Polygon’s Legal Team Advocates for DeFi as National Security Asset

• A new proposal suggests making some DeFi protocols “critical infrastructure” in the U.S., overseen by a cybersecurity agency.

• The plan distinguishes between truly decentralized DeFi and those with centralization, applying existing financial rules to the latter.

A newly proposed regulatory framework in the United States could usher in a significant shift in the treatment of decentralized finance (DeFi) protocols. In collaboration with Michael Mosier of Arktouros, the legal team behind Polygon Labs has published a comprehensive framework advocating for the designation of certain DeFi protocols as “critical infrastructure.”

This designation, if adopted, would bring these protocols under the oversight of the U.S. Treasury’s Office of Cybersecurity and Critical Infrastructure Protection (OCCIP), marking a notable development in the evolving landscape of DeFi regulation.

1/ Today, @m_mosier_ @katjagilman & I are sharing a paper that begins a conversation around, & proposes a conceptual framework for, how to answer the "illicit finance" policy question as it relates to DeFi. A brief thread below, with links to the full paper + a summary document. pic.twitter.com/1OQ1gCHiAX

— Rebecca Rettig (@RebeccaRettig1) January 29, 2024

In their 45-page paper titled “A Conceptual Framework for Combating Illicit Finance Activity in Decentralized Finance,” the authors propose that truly decentralized DeFi protocols be classified as critical infrastructure. This designation is not arbitrary but stems from a desire to enhance security and resilience in the financial services sector. It positions DeFi protocols as vital components of the modern financial ecosystem, deserving careful oversight.

The Role of OCCIP

Despite not being a traditional financial regulator, the OCCIP is essential in directing efforts to improve cybersecurity and lower operational risk in the financial services industry. The framework seeks to improve security in the DeFi domain by utilizing the OCCIP’s experience by controlling some DeFi protocols. This strategy highlights the increasing understanding of DeFi’s importance in the larger financial sector.

Although the framework supports critical infrastructure classification, it recognizes a key difference within the DeFi ecosystem. There is variation in the level of decentralization among DeFi protocols. Certain ones have centralized components; therefore, they could be covered by current financial regulations. This complex approach acknowledges the diversity of DeFi projects and their differing degrees of decentralization.

A novel aspect of the proposed framework is the introduction of a new category termed “critical communications transmitters.” These entities would interact with genuine DeFi systems and assume tailored obligations to safeguard U.S. national and economic security. They would not be classified as “financial institutions” under the Bank Secrecy Act. This innovative category seeks to balance regulatory oversight and DeFi innovation.

The framework also draws a clear line between DeFi and centralized finance, commonly referred to as TradFi. The regulatory approach for these two realms would differ, with TradFi subject to separate controls guided by the U.S. Treasury’s Financial Crimes Enforcement Network. This differentiation recognizes the unique characteristics and challenges associated with each domain.

The llicit finance

Crypto industry lawyer Jake Chervinsky emphasized the growing concerns surrounding illicit finance within the digital asset industry. He noted that while discussions regarding securities and commodities laws often dominate policy conversations, policymakers in Washington, D.C., are increasingly focused on addressing illicit financial activities.

Huge drop today

In the crypto industry, the policy conversation is often dominated by headlines about the securities and commodities laws.

But in DC, policymakers are much more concerned about illicit finance than anything else.

This could be the start of a real solution https://t.co/6bh2Le2AM8

— Jake Chervinsky (@jchervinsky) January 29, 2024

Chervinsky expressed excitement about the proposed framework, claiming it might be the start of a meaningful solution to the problems caused by illicit financial operations in the DeFi area.

While combatting illegal financing operations remains a top priority, the authors stress the need to strengthen legitimate and beneficial activity in the DeFi space. This viewpoint is consistent with the Treasury’s responsibility to promote economic growth and ensure the financial stability of the United States. The framework aims to balance regulation and innovation by creating an environment that encourages innovation and responsible DeFi practices.