Weekly Gauge #40 : Governance Wars & Regulation Part-2
Weekly Gauge #40 : Governance Wars & Regulation Part-2
A Lawyer’s Answers to Key Questions
To follow up on last week's article introducing the regulatory concerns of Governance Wars, this interview will be split into three major parts or topics to funnel from the technology to the final users.
Base layer
Participants (projects)
Participants (Retail)
To give a bit of context to the readers, Hugo is a lawyer in banking law specialized in crypto, regulatory affairs manager at ADAN, a professional association that federates 200 companies in the crypto sector in the world, across all use cases, and whose objective is to bring the way of these actors for the benefit of innovation, in a stake of economic sovereignty.
—---------------------------------
Interview :
W: I wanted to start with a question that came up during our first call in preparation for the interview and that I found particularly interesting to open the debate. We asked, I quote, "could regulation come before innovation?", so I would have liked you to define for us the terms innovation and regulation and then to give us your opinion on the question.
H: In terms of innovation: liquidity wars are revolutionizing the way liquidity has traditionally been managed on markets, by opening up this activity to retail users via protocols like Curve and Balancer and by creating healthy competition between the different protocols to get a share of the liquidity on these ecosystems.
In terms of regulation: Several things, mainly the objectives of the regulators to supervise the DeFi and thus the incentive voting systems will often be modeled on those for the traditional capital markets, namely :
Ensuring the stability and integrity of the markets: to avoid the collapse and contagion of a market on other markets, e.g. real estate market in 2008 took the banking system in its fall
Ensuring the protection of users: making sure that players respect a certain number of requirements so that risks are controlled and that the transparency of information allows for informed investment.
Overall, this is an issue that is not specific to DeFi and we can take the example of internet regulation, innovation often comes before regulation. For crypto we see that the first transaction on Bitcoin was in 2009 and that France - which was nevertheless a pioneer country in the regulation of crypto - created a framework in 2019, 10 years later.
And this is seen in the incentive voting markets as regulators do not yet seem to grasp the objectives of these new products and could put them in a general category like "yield farming" . But this approach is not to blame, it just shows a need for education on the role of the different flywheels that are concentrated around the Curve and Balancer ecosystems and their dissociation with players specialized in yield strategies in DeFi like Yield optimizer.
W: It's very interesting, I noticed some arguments that are linked to my next questions. You explained that one of the objectives of the regulators is to prevent the risk of contagion of the fall of a market, taking the example of the 2008 real estate crisis that affected the banking system. Could we draw a parallel with Curve's ecosystem, and could you tell us about this risk?
H: Indeed, this risk of concentration of applications is one of the main pain points identified by regulators who position themselves on the DeFi framework.
Two recent examples:
The FSB (Financial Stability Board) explained in its recent report "The Financial Stability Risks of Decentralized Finance" that one of the main risks associated with DeFi is the concentration risk;
https://www.fsb.org/2023/02/the-financial-stability-risks-of-decentralised-finance/
The ACPR (Autorité de Contrôle Prudentiel et de Résolution) in its consultation on "Decentralized" or "disintermediated" finance: what regulatory response?
https://acpr.banque-france.fr/en/decentralised-or-disintermediated-finance-what-regulatory-response
Thus, the composability of different applications is an inherent part of the ecosystem's value proposition, it is sometimes seen as a concentration risk. And so if we draw the parallel, protocols like Curve originally specialized in stablecoin exchange, whose main assets are USDC, DAI, FRAX etc, have a big liquidity risk due to their intrinsic correlation. So, if - like the UST, all things considered - the USDC were to fall (especially in the context of a banking crisis), it could take the DAI with it and potentially put the Curve ecosystem and therefore the flywheels that depend on it in trouble.
This concentration risk could thus be analyzed through the prism of voting incentives to consider them, through a rather pejorative analysis of regulators.
W: So I find the comparison with UST interesting because it demonstrates the difficulty of considering the technical differences of assets even within the stablecoin family, and allows me to follow up with a question about the risk of manipulation and market abuse this time, still related to gauges tokenomics, taking the example of the balancer ecosystem and the major holder of veBAL, Humpy.
H: So, in fine I won't limit myself to the Balancer ecosystem, it will depend on how the incentive vote is interpreted by the regulator. The governance wars as it stands is a virtuous mechanism that sets up a system based on game theory, which economically makes complete sense, but which taken with a certain amount of hindsight by the regulator could be misinterpreted, since it is a transparent and voluntary way of incentivizing the allocation of rewards on a pool. This is essentially based on the fight against insider trading, and the fact that multiple players are coordinating to influence the price of an asset and the associated returns.
