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With Decentralized Finance and Sanctions Come Crypto Regulation

April 14, 2022, 8:45 AM

It was bound to happen. The cryptocurrency template has been copied. After all, if an alternative to money can be acquired and traded independently of central banks, why can’t financial instruments be acquired and traded independently of brokerages as well? That is the idea behind what is euphemistically called decentralized finance, or DeFi.

Say, for whatever reason, you want to acquire, trade, and store crypto without having to engage with an exchange. Or deposit your crypto while earning interest. Or borrow or loan on a peer-to-peer basis. Or join with others in a philanthropic venture to support a worthy cause? Or even to take out an insurance policy. All of that and more is possible with DeFi, which for a variety of technical reasons operates on the Ethereum network.

And it’s popular. According to DeFi Pulse, the total value of DeFi applications topped $107 billion by the end of November 2021. The surge prompted critics, including prominent politicians, to warn consumers about the lack of regulation. Just as crypto was intended to function in its own ecosystem free from government regulation, DeFi was as well. Since anyone with an internet connection can take advantage of DeFi any hour of any day, it certainly is convenient, but the absence of regulation is an open invitation to experienced crypto rip-off artists.

Why DeFi Is a Challenge for Governments

Cryptocurrency and DeFi, however, present numerous opportunities for abuse. They have been used to enable fraud, tax evasion, money laundering, and the transfer of funds to criminal enterprises and even terrorist organizations. Until now, addressing blockchain-enabled crimes such as these have been the main, and even sole, priorities for governments, regulators, financial institutions, and law enforcement agencies. The Financial Action Task Force, or FATF—an intergovernmental forum founded in 1989 on the initiative of the G7 to develop policies to combat money laundering—has taken a lead in mobilizing the international community to address this issue. But a different challenge has arisen.

The sanctions imposed on Russia following its invasion of Ukraine have focused attention on the ways in which the blockchain can be used as a tool to circumvent them. Certainly, from the Russian perspective, there is every good reason to do so. As a result of the sanctions, the value of the ruble initially sunk by 30%, prices for imported goods shot up in tandem and the Bank of Russia, whose access to its foreign currency reserves in the West was frozen, raised its prime interest rate to a staggering 20% overnight. There is widespread concern as well that Russia will begin to default on loans to Western banks as early as this spring if the sanctions remain in place.

Meanwhile, Visa, Mastercard, and American Express have ceased to service Russian banks, which have also been disconnected from SWIFT. PayPal has ceased servicing Russian consumers, too. So there are few, if any, options for Russian consumers to pay foreign merchants―except for the minority of them who hold cryptocurrency. Their numbers swelled immediately after sanctions were imposed when large numbers of ordinary Russian citizens withdrew rubles from their banks and used it to purchase crypto as a hedge against their currency’s overnight deflation.

And now they can move it around, loan it, invest it, and a lot more using DeFi. For obvious reasons, there is significant concern in the West that the blockchain, and specifically DeFi, will be used to mute the effect of the sanctions and keep the country’s economy afloat. That realization has awakened the international community in general, and the West in particular, to the fact that crypto issuers and exchanges that are not formally registered in any specific jurisdiction can easily skirt sanction requirements because it is difficult for any government to go after them.

A government’s ability to enforce action against locally domiciled companies doing business with individuals, businesses and governments otherwise restricted by financial sanctions or FATF enforcement leaves a wide gap for countries like Russia to exploit. Virtually all FATF members are Western democracies. But should it seek to issue recommendations designed to bridge the gap, it will face opposition from Russia, which also happens to be a member.

So what will happen? For Western democracies, a logical response would be to require all crypto exchanges and platforms operating within their borders to uphold their sanctions. But that necessitates licensing, and licensing means regulation. Which is why the Executive Order on Ensuring Responsible Development of Digital Assets, issued on March 9, is so timely. While most attention has been drawn to its proposal for a central bank digital currency, it lists a number of other “principal policy objectives” regarding digital assets, including, and not by coincidence, the following:

“We must mitigate the illicit finance and national security risks posed by misuse of digital assets. Digital assets may pose significant illicit finance risks, including money laundering, cybercrime and ransomware, narcotics and human trafficking, and terrorism and proliferation financing. Digital assets also may be used as a tool to circumvent United States and foreign financial sanctions regimes and other tools and authorities. ... Growth in decentralized financial ecosystems, peer-to peer payment activity, and obscured blockchain ledgers without controls to mitigate illicit finance could also present additional market and national security risks in the future.”

The executive order further requires the attorney general, in consultation with the secretary of Treasury and the Federal Reserve chair, to provide within 210 days a legislative proposal that would enact its provisions into law. What that means is that the creation and institutionalization of a U.S. government regulatory infrastructure that will police cryptocurrency and DeFi transactions is now less than a year away.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Michael B. Cohen is a co-founder and vice president of global operations at MyChargeBack. He is an expert in the field of complex dispute resolution.

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