Self-Imposed DeFi Regulations on Blockchain Networks: A Necessary Step for Sustainable Growth

The Internet presents us with an opportunity to rethink and recreate our political and social institutions. We must seize this opportunity or risk losing our freedom.

Peter Ludlow - High Noon on the electronic frontier - 1996

Introduction: [TLDR at the end]

Reflecting on the events of the past year concerning regulations and the resurgence of concerns over bank failures, I began to contemplate the purpose of regulations and how the crypto space currently exists in a limbo, awaiting stringent regulations from powerful governments that could potentially hinder its growth.

However, it's essential to consider the true, supposed, intentions behind regulations: to protect the market from collapsing and damaging the economy, defend against external threats, safeguard small and medium investors, and ensure that the systems function correctly.

As long-time participants in the new digital landscape, we are well-aware of the presence of malicious actors. One of the advantages of this environment is the ability to thoroughly investigate providers by examining their on-chain history. The process becomes more challenging when we need to venture into the real world, where situations are often messy, subjective, and non-deterministic.

In the blockchain space, variables are more manageable, often fewer in number and self-imposed compared to the real world.

So why wait for external regulations when the tools to protect investors already exist within our own ecosystem?
Why construct the constraints of traditional asset classes when code can automate trust and reduce counterparty risk?
Why be content with centralized power structures when decentralized networks can redistribute power and promote equitable participation?

This thought process led to the development of the idea: Self-Imposed DeFi Regulations on Blockchain Networks – A Necessary Step for Sustainable Growth.

Regulations on traditional financial systems:

In the aftermath of the 2008 financial crisis, a range of regulatory measures were introduced to enhance stability, transparency, and accountability within the financial sector. These regulations can potentially be adapted for the DeFi space to achieve similar objectives:

Capital and Liquidity Requirements: Post-crisis, the financial sector saw the implementation of regulations such as Basel III, which established minimum capital and liquidity requirements for banks. This was done to ensure banks could weather financial shocks and prevent insolvencies and systemic risks.
Stress Testing: Following the crisis, regulators started mandating stress tests for banks to assess their ability to endure adverse economic situations. These tests help identify vulnerabilities and ensure the resilience of financial systems under extreme market conditions.
Transparency and Disclosure: Regulations like the Dodd-Frank Act in the United States were introduced to enhance transparency. The Act required financial institutions to disclose comprehensive information about their operations, risks, and performance to promote trust and minimize potential for fraud.
Know Your Customer (KYC) and Anti-Money Laundering (AML): In the wake of the crisis, traditional finance strengthened KYC and AML requirements to tackle illicit activities. This involved implementing identity verification and transaction monitoring systems, which allowed for compliance with global AML standards while still maintaining privacy and decentralization.

Common Parachain objectives:

I propose to create a Decentralized Autonomous Organization (DAO) on a Polkadot common good parachain with intents to implement self-imposed DeFi regulations through the following steps:

Establish Governance Framework: To begin, the parachain should develop a robust governance framework that allows stakeholders to propose, discuss, and vote on self-imposed regulatory measures. The DAO can use Polkadot's on-chain governance mechanisms, such as referenda and public proposals, to enable decentralized decision-making.
Define Regulatory Standards: The DAO should collaborate with industry experts, developers, and community members to define clear regulatory standards for DeFi platforms operating within the common good pallets. These standards should cover aspects such as security measures, risk management, and transparency requirements. They should also be flexible enough to accommodate the rapidly evolving DeFi landscape.
Incentivize Compliance: The DAO should design incentives for DeFi platforms to comply with the self-imposed regulations. This can be done by rewarding platforms that meet the regulatory standards with native parachain tokens, lower transaction fees, higher grading or other benefits. On the other hand, non-compliant platforms could face penalties or increased fees. And other incentive can be implicit through other parachains to require a specific grading for XCM traffic to be opened.
Monitor and Enforce Compliance: The DAO should establish a system to monitor and enforce compliance with the self-imposed regulations. This can be achieved through periodic audits, on-chain data analysis, and transparent reporting mechanisms. Any violations of the regulatory standards should be addressed through predefined enforcement mechanisms, such as penalties, temporary suspensions, or even permanent bans from the ecosystem, depending on the severity of the violation.

