Government's can't regulate DeFi, can they? It's too wild and uncontrollable.
DeFi, or decentralized finance, is the set of anarchic financial tools built on top of the Ethereum blockchain. These tools mimic what you'd see in the real world. MakerDAO is a decentralized bank, Compound and Aave are decentralized lending marketplaces (like Lending Tree), and Uniswap is an exchange, like the NASDAQ, except on a blockchain.
Unlike regular financial institutions, none of these Ethereum-based institutions operates with a license, registration, or a permit.
MakerDAO, for instance, recently financed some real world mortgages by issuing U.S. dollar deposits. So it seems to be operating as a commercial bank. However, MakerDAO hasn't secured a banking license from any of the world's biggest banking regulator, say OSFI, the FCA, OCC or any of the 50-some U.S. state financial departments.
Because DeFi is so new, it operates in a grey zone. On the one hand we can argue that the collection of smart contracts and governance mechanisms that comprises MakerDAO probably ought to do the bankerly thing and apply for a banking license. On the other hand there doesn't seem to be an express written rule about smart contracts on Ethereum requiring licensing.
But lets say that a bank regulator made an explicit announcement that MakerDAO and other DeFi tools acting as banks all had to get a license. Could MakerDAO get away without complying?
Because tools like MakerDAO are built on blockchains, and blockchains are too wild to be controlled, the theory is that there is no way for a regulator to exert sufficient pressure on the tool owners to instigate change. MakerDAO's owners will just laugh and keep doing what they've been doing. So would Aave, Uniswap and Curve. Smart contracts are just bits of unstoppable code, after all. They can't be punished for non-compliance.
So DeFi is not only unregulated, goes the theory. It is unregulatable.
I think regulating DeFi would be fairly easy. U.S. regulators just announce "thou art now regulated and must comply with the following set of rules" and that'd be sufficient. Pretty soon, the biggest DeFi tools would fall into line.
Much of a regulator's leverage is exerted indirectly, via users. Even if the operators/administrators of major DeFi tools are against the idea of falling into line, their users will drag them towards it.
Right now, the status of most DeFi tools is undefined. Users aren't doing anything illegal by interacting with them. They aren't doing anything legal, either. So people just shrug and use them. But regulation would change that status. Suddenly, tools and their users would be placed squarely in the illegal category, albeit with a pathway to legality.
U.S.-based financial institutions make up the largest group of financial tool users. And financial institutions generally prefer to avoid doing unlawful things, say like connecting to illegal financial tools. Retail customers, a less important customer group, are less picky. Some will do illegal things. But they mostly prefer to be on the side of the law.
That means any decentralized financial tool that wants to continue capturing the two biggest pools of money —institutional capital and licit retail funds—will have to make it legal for these users to connect to them. The proper licenses will have to be secured, regulatory-compliant smart contracts created, and a mechanism devised for users to port over. The biggest DeFi tools will choose to conform... if they want to stay the biggest.
Sure, plenty of DeFi tools won't bother complying with regulation. But these tools will only end up appealing to an underground clientele, and that's always going to be a smaller market than the pool of licit users.
Network effects will be on the side of regulators. Read on...
A portion of DeFi users (traders, borrowers, liquidity providers, token issuers etc) will be indifferent between lawful DeFi tools or illegal tools. They just want to use the best ones. These agnostics will probably end up using the regulated tools by default. There is much more licit capital than illicit capital. And so regulated DeFi tools will have the best liquidity, tightest spreads, and lowest fees. The go-to choice will always be regulated DeFi.
This network effect operates in the same way as the U.S. government's decision to impose Daylight Savings Time. You may hate DST or you may be indifferent, you may not understand it or you may have forgotten about it. But come March 14 and November 7 you unfailingly move your clocks forward or backwards. Using a different clock than everyone else is just too much of a burden. Likewise, if the government announced a DST equivalent for DeFi, much of the space would get dragged, perhaps kicking and screaming, into a state of being standardized, or regulated. Remaining out-of-standard is too costly.
Regulated tools would probably stop interacting altogether with illegal tools. DeFi, currently an open playground, would further balkanize into underground DeFi and legit DeFi. Choosing underground DeFi would be an increasingly costly choice, since one risks being forever cut-off from legit DeFi.
So DeFi, or at least a big part of it, can probably be regulated. However, there will always be an unregulatable anarchic edge. Good luck stopping an Ethereum-based ponzi scheme, for instance. These are blockchains, after all. And they are open to everyone.