MENU

House Financial Services Subcommittee Hearing  

September 30, 2024 Uncategorized

HOUSE FINANCIAL SERVICES COMMITTEE HEARING

OVERVIEW   

For questions on the note below, please contact Edmund Perry at (202) 547-3035 or Ruth Lunsford at (434) 238-7224.  

On September 10, the House Financial Services Committee Subcommittee on Digital Assets, Financial Technology, and Inclusion held a hearing entitled “Decoding DeFi: Breaking Down the Future of Decentralized Finance.”  Witnesses in the hearing were: 

Legislation noticed for the hearing: 

  • H.R. ___, To require the Securities and Exchange Commission, Commodity Futures Trading Commission, and the Secretary of the Treasury to jointly carry out a study on decentralized finance 
  • H.R. ___, To require the Secretary of the Treasury to report on privacy-preserving technologies 

Below is a summary of the hearing prepared by Delta Strategy Group.  It includes several high-level takeaways from both panels, followed by summaries of opening statements and witness testimonies and a summary of the Q&A portion of the hearing. 

KEY TAKEAWAYS 

The following is a summary of the main topics explored in today’s hearing.  Each is discussed in further detail in the Discussion section below.   

  • Today’s hearing featured discussions of potential regulatory frameworks for the oversight of decentralized finance (DeFi).  Witnesses emphasized that, while DeFi presents significant opportunities for financial innovation, it also introduces unique risks, particularly related to cybersecurity and illicit activities.   
  • Subcommittee Chairman French Hill (R-AR) emphasized the need for a thoughtful regulatory framework to integrate DeFi with traditional finance while ensuring adequate consumer protections are in place.  Hill stressed the importance of bipartisan support for legislation like the Financial Innovation and Technology for the 21st Century Act (FIT21) and expressed concerns about the Biden administration’s approach to DeFi and concerns with the U.S. remaining competitive. 
  • Ranking Member Stephen Lynch (D-MA), focused on the risks associated with DeFi, particularly its use in illicit activities and lack of AML/CFT compliance, calling for more robust regulations over DeFi.  He said that DeFi should be subject to existing regulatory structures, not receive a new tailored structure. 

SUMMARY

Opening Statements and Testimony  

Subcommittee Chairman French Hill (R-AR) 

DeFi represents a transformative development in our financial landscape.  We must carefully explore its technology, potential benefits, risks, and regulatory implications to ensure its safe integration.  The bipartisan support for FIT21 legislation reflects our commitment to a balanced approach.  DeFi envisions a financial system that is permissionless, transparent, efficient, and built on top of blockchain networks.  It is based on the fundamental idea that individuals should have the freedom to transact without the fear of illegal surveillance or abuse by governments.   

By substituting intermediaries for autonomous self-executing code, DeFi can shift the way the financial markets are currently structured and governed.  It is crucial that we engage in open-minded dialogue to determine how Congress can best support Americans in leveraging DeFi safely and effectively to improve financial services for businesses and consumers alike. 

Subcommittee Ranking Member Stephen Lynch (D-MA) 

There is no consensus on the definition of DeFi among regulators or industry which makes this a difficult sector to assess.  DeFi providers claim to offer permissionless and interoperable payments resulting in efficiency.  However, it has become increasingly evident that these features have made DeFi most attractive to illicit actors who seek to conduct illegal activity.  Treasury reports have highlighted the risks posed by cybercriminals and the need for robust AML/CFT compliance. 

Modernizing our payments and banking systems is essential, and we advocate for the e-Cash Act and innovation within a safe framework.  It is imperative to address the crypto lobby’s attempts to secure exemptions from crucial investor and consumer protections.  The industry demonstrates how episodes of implosion in the digital assets industry makes industry survival contingent on regulatory oversight.  

Brian Avello, Chief Legal Officer, UDHC 

My experience in the cryptocurrency space, including my role in the Maker ecosystem and investments in DeFi startups, underscores the need for a well-considered regulatory framework.  It is essential to integrate DeFi with traditional finance thoughtfully.  If DeFi is to move toward full inclusion with traditional financial rails, a common-sense regulatory apparatus that recognizes DeFi’s unique aspects and focuses foremost on compulsory disclosure is paramount to our industry’s success in the coming years.  Permissionless decentralized technology poses perplexing questions for regulators accustomed to intermediary touchpoints for market insight and enforcement.  Consumer protections must be enhanced through mandatory disclosures that cover technology explanations, token distributions, and governance transparency. 

