Managing Compliance Risk

Managing compliance and legal risks in decentralized finance (DeFi) requires a proactive and comprehensive approach due to the rapidly evolving regulatory landscape and the inherent complexities of blockchain technology.

This checklist is a starting point for DeFi protocols and their stakeholders to manage compliance and legal risks. Given the dynamic nature of DeFi and regulatory environments, it's crucial to adapt and update risk management practices regularly. Collaboration with legal professionals and continuous monitoring of regulatory developments are key to navigating the complexities of compliance and legal risk in the DeFi space.

1. Jurisdictional Analysis

• Identify all relevant jurisdictions for developers and likely user base

• Research applicability of securities, licensing, AML laws for each jurisdiction

1. Token Classification

• Seek legal opinion on whether native protocol tokens qualify as securities or commodities in major jurisdictions

• Structure issuance and distribution to comply with regulations

1. KYC Implementation

• Evaluate need for user identity verification systems to meet AML/CFT norms

• Consider risk-based customer screening against sanctions/PEP lists

1. Geoblocking Controls

• Set up monitoring and restrictions to block access from sanctioned jurisdictions subject to trade embargoes

1. Activity Monitoring

• Implement transaction monitoring to detect sources of funds from high-risk jurisdictions or wallets associated with prior suspicious activity

1. Emergency Freeze Capabilities

• Incorporate ability to freeze or clawback funds in event of detected criminal activity as a last resort

1. Insurance Coverage Assessment

• Evaluate feasibility for insurance products to cover risks like funds loss due to hacks/exploits

1. Legal Partner Network

• Maintain access to law firms across jurisdictions for regular guidance on evolving regulations

1. Contingency Planning

• Develop contingency plans for disabling/winding down operations if legal/compliance costs become prohibitive

It is necessary to review and regularly build this checklist to manage widening compliance obligations across jurisdictions and safeguard from legal repercussions.

Regulatory Compliance

• Stay Updated on Regulations: Regularly monitor changes in laws and regulations that affect DeFi operations globally.

• Legal Consultation: Engage with legal experts specialized in blockchain and financial regulations to get advice tailored to your protocol.

• Compliance Framework: Develop a robust compliance framework that addresses key areas such as AML, CTF, securities, and privacy laws.

• Regulatory Engagement: Where possible, engage in dialogue with regulators to understand expectations and convey the benefits and operations of your DeFi protocol.

User Identification and Verification

• Implement KYC Procedures: For parts of the platform that require it, implement KYC procedures that comply with global standards.

• Data Privacy Compliance: Ensure compliance with data protection laws like GDPR, considering user consent and the right to data deletion.

Legal Structure and Entity Formation

• Form Legal Entities: Establish legal entities in jurisdictions with clear regulatory frameworks for blockchain and DeFi.

• Liability Assessment: Regularly assess the potential liabilities of your protocol and its legal entities to mitigate risks.

Smart Contract Security and Legal Audits

• Conduct Smart Contract Audits: Regularly audit smart contracts for technical vulnerabilities.

• Legal Review of Contracts: Have legal experts review smart contracts and other on-chain mechanisms to ensure they comply with applicable laws.

Transparency and Reporting

• Transparent Operations: Maintain transparency in protocol operations, decision-making processes, and governance.

• Regulatory Reporting Capabilities: If applicable, develop capabilities for regulatory reporting that comply with financial authorities.

Intellectual Property Management

• IP Protection: Identify and protect the intellectual property of the protocol.

• Open-source