W: I see. I think this makes an excellent link with our second major part since I would tend to say that even if Curve or Balancer provide fertile grounds for the development of these markets, the direct stakeholders in governance wars are two types of actors, on one hand the projects that seek to direct the rewards to the pools of their native tokens, and on the other hand the holders of veTokens who will direct emissions to maximize the value of their voting power. Before analyzing them in more detail, could you explain to us how we could interpret a DeFi voting incentive from a legal point of view?
H: First of all, this is a question to which there is no consensus answer. Also, the way in which governance protocols could be qualified would be approached differently in different parts of the world.
The European approach, which is the most adapted in my opinion, focuses on moving towards an ad hoc framework adapted to decentralized finance. MiCA, which is the first step in the regulatory process, excludes DeFi from its scope but foresees that further reflections will be made in the future, probably leading to a MiCA II. .
➡️refer to " ECB President Lagarde: Crypto Staking and Lending Must Be Regulated " By Decrypt
https://decrypt.co/103565/ecb-president-lagarde-crypto-staking-and-lending-must-be-regulated/
The EU will therefore accelerate its reflections on the regulation of DeFi in the coming months, and through all this, voting incentive systems could be framed as a new form of specific service in the ecosystem, in parallel with AMM, liquidity protocols (or "lending protocols", or staking protocols).
The American approach is much more case by case, regulatory authorities like the SEC will regulate DeFi -without really having a textbook case on governance protocols- through the Howey test in order to identify if a token is comparable to a security, by interpreting if there is "in any form, a contribution of value in a common enterprise with an expectation of profit from the efforts of others"; so if you draw the parallel with voting incentives, a broad and unsuitable interpretation could lead to these protocols being governed by the rules of American securities law.
W: Ok and so to continue on the role of the user in the scheme, we also have two cases, the holder of voting power can be a small holder or a whale with an important control on the governance, should we make a comparison with the boards of directors of traditional companies?
H: I think that it doesn't directly concern the subject of voting incentives but rather the distribution of the governance token among the holders. If you are a first mover on a protocol you can become a whale and you will be forced to get involved in governance since you will have a very important stake and collective power in the development of the project. And in this direction, we can make a shortcut that is not really adapted to a kind of decentralized board of directors, according to which the users can delegate a great deal of governance power to a group of individuals, each with expertise useful to the development of the project.
This also shows that we have accepted that not everyone can participate in the governance process at every level, and that we are therefore moving towards a compromise between decentralization of power and management efficiency.
W: I can imagine that depending on the role that an individual plays in the development of the project, and in this case in governance, he will have to report differently to the regulators?
H: Yes, the involvement of a stakeholder in a project can clearly have an impact on his liability later on in case of litigation before a judge. In the US, if you take the OOkie Dao case, when users complained to the SE, they considered that the BzX token was a security and that the core contributors, de facto directors of the unregistered company, were responsible for the losses caused by the protocol.
In the case, it was interpreted that the DAO is functionally a general partnership, and that its general partners are jointly and severally liable for the actionsof the DAO.
Here, the level of involvement has been interpreted relatively broadly since all governance token holders are considered general partners, which would lead to the plaintiffs in this case - who were users of the protocol and thus had governance tokens - being partners in the de facto corporation. Ultimately under this interpretation and level of involvement, one comes to the conclusion that the plaintiff is suing himself.
What is also interesting is the way in which the CFTC filed its complaint, on the Ookie DAO governance forum.
W: Right, and so it's important to recognize who is who, and who is doing what. We can certainly find a good axis to conclude this interview by thinking about the legal and technical advances that would allow a better understanding and compliance of DeFi, i.e. proof of humanity, algo governance etc., what do you think?
H: So it's a bit like a recap of the topics actually, the classic models of governance 1: 1 governance models without incentive systems or power allocation and other models that are not completed create risks of concentration both functionally and in terms of governance, and so it is important to identify the most efficient mechanisms to innovate while remaining in compliance with the missions of the regulators, and this can go through the POH, Frax's DeGov, Uniswap's limited governance, DAO stack's reputational voting, etc... but one primitive that I find particularly strong in DeFi is the delegation system!
W: Thanks for your answers, it was really informative and I'm sure the readers will also have a better understanding of the governance wars they participate in every week!
