CFTC Advisory Group Proposes Regulatory Approach to DeFi and AI

In a new Report, a CFTC Technology Advisory Subcommittee ("Advisory Group") described the "promising opportunities and complex, significant risks to the U.S. financial system, consumers, and national security" associated with decentralized finance ("DeFi") and generative artificial intelligence ("AI").

In the "Report of the Subcommittee on Digital Assets and Blockchain Technology," the advisory group warned that "in the absence of effective regulation, enforcement, and compliance, many of these DeFi projects, enterprises, and ecosystems have been vulnerable to fraud, mismanagement, and serious regulatory violations" and that the "risks have been compounded by periods of extremely high market volatility, exposing investors, customers, and other stakeholders to significant losses." The advisory group said that the "central concern relating to DeFi systems is the lack of, and some industry designs to avoid, clear lines of responsibility and accountability" and summarized that the benefits of these technologies "depend significantly on the design and features of specific systems."

The advisory group said that the Report should be used as "a conceptual framework for understanding and taking steps to address these opportunities and risks across these diverse enterprises, projects, and ecosystems." The advisory group stated that the framework is "grounded" in a "technical understanding of the core features of DeFi, the current state of play, and the likely consequences—both positive and negative—stemming from its continued development and growth."

The advisory group recommended that policymakers:

• improve their resource assessment and data gathering;
• map "the existing regulatory perimeter";
• "systematically identify, define, and catalogue the risks arising in connection with DeFi, including those pertaining to asymmetric information and conflicts of interest, operational and security vulnerabilities, liquidity and maturity mismatches, over-leverage, hardwired algorithmic failures and procyclicality, complexity and concentration risks in DeFi compositions, and market manipulation and illicit finance";
• identify and evaluate the range of potential policy responses;
• foster greater engagement and collaboration with domestic and international standard setters, regulatory efforts and DeFi builders; and
• apply the "recommended framework to drive near-term, prioritized progress on digital identity, 'know your customer'" and anti-money laundering (AML) regimes, and calibration on privacy in DeFi."