec um Securities Exchange Commission inquiry regarding ethereum proof of stake upgrade so they considered reward tokens uh resembling investment contracts and based on decision on 1946 and H in cor they said okay this could be classified as Securities so this is an example of implying implementing an existing Regulatory and legislative mechanism for something new and unknown so it was an upgrade it's very recent information March

2024 uh second possible approach is to implement selective adjustments as demonstrated on the example of the SS uh U the S act on the adoption of federal law to development and distributed electronic R technology and uh the last option is to adopt new tools something new like such a usually the last tool is aimed at controlling the network so regulator and not on American Regulators Regulators all over the world they have different possibilities and new tools ultimately and in most cases are aimed at controlling the exit or entrance points to the network such as

bit license bit license um is an example of controlling the entrance Point without getting a license you are not able to undertake particular set of activities right uh the same as uh with uh European Union mik regulation um the third part of uh this presentation describes uh defi as an elementary subsystem and finance should we agree or disagree with the elementary nature and character of of defi this is important as far as complex things imply different set of behavior so if we

consider Defi and defi is is is much more complex replying this question it's not Elementary subsystem in finance we see that um some particular uh initials attributed to a complex framework would be attributable to defy as well so this would be um possibility of um coding mistakes of course uh second uh would be the uh the higher likelihood of unpredictable behavior on the network so defi decentralized Finance open finance in finance uh is not an elementary

subsystem it looks like it's a uh complex uh framework and if you would like to see more you could I recommend reading uh MO is different by Anderson science 1972 on this topic so we get to understand um the concept of U complexity much much much easier um this is very interesting uh to note that uh the fourth Industrial Revolution embracing all these cross- cutting Technologies is the first Industrial Revolution in the history of mankind directly affecting the sector of Finance never before any previous industrial revolutions never affected the the the

sector of finance and um as a as as a result uh the character of interactions with these new technologies affecting the sector of Finance uh as far as it's these are new these are Technologies uh never been used by the humankind before we saw the the progressive development from 1960s from quatron right uh and voluntarily and involuntarily uh usage of Technologies um relates to under assessing or working with risks and that's why um if uh the the more the more the more Society works with uh with Technologies

the more Society likes the Technologies and the less Regulators would be assessing those Technologies as uh as Sinister as bad bad risks defy Innovation possibly uh started with with the product renovation as as in most uh of of the new things uh in in um in our in our society embraced by the previous industrial revolutions so here um the the first the first uh manufacturer of of of cars uh in America

Ford they were more uh concerned about uh product Innovation until a particular moment in time and it's it's it's uh similar for all the Innovative Technologies similar for all the sectors of of of of um of the global economy and then after a particular level of product Innovation is reached so in terms of uh automobile industry this would be the more competitive designs uh more more interesting um um elements of Decor of of of of a car and similar only after that time the the producers and in our case the developers

and coders would start to think about the process Innovation how we could make it more user friendly and how we could um get a new uh layer protocol to be less uh energy consuming to be be more efficient basically all these features and qualities related not to product Innovation but to the process Innovation so these are the different stages you see them here this is the fluid phase then there is Transitional phase and then there is specific phase and uh the the common framework we've been talking about um on on the

previous slides the ABCD right ABCD framework of enable Technologies including blockchains and decentralized finance as crosscutting enabling Technologies such as blockchain is currently approaching the dominant design stage and the product design model uh will be um most likely dictated by regulation because in the history of a mankind all the Innovations pass through these stages and on on every stage and on every sector if uh this or not invention or sector would uh go to the mode of product um uh design uh dominant design stage with the product design this would be dictated by

regulation so it was similar to all the sectors in the past so there is nothing new and we all remember you know the nominon product design for example it's the the the quity keyboard this is the one of the examples of the dominant product design also uh uh the Dos operating system uh this are dominant product design they do little in the way of breakthrough but they provide and encourage that so much sort standartization so uh defi Innovations most likely would be limited to dominant prct design on the market I'm just

getting very quickly through the uh through the second half of the presentation I don't want to keep you uh here so uh regarding the risks it's important to emphasize once again that the voluntary and involuntary activities they implying different uh approach to risks so if I would tell you you going to receive your salary in Bitcoins tomorrow starting from tomorrow you would say well Bitcoin well salary I want to do it when I want to do it right but if you would tell me that your salary would be in Bitcoins only starting from tomorrow you would start thinking okay I want to do maybe I would use a cold wallet well maybe I don't need Bitcoin I want eth well I don't

know I'm not sure so depends on whether this uh is voluntary or involuntary activities so different approaches to risks right um and these concerns are the guiding principles for Collective action uh by Regulators in particular this is how the the the risk assessment is conducted basically uh a lot of developers a lot of coders they've been asking me what by The Regulators adopting this decision or adopting that decision so this is the The Matrix generally used by Regulators all over the world from the 1960s to approach the risk so there are two factors first is that we need to understand to what extent it's unknown risk or known so

unknown risk would be microwave or winds for example or electric Fields uh depending on the year and uh second second factor is to what extent it's a dreadful risk or not um so on the example of the vaccine uh risks it possible to to classify the risks here okay so we are wrapping up um particular conclusions uh would include that um upon certain conditions and only upon certain conditions such as stability of Technologies when we would be able to receive a uh technical audit for technology and privacy and compliance by