Rebecca Rettig, Chief Legal and Policy Officer, Polygon Labs 

DeFi’s unique mechanics have influenced global regulatory responses and highlight its role as critical infrastructure that allows for novel ways of transacting, bringing new and different benefits from the traditional financial system.  DeFi is not without its risks, however, the sources of those risks differ significantly from those in the traditional financial system.  In fully decentralized systems, risk to users and to market integrity is borne primarily from technology risk and cyber risk, or from integration with centralized systems. Ensuring effective risk mitigation and market protection requires recognizing DeFi’s open-source nature and its reliance on public blockchain infrastructure.  Treating DeFi as critical infrastructure, akin to roads and bridges, will help safeguard user and market interests. 

Amanda Tuminelli, Chief Legal Officer, DeFi Education Fund 

The best financial system is one in which people can access finance regardless of where they sit or the subjective merits of an individual’s application.  DeFi represents a significant advancement over traditional finance by providing open access, faster transactions, and self-custody of assets.  Existing regulatory approaches are inadequate and untenable for DeFi’s intermediary-free nature, necessitating a new framework.  DeFi was created to eliminate intermediaries because “the status quo is not working” and is actively seeking a clear path forward to existing in the U.S.  We must foster a supportive environment for the DeFi industry within the US and overcome “hostility to innovation.” 

Peter Van Valkenburgh, Director of Research, Coin Center 

Peer-to-peer financial systems are crucial for the future of the U.S. economy.  If we do not allow their use and development by Americans, they will be used and developed overseas.  The current regulatory approach, which follows regressive strategies, risks undermining US competitiveness alongside “American dynamism.”  Legislative clarity is essential to support innovation and protect constitutional rights.  The Blockchain Regulatory Certainty Act, the Keep Your Coins Act, Financial Innovation and Technology for the 21st Century Act (FIT21), and other initiatives seek to provide the necessary regulatory clarity and encourage innovation. 

Mark Allen Hays, Senior Policy Analyst, Americans for Financial Reform 

Cryptocurrency and DeFi are promoted as an alternative to traditional finance that eliminate powerful intermediary gatekeepers and offers a new tool for access to finance and wealth building.  The crypto industry’s volatility and propensity for fraud pose significant risks to investors, especially those from marginalized communities.  DeFi is replete with risks and practices that harm or have the potential to harm consumers, investors, and financial markets.  Congress must prioritize investor protections and market regulations for DeFi, focusing on transparency, price discovery, and stability.  DeFi’s claim of decentralization is undermined by the concentration of control among a small number of powerful players, with 1% of DeFi users controlling 90% of governance tokens on major platforms. 

DISCUSSION 

Hill (R-AR):  What are the primary risks associated with DeFi, and what steps are being taken to mitigate those risks?  What is the best way to protect consumers from being hacked?  Tuminelli:  Illicit finance is a risk in every system, except the way we deal with it in DeFi needs to be different from how we address it in centralized finance.  The primary risks in DeFi are cyber-security, system management, and user-related.  Current efforts to combat these risks include the Security Alliance, which looks at risks from both the financial and technological perspectives.  There are also public-private partnerships with law enforcement to address these risks.  To protect consumers from hacking, cybersecurity measures need to be localized and effectively managed through tools like crypto individual savings accounts (ISAs).  Additionally, integrating fraud and spam alerts can play a crucial role in mitigating these risks. 

Hill (R-AR):  The Securities and Exchange Commission (SEC) proposed a new rule that broadly expands the definition of an exchange to capture not just decentralized digital asset platforms but also DeFi.  It is broad and not very well defined and seems to be an overreach by the Commission.  How should the DeFi industry think about this rule?  What is wrong with it and what is a better approach?  Tuminelli: One of the primary issues is that the SEC has not yet defined what constitutes digital asset security.  This lack of clarity creates a barrier to discussing and regulating exchanges properly and prevents compliance with securities regulations; Van Valkenburgh:  The SEC has swept so broadly in its exchange rulemaking that its run right into the First Amendment of the Constitution. 

