Decentralized Finance (DeFi) is at the forefront of a financial revolution, creating a paradigm where smart contracts and decentralized applications replace traditional financial intermediaries. However, with innovation comes scrutiny, and these entities are now facing a new wave of regulatory oversight in the United States.

The US regulatory climate, marked by a series of actions from the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), highlights a stringent stance that nudges DeFi entities toward compliance and operational transparency

Is DeFi Become Illegal in the US?

Web3 legal strategist Jose Bencomo likened the current regulatory climate in the US to “traversing a field of landmines.” The recent actions by the CFTC against DeFi entities such as Opyn, ZeroEx, and Deridex underscore a stringent stance on regulatory compliance and operational transparency.

These actions and a lack of clear guidelines threaten innovation. They could also deter new entrants into this growing sector, signaling a more hawkish regulatory approach​​. Furthermore, the SEC has warned of more legal actions against centralized exchanges and DeFi platforms, underlining the gravity of compliance​​.

“The recent regulatory actions hint at a likely consolidation in the industry as smaller protocols grapple with compliance, yet could also be paving the way towards a more mature, compliant DeFi ecosystem. The long-term reverberations remain veiled, but the substantial impact thus far is undeniable, steering a robust dialogue that’s likely to persist in the foreseeable future,” Bencomo told BeInCrypto.

Amid this hostile regulatory environment, DeFi and Web3 companies are urged to anchor themselves outside the US. Like Coinbase, Ripple, and other firms, they must tap into international markets while US regulations evolve to survive.

Read more: Top 5 DeFi Lending Platforms

Bencomo also advised DeFi protocols to align with US compliance norms akin to those adhered to by traditional financial entities. Consequently, focusing on Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations.

This stance, complemented by restricting US persons from accessing their platforms, could be a prudent buffer against potential financial setbacks arising from non-compliance.

“Crafting a robust compliance blueprint is pivotal, especially detailing the steps toward regulatory registration and customer identification. The next stride involves the actual rollout of this plan, entailing the establishment of KYC and AML frameworks, deploying transaction monitoring mechanisms, and appointing a compliance custodian. Periodic revisiting and fine-tuning of these compliance protocols in sync with regulatory updates is essential to uphold compliance integrity,” Bencomo added.

Crypto Regulation on the Works

On a global front, the regulatory ambiance towards DeFi in the US starkly contrasts with the more progressive stance in regions like the EU, Singapore, and the UK. There, regulators are developing regulatory frameworks to nurture DeFi innovations.

Unlike the cautious approach of the US, these regions are fostering DeFi growth through regulatory sandboxes and crypto asset frameworks. Such a divergence underscores the necessity for the US to adapt to the shifting paradigms to remain competitive globally.

“US regulators can garner valuable insights from the balanced regulatory approaches adopted worldwide. Key lessons include fostering a conducive environment for innovation while ensuring consumer and investor protection. Establishing regulatory sandboxes that enable a controlled environment for testing new DeFi products provides regulators with a clearer understanding of the technology and its implications. Additionally, engaging with DeFi entities in the regulatory process, a collaborative approach can lead to the development of fair, practical regulations that cater to industry growth and user protection,” Bencomo emphasized.

Read more: Crypto Regulation: What Are the Benefits and Drawbacks?

Moreover, technological solutions like verifiable credentials (VCs) and zero-knowledge proofs (ZKPs) are heralded as pivotal tools in aligning with regulatory requirements while preserving user privacy.

VCs provide a digital representation of personal credentials, facilitating adherence to KYC and AML directives without accessing personal data directly. Likewise, ZKPs offer a cryptographic avenue for validating information possession without revealing the information itself, instrumental in age verification without disclosing the date of birth.

“While the trade-off between decentralization and permissioned constructs is palpable, with potential risks of censorship, the overarching advantages of regulatory alignment, trust cultivation, and user facilitation often outweigh the decentralization compromise for numerous DeFi entities. As the DeFi landscape matures, the emergence of more permissioned designs is anticipated, given their instrumental role in reconciling DeFi’s decentralized character with regulatory compliance, fostering a conducive environment for DeFi’s growth and mainstream acceptance,” Bencomo stated.

Looking ahead, the balance between innovation in DeFi and regulatory compliance hinges on a synergy of education, cooperation, and compromise. Bencomo highlighted the importance of a collaborative ethos where regulators and DeFi companies work together to craft fair, workable regulations.

Establishing regulatory sandboxes can provide a controlled testing ground for new DeFi products and services. This can aid regulators in understanding DeFi’s potential and risks.

“By adopting a learning mindset, staying abreast with DeFi advancements, and being open to adapting regulations in response to the fast-evolving landscape, US regulators can craft a regulatory framework that’s both innovation-friendly and effective in safeguarding stakeholders’ interests, ensuring that the US continues to play a pivotal role in the global blockchain and DeFi arena,” Bencomo said.

Together for the Growth of Web3

Forming industry associations could also resolve the tension between DeFi innovation and regulatory compliance. According to Bencomo, these DeFi associations can act as a conduit to represent their interests and engage with regulators for fair regulatory frameworks.

Regular dialogues between the two parties can foster trust and understanding and identify opportunities for regulatory enhancement.

“Engaging with regulators and initiating dialogues to elucidate your operations and the DeFi sector’s potential is invaluable. Employ legal expertise with a grasp on fintech and DeFi regulations and establish robust compliance procedures like KYC and AML processes. Maintain operational transparency and keep detailed, auditable records to build trust with regulators and users. A thorough risk assessment paired with insurance can mitigate financial risks,” Bencomo concluded.

In light of the regulatory challenges and potential compliance measures, the evolution of DeFi companies is at a pivotal juncture. Integrating technological innovations, active engagement with regulatory bodies, and a willingness to adapt to evolving regulatory mandates are essential for navigating this complex terrain.

A judicious balance between regulatory compliance and fostering innovation can cultivate a conducive ecosystem for DeFi’s growth. Therefore ensuring stakeholder protection while propelling the US into the forefront of the global DeFi narrative.