Decentralized Finance Collaboration to Address Regulation

Decentralized finance experts agree that collaboration is key to building a framework that addresses regulators’ concerns without undermining the potential of decentralized technologies.

Bybit Hack Puts DeFi Regulation Debate in Spotlight

Following the Lazarus Group’s Bybit hack, which is said to be the biggest crypto heist in history, initial industry-wide cooperation to block the outflow of over $1.4 billion in stolen funds was met with praise. However, disagreements quickly surfaced, with several platforms, particularly decentralized ones, facing accusations of aiding the hackers.

Allegations of complicity grew louder as the value of the stolen digital assets increased. According to reports from Bitcoin.com News and other outlets, anger was initially directed at Thorchain and later at OKX, a Seychelles-headquartered cryptocurrency exchange. Critics argued that both platforms had not done enough to thwart the hackers, who were reportedly working tirelessly to move the stolen funds.

Proponents of DeFi protocols defended their stance, framing attempts to censor or alter underlying code to appease regulators as a betrayal of core principles. Others argued that regulators were overstepping their bounds by trying to impose traditional financial regulations on a fundamentally different system.

Meanwhile, Thorchain faced community backlash, but OKX, which recently obtained a license to operate in the Eurozone, encountered significant pressure. Its license appeared to be used as leverage by European regulators to launch an inquiry into OKX, following claims that Bybit hackers used the exchange’s decentralized exchange (DEX) aggregation app to move some of the stolen funds.

After initially denying the investigation, OKX confirmed it by announcing the suspension of its DEX aggregation app on March 17, stating this was to allow for “additional upgrades to prevent further misuse.” OKX cited an “incomplete labeling” problem as the reason for the mistaken identification of its DEX aggregator as the “point of trade.”

Crypto Industry Security Lags

The exchange clarified that the DEX aggregator operates as a non-custodial platform, meaning it does not hold customer assets. However, the suspension signals a broader trend: regulators are increasingly utilizing or creating frameworks like Markets in Crypto-Assets Regulation (MiCA) to exert greater control over the crypto industry.

This move, along with actions from U.S. authorities who blacklisted Tornado Cash, a decentralized privacy tool, demonstrates the length to which regulators will go against decentralized technologies perceived as facilitating illicit activities.

The regulator’s actions highlight the critical issue of balancing security and compliance with the core principles of decentralization and censorship resistance. The fallout from the Bybit hack has shown that not everyone in the crypto community is unwavering in adhering to the decentralization mantra when significant stakes are involved.

To prevent future disunity, a solution acceptable to all stakeholders is needed. Nanak Nihal Singh Khalsa, co-founder at Holonym, believes this solution doesn’t require centralization or harmful censorship. However, he asserts that the industry’s lack of recent security improvements makes regulatory intervention appear inevitable.

“Unfortunately, the industry has not improved recently, so it is possible regulators will step in and impose solutions such as traditional AML/KYC protocols. This would unfortunately increase censorship and centralization,” said Khalsa.

Andrei Grachev, Managing Partner of Falcon Finance, advocates for collaboration among all stakeholders. He believes regulators, security experts, and protocols must work together to establish decentralized risk mitigation frameworks that protect users without compromising core principles of open financial systems.

A key argument against allowing regulators to dictate events in decentralized finance (DeFi) is that it stifles innovation. Anti-censorship advocates insist that regulating the DeFi ecosystem could drive development underground. However, a security advisor with Apex Foundation, who requested anonymity, argues that this isn’t inherently true.

“External regulatory influence isn’t inherently problematic; it depends on alignment with a project’s core values. When stakeholders are properly informed and governance structures function effectively, each project can evaluate whether compliance compromises its mission,” said the security advisor.

To illustrate, the advisor points to the stance taken by privacy-focused services like Protonmail and Tutanota against the EU’s encryption regulations. After determining that certain regulatory demands contradicted their core mission, they opted to withdraw services.

The advisor believes that the industry currently has an opportunity to demonstrate its ability to self-regulate, which it must utilize before more restrictive measures are implemented.

The three experts agree that collaboration is key to building a framework that addresses regulators’ concerns without undermining the potential of decentralized technologies. They offered differing opinions on achieving this, with the Apex Foundation advisor highlighting the importance of the collaborative framework’s structure. Khalsa emphasized that the framework should focus on securing underlying protocols and wallets.