Lynch (D-MA):  How can you argue that markets do not need intermediaries when these markets are rife with fraud?  What benefits do bad actors gain if we do not employ Know Your Customer (KYC) or anti-money laundering protocols connected to DeFi?  Hayes: There is always a human component involved in markets, and the problems in DeFi mirror issues in the traditional financial system.  If we allow there to be gaps in the regulation of DeFi, we risk these markets facilitating money laundering.  We need consistent rules across asset classes to ensure constant protections against illicit financial activity.  If decentralization cannot be defined or realized, it will be difficult to create these protections. 

Lucas (R-OK): How does blockchain technology enable decentralized digital ownership, and what are some Web3 cases use beyond DeFi?  Could you please share your perspective on the impact of decentralizing the internet?  Rettig: Blockchain technology enables decentralized digital ownership through various applications.  For example, the California DMV has digitalized 42 million car titles, and GEODNET uses satellite data to improve weather prediction for farmers;  Van Valkenburg: Currently, hackers target centralized servers.  Decentralizing the internet could mitigate this risk by distributing data and reducing single points of failure. 

Lucas (R-OK):  Regarding the untapped potential of quantum mechanics, how much attention has been given to post-quantum cryptography in the context of DeFi protocols?  How will we keep up with the effects?  Tuminelli: Cryptography is fundamental to blockchain technology and, by extension, to DeFi technology.  It is crucial for the future of DeFi; Van Valkenburg: We would address vulnerabilities in real-time, as open systems allow us to quickly identify and respond to issues.   

Foster (D-IL): How do you implement identification methods and effectively ban bad actors in an anonymous self-hosted situation in DeFi?  Avello: Zero-Knowledge protocols are being implemented to address these issues;  Rettig: The DeFi Security Alliance (DSA) collaborates with the public and private sectors.  They are developing a new category of “critical communications translators” that will allow the Financial Crimes Enforcement Network (FinCEN) to trace anonymous wallets more effectively.  Funds from some of the worst actors are currently frozen and cannot be moved following immediate identification.  However, once some funds are frozen, it is challenging to permanently ban bad actors. 

Foster (D-IL):   When a bad actor reappears in an anonymous self-hosted wallet, how do you identify them as a bad actor? How do you trace all users of anonymous wallets? Avello:  Law enforcement and blockchain analytics tools can trace a lot of these problems very transparently. Through public/private partnerships and working with the Federal Bureau of Investigation (FBI), Department of Justice (DOJ), and many of these agencies, we can trace wallets quickly. Even more quickly than the decades it has taken to trace illicit funds in the traditional financial world. 

Rose (R-TN):  The IRS proposed a rule requiring broker reporting of sales and exchanges of digital assets. Is this proposal workable?  Tuminelli: The proposed definition of a broker is extremely broad and not workable.  The IRS has finalized part of the rule that applies outside of DeFi. 

Rose (R-TN):  The Biden administration has been criticized for scapegoating the digital asset industry, claiming that the industry is designed to avoid tax liability.  How can the DeFi industry support tax compliance?  Tuminelli: As an industry, there are software and technology solutions that make it easier for a person to assess their tax liability and pay their tax liability, but it is the individual’s responsibility. 

Rose (R-TN):  FinCEN has taken an aggressive enforcement path.  What impact does this have on the DeFi industry?  Tuminelli:  The Department of Justice has ruled that the FinCEN guidance is merely a suggestion.  This has led to two government entities disagreeing on what the law is, creating regulatory uncertainty 

Waters (D-CA):  DeFi platforms with unclear governance and control mechanisms may create hurdles for regulators to establish responsibility and accountability.  How can regulators deal with mass non-compliance by entities that claim to be decentralized to avoid regulatory compliance?  What more needs to be done to ensure robust consumer and investor protections in this industry?  Hayes: Regulators should continue their current efforts.  Rulemaking provides the clarity needed to understand how exchanges operate and to address these issues effectively. 

