ConsenSys warns CeFi and DeFi pose different risks in FSB response

The global financial trendsetters at the Financial Stability Board should prioritize the financial stability risks posed by centralized crypto entities before addressing DeFi, according to blockchain software developer ConsenSys.

“Risks relating to programmable blockchain and DeFi are novel, less understood, and cannot be addressed by a ‘one size fits all’ regulatory approach,” regulatory director Bill Hughes and legal counsel Natalie Linhart wrote to the FSB, in a report published on the FSB's website in January and due to be released by ConsenSys on Friday. 

Hughes and Linhart heeded to the FSB’s call for responses on their October proposal for an international framework on crypto regulation. Their response was sent the FSB office in Basel, Switzerland in Dec. 2022, and will become public later on Wednesday.

“In our view, the most effective way to safeguard financial stability and protect users would be to focus, as the first step, on the risks posed by centralized issuers and providers of crypto asset services (including players that are ‘decentralized in name only’),” they wrote in their response.

The financial agency promised to respond to all industry input later this year, and lay out their final guidelines for regulators overseeing the crypto industry around the world.

Focus on regulatory outcomes

The FSB's October report said that effective regulation should follow a principle of “same activity, same risk, same regulation.” Regardless of whether a crypto asset would be characterized as a security, payment method or another financial instrument, crypto should be “subject to equivalent regulation” as the traditional financial function.

ConsenSys’ regulatory duo reject this approach, as it could lead to rules that are ill-suited for DeFi compliance. “We caution against applying the same rules to CeFi and DeFi activities that are, at first sight, similar, but function differently and pose different risks to markets, consumers and financial stability.”

The ConsenSys response letter pointed the G20 bankers at the FSB toward the European Commission-funded study published last year about various DeFi supervision possibilities. The academic report on bespoke regulatory proposals for DeFi laid out a taxonomy of approaches depending on the kind of activity.

The authors also pointed out that regulators may be interested in embracing decentralized solutions. “One of the biggest benefits of decentralized governance, from a regulatory perspective, is the transparency of decision making.” 

'Respectfully disagree'

In the FSB’s invitation for criticism on the report, the blockchain development firm had a few points of divergence. For example, when it comes to staking service providers and delegated proof of stake, Hughes and Linhart "respectfully disagree" with the FSB assessment that the providers “can resemble issuers (e.g., of interests in a pooled vehicle or other investment opportunity).” They clarified that staking rewards are generated through a protocol in the validation process, not by the service providers.

A clash between staking service providers and regulators erupted last month when the Securities and Exchange Commission targeted crypto exchange Kraken, settled with a $30 million fine. The shockwaves sparked a heated debate about where to draw the line between tech and financial services.

Software developers should also not be categorized as service providers for regulators, according to ConsenSys. "A clear distinction must be drawn between the development of the underlying technology that supports a product or service, and the actual product or service that is offered to the public," the authors wrote. 

Enforcement of anti-money laundering laws on decentralized protocols puzzled the industry after U.S. authorities sanctioned crypto mixer Tornado Cash last August. The U.S. Treasury accused Tornado Cash of laundering money for "malicious cyber actors." Tornado Cash developer Alexey Pertsev is still detained in the Netherlands awaiting trial.

Correction: story updated to show Financial Stability Board's response was published in January.