Pallets targeting regulations directly:

Developers can create and integrate dedicated pallets for regulatory targets like the ones previously mentioned:

Capital and Liquidity Requirements Pallet: Develop a pallet that enforces minimum collateralization ratios for lending protocols and requires liquidity providers to maintain adequate reserves. This pallet can also include mechanisms for monitoring and adjusting these ratios based on market conditions.
Stress Testing Pallet: Create a pallet that facilitates regular stress tests on DeFi platforms to evaluate their ability to withstand adverse economic scenarios. This pallet can provide tools for simulating extreme market conditions and assessing the resilience of the platform's smart contracts, algorithms, and risk management systems.
Transparency and Disclosure Pallet: Develop a pallet that enforces transparency and disclosure requirements for DeFi platforms. This pallet can require platforms to provide clear documentation, maintain open-source code, and submit to regular audits of their smart contracts. It can also include mechanisms for reporting and verifying the disclosed information.
KYC and AML Pallet: Create a pallet that supports identity verification and transaction monitoring systems for DeFi platforms. This pallet can enable platforms to comply with global AML standards while preserving privacy and decentralization. It can also facilitate the integration of third-party identity verification solutions (Litentry, Kilt, etc), ensuring a seamless user experience while maintaining compliance.
Develop a Regulatory Compliance Pallet: Create a dedicated pallet that manages and enforces regulatory compliance across DeFi platforms operating within the common good parachain. The regulatory compliance pallet should include the following features:

Compliance Registry: Maintain a registry of DeFi tools that have successfully complied with the self-imposed regulations. This registry can serve as a reference for users and investors to identify trustworthy platforms within the ecosystem.
Automated Monitoring: Implement mechanisms for automatically monitoring DeFi platforms' adherence to the regulatory standards. The pallet can use on-chain data and XCM interactions to ensure that parachains comply with the established rules.
Reporting and Escalation: Enable a reporting system where users and community members can flag potential regulatory violations. The regulatory compliance pallet should have a mechanism for addressing these reports and escalating issues when necessary.
Upgradable Framework: Design the pallet to be upgradable, allowing for the integration of new regulatory standards as the landscape evolves. This will ensure that the common good parachain stays current with industry best practices and emerging regulatory requirements.

Enforcement Challenges:

Parachains: If parachains have the option to enforce these regulatory pallets, they might also choose not to do so. To address this issue, we could establish alliances of common good parachains that require adherence to these regulations for interaction. The openness of XCM channels between different parachains could be contingent on compliance with these standards.
Incentive Pool: Parachains can create a pool of incentives to encourage compliance with regulatory measures. For example, Crust could offer lower storage costs to parachains that conduct their due diligence and adhere to self-imposed regulations.
Relay Chain Governance: If permitted by the governance system, relay chains like Kusama or Polkadot could provide various benefits to compliant parachains, such as reduced XCM transaction fees, assistance with opening channels, and other forms of support.
Dispute Resolution: Create a dispute resolution mechanism to address disagreements and conflicts related to compliance matters, providing a transparent and decentralized method for resolving issues.
Community Involvement: Encourage community members to report potential violations, fostering a sense of shared responsibility and vigilance.

Regarding the technical challenges, it's something I encourage people to provide counter-arguments. I'll try to pursue this, but at the moment of writing this my substrate and polkadot architecture knowledge is quite limited as I haven't directly worked with it.

TL;DR:

I proposes self-imposed DeFi regulations on blockchain networks for sustainable growth, drawing inspiration from traditional financial regulations introduced after the 2008 crisis.

A Commongood parachain can establish a governance framework, define regulatory standards, incentivize compliance, and monitor/enforce compliance. Pallets can target specific regulatory aspects, such as capital/liquidity requirements, stress testing, transparency/disclosure, and KYC/AML.

To overcome enforcement challenges, alliances of common good parachains, incentive pools, relay chain governance, dispute resolution mechanisms, and community involvement can be utilized.

GENGE