Steil (R-WI):  Can you discuss what DeFi protocols in the broader community have done to address risks and vulnerabilities?  Rettig:  Any of the hacks, risks, or fraud should be mitigated as soon as possible. The three primary risks are cyber, system management, and usage. There are current efforts to combat those, and the DSA looks at all those risks. But DSA also trains developers how to build safer ecosystems in general and put in appropriate system management controls so there are not these centralized places of data or other vulnerable areas. 

Steil (R-WI):  What should regulators be looking at and considering with respect to rules required around disclosures?  Avello: I think there must be a lot of interaction with the industry. It is also a matter of making the information as simple and clear as possible for the users so there is no confusion. 

Casten (D-IL):  If a DeFi protocol is found to be violating anti-money laundering laws, should the creators, operators, and maintainers of the service be held liable?  Van Valkenburgh:  There is no liability on DeFi operators for bad actor usage; Tuminelli: The bad actors who commit the crime should be held liable, not the developers or creators of the software; Hayes: Developers often intervene in DeFi platforms, changing, updating, and validating transactions.  Given their involvement in facilitating transactions, they should be held accountable to some degree.  However, the line for accountability needs to be defined. 

Casten (D-IL): DAO transactions require identity verification and are not anonymous; should similar rules be enforced for DeFi protocols?  Rettig:  Imposing such rules would be like importing intermediaries into disintermediated systems, putting the U.S. at a competitive disadvantage in an emerging technology. 

Flood (R-NE):  How could a decentralized web change how we consume information, particularly in the context of traditional media like newspapers?  Do you have any sense of how far along we are toward a potential decentralized web, and when might we see decentralized web solutions more broadly offered?  Rettig: A decentralized web allows individuals to share information in an immutable context, effectively crowdsourcing information and creating a permanent record.  We are progressing at an exponentially rapid pace, changing the way we consume information.  Decentralized web solutions are evolving quickly and will soon be more widely available. 

Nickel (D-NC):  DeFi is a bipartisan issue, and there is a push to find common ground to encourage domestic innovation.  Can you discuss some of the risks associated with DeFi and how this Committee should address them?  How are other jurisdictions approaching DeFi regulation, and is the U.S. falling behind countries like China?  What is the impact of falling behind in these sectors?  Rettig: The greatest concern is illicit finance risk.  There are three parts to the proposed framework: expand the definition of independent control in the 2019 FinCEN guidelines to close gaps in risk assessment, treat pure technology protocols as critical infrastructure, and create a new category of entities with additional risk mitigation obligations to meet Bank Secrecy Act (BSA)requirements and bad actor deterrence.  The US is falling behind the rest of the world.  Regulators have been engaging with the industry in the past five years around the globe.  Most countries have explored or implemented DeFi regulation, and studying DeFi is the right way forward; Avello: Highly qualified teams are moving their businesses abroad due to regulatory uncertainty.  There is significant interest in staying in the US, but the lack of clarity is hindering innovation. 

Davidson (R-OH):  How can we reconcile the need for privacy in DeFi with the need to prevent illicit activity?  Rettig: I think you will have pseudonymity over who you are and certain types of information in that regard. The right to anonymous transactions is a constitutional right that should be protected. 

Sherman (D-CA):  How can DeFi be regulated to prevent tax evasion?  Hayes: Tax evasion is a crime that should be aggressively policed.  However, it does not justify a fully surveilled and controlled financial system.  The IRS should provide clear tax guidance and enforce third-party tax reporting requirements. 

Timmons (R-SC):  What challenges does the U.S. face in incorporating DeFi into its regulatory framework?  Van Valkenburgh:  Clear tax guidance from the IRS is crucial.  The IRS should have provided guidance on brokers who need to file third-party tax reports long ago. 

Timmons (R-SC):  What can the US learn from other jurisdictions that have developed regulatory frameworks for DeFi?  Rettig:  Foreign jurisdictions have implemented centralized crypto regulation and have been more proactive in studying and experimenting with DeFi.  They have also looked at DeFi protocols from a cyber security perspective.