The Financial Action Task Force (FATF) has issued guidance suggesting that decentralized finance (DeFi) platforms exhibiting centralized characteristics should be regulated similarly to traditional financial businesses. This guidance aims to address a significant gap in current global regulatory application and the potential for illicit actors to exploit DeFi.
According to the report, FATF rules already apply to DeFi arrangements where an identifiable person or entity maintains control or sufficient influence. The FATF categorizes DeFi into three groups: platforms with identifiable controllers, those with centralized but hidden operators, and truly leaderless protocols. Centralized elements in DeFi frequently persist through concentrated governance tokens, administrative privileges, control over upgrades, and insider fees or rewards.
FATF President Giles Thomson stated that the goal is to prevent criminals from exploiting new technology for money laundering while supporting responsible innovation. The report outlines on-chain and off-chain signs of control, including upgrade keys, ‘kill switch’ functions, the power to set fees and risk parameters, concentrated voting power, command over websites or applications, and corporate entities employing developers or holding treasuries.
Where control exists in DeFi, the FATF believes the individuals or entities behind these platforms should be licensed and supervised like any financial firm. The report also notes that operating a front-end interface that directs users to a protocol can be sufficient to qualify for regulation.
Global Enforcement Gap
Despite these guidelines, a substantial enforcement gap exists. Nearly 93% of the jurisdictions that responded to a recent FATF survey have not applied FATF standards to qualifying DeFi arrangements. Out of 142 jurisdictions surveyed, only 26 have assessed DeFi risks, and while four have licensing rules on the books, only two have actually used them.
FATF guidance is not legally binding law, but member countries are evaluated on their adherence. Persistent gaps in following FATF guidance can lead to a country being placed on the international ‘grey list.’ A recent FATF update indicated that most countries are struggling to enforce cryptocurrency rules broadly.
The FATF wants countries to close this gap by requiring or encouraging DeFi projects to build anti-money laundering (AML) controls into their smart contracts or interfaces. For leaderless projects, the FATF suggests regulators focus on choke points such as stablecoin issuers, exchanges handling fiat on/off-ramps, and front-end operators. As a last resort, jurisdictions can ban a platform from operating within their territory if it refuses to cooperate.
Risks and Illicit Use
Banks and exchanges are advised to conduct due diligence on any DeFi platforms they interact with or cease dealing with them altogether. The report highlights the risks associated with unregulated DeFi, noting that North Korea state-linked hackers were behind two April attacks that drained over $570 million from Drift Protocol and KelpDAO. These attacks accounted for approximately 76% of the year’s crypto-hacking losses. Ransomware crews, professional laundering networks, and investor frauds are also identified as heavy users of DeFi mixers, bridges, and swaps.
In parallel, U.S. prosecutors have pursued legal action against individuals involved in DeFi. This year, they secured prison terms for the co-founders of Samourai Wallet and a conviction against Tornado Cash developer Roman Storm. These cases are built on the principle that the individuals who build and run the code can be treated as regulated financial businesses.
DeFi’s total value locked reached $86.6 billion this year, an increase of about 85% since 2023. The top dozen DeFi protocols hold more than 60% of this total value, suggesting these are key entities that could be subject to regulatory efforts or pose systemic risks.
Uncertainties Remain
However, uncertainties remain regarding the exact definition and threshold for ‘sufficient influence’ in DeFi arrangements, as well as the practical implementation and enforcement mechanisms for regulating these platforms across diverse jurisdictions. The extent to which truly leaderless DeFi protocols exist and how they might be regulated also presents a challenge.
Why This Matters
The FATF report signifies a notable activity in how decentralized finance platforms with centralized elements will be treated by global regulators, aiming to close existing gaps in anti-money laundering and counter-terrorist financing efforts.
Broader Context
The FATF is the world’s primary intergovernmental body dedicated to setting standards and developing policy recommendations to combat money laundering and terrorist financing.
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