DeFi & the FATF: Is It Regulated? KYC & AML
- DeFi operates by executing transactions via blockchain code, eliminating the need for intermediaries in financial services.
- Regulatory events in 2022 included a protocol-level sanction action against DeFi platform Tornado Cash by the OFAC.
- The FATF's regulatory approach focuses on identifying Virtual Asset Service Providers (VASPs) within the DeFi sector and applying AML and CFT obligations to them.
- The EU is considering a shift towards an activity-based regulatory approach for DeFi, which would involve regulating the connections between regulated entities and DeFi platforms, smart contract features, and the project teams behind DeFi applications.
- Both the FATF and the EU plan to continuously monitor and assess developments in the DeFi sector.
[1] Financial Action Task Force (FATF) (2021). Updated Guidance for a Risk-based Approach to Virtual Assets and Virtual Asset Service Providers, p. 27, para. 67.
[2] FATF (2021). Updated Guidance for a Risk-based Approach to Virtual Assets and Virtual Asset Service Providers, p. 28, para. 69.
[3] EU Parliament (2023). Markets in Crypto Assets, p. 6, para. 22.
[4] FATF (2022). Targeted Update on Implementation of the FATF Standards on Virtual Assets/VASPs, p. 20, para. 34.
[5] EU Parliament (2023). Markets in Crypto Assets, p. 141, para. 1(a).
[6] EU Parliament (2023). Markets in Crypto Assets, p. 139, para. 2(t).
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FAQs
FATF states that a DeFi software application isn't inherently a VASP. Instead, entities with "control or sufficient influence" over DeFi, such as those with ongoing business relationships, profiting from DeFi, or having parameter-setting abilities, should adhere to AML and CFT obligations. However, FATF admits pinpointing such entities can be tough, and in certain situations, a VASP might not be present. Holding governance tokens doesn't automatically deem someone a VASP unless they can influence the protocol substantially.
The Crypto Travel Rule seeks to assess the approaches of FATF and the EU towards DeFi. While FATF's stance revolves around the interpretation of VASP definitions, the EU emphasizes the dynamic and decentralized nature of DeFi, proposing various access points for effective regulation.
The EU believes traditional regulatory approaches might not fit DeFi's decentralized environment; hence, a shift to activity-based regulation is considered. On the other hand, FATF works on a case-by-case basis to determine if an entity within DeFi qualifies as a VASP based on their standards.
For FATF, DeFi software applications do not inherently qualify as VASPs. It's the entities with significant control or influence that may be considered. EU's perspective is that fully decentralized crypto-asset services fall outside the regulatory scope unless controlled by natural or legal entities.
DeFi regulation is crucial as the sector experiences rapid growth with increasing interest from investors. Effective regulatory frameworks ensure that the sector can expand safely, minimizing risks while providing clarity and confidence to both retail and institutional investors.
Regulation of DeFi offers multiple benefits: It ensures investor protection, provides clarity for DeFi developers and users, minimizes potential financial risks associated with DeFi exploits, and fosters a more trustworthy and stable environment for the sector's continuous growth.
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