Design framework when the privacy and compliance solutions would be embedded in our product from the beginning at the factory not at some later stage upon the product Lounge we would be able to speak about uh Technologies being able to substitute traditional financial institutions including Banks so this is basically I think the the future of uh of uh of the regulatory Paradigm for for the ji thank you very much for your attention sorry was not so much time ah had but thank you very much for your patience right thank you very much P questions questions I don't know why the microphones decided to go a bit quiet there we are thank you very much pavl and uh we have time for a very quick Q&A if there's any questions from the

audience briefly one question none at all I'm sure one there one question there we go hello sir go on go on running up he's on the way elev music it's coming thanks are you are you not con concerned that kind of the The Branding of defi in this context is not real defi like you spoke about FTX you spoke about Celsius they're not defi they're gateways that are ultimately unlicensed Banks but if we have this regulatory framework then real defi protocols like a Moro Oiler yarn they're being branded under this regulatory framework when in

reality they are real Define do not need to be regulated but the people that are creating the gateways they're not defi they should be called cd5 do not think this regulatory framework can impact real defi protocols yeah well the the of course the FTX is is well it's not even closer to to a defi project not even closer to a very popular currently business model of you know combining centralized and decentralized exchanges Etc the Celsius yes uh neither but um the framework for Tech FS again you know we're coming to a standpoint when uh whether you need to consider defy as a complex thing as a complex uh uh field within the within the field of financial you know services

in general implying that we have coding errors that we have unpredict uh some some features of unpredictability and unpredicted behavior because on the complex markets on the complex uh on the complex structures and the complex architecture there is always a higher level degree of uh the mistakes to to possibly to be made and also the unpredictability that behavior that rate in a complex system is like five times three four five times higher than in any other uh sector and as we discussed the cross cutting enabling Technologies they're not in they are they're cross cutting they're not precisely as in the

same similar manner as decentralized Finance they are not precisely uh fit into a category of tech or fintech or rech so if we speak about uh FTX then yes it's a it's a it's a fintech uh company if we speak about defi it's a cross cutting enabling technology which might be used by all the all the business models possible facilitating the same uh one aim of eliminating traditional financial institutions so the I'm just to emphasize that it doesn't matter uh how we call it and it doesn't matter uh the

past experiences well it matters but not to that extent when we do the the risk assessment so when we assess uh the risks as a regulator based on the Matrix of the risk assessments from the 1960s we still see that um and you will see that all the Technologies embraced by the fourth Industrial Revolution including uh blockchain they are will be implying the same level of assessment because they would still constitute the same level of risk so what you're saying when you're emphasizing that defi differs well I agree uh differs to to to a better extent but you have to take into account that the market share of defi is not

that big like currently about 4% of the all crypto crypto uh Global turnover so when it will be 50% when it will be 60% then you will be saying well okay you remember that case of they you know defy protocol you know it went bankrupt this one and that one I'm sure because it's like five times more predictability in terms of bankruptcies and and malfunctions on the market yes I don't know I I really tend to disagree with you here um I think there is I don't really want to be pictured I think there is clear separation and I think the assumption is unpredictable is completely false um defi is open source by default you can see all of the protocols how they function you can

validate this yourself there's already regulatory bodies that's called the community that will check this code and see if this is bad or malicious so I think there needs to be a clear distinction because if there's not a distinction this words and these presentations will impact the real def community and not people that are celsus and FDX it's completely different companies FTX and Cel is a private you cannot see the code base defi you can it's very different yeah yeah you're absolutely right in this as well you know by the smart contracts and the system of decentralized uh communities that that provides a lot of clarity but still in 1970s in 1980s and 1990s people were still thinking wow you know we we

we invented you know uh uh this or another invention and and it it won't affect the the Free Speech it won everybody was that but unfortunately it affects unfortunately just to interrupt the only thing that is an open source is our time schedule and Free Speech doesn't exist in this stage today unfortunately when we run over speech that's not the Free Speech uh all conversations and questions though of course everyone will be outside and available and there will be beers later on to continue the deeper conversations like these ones but I'd like everyone to give everyone pavl a thank you for being on the stage as well thank you thank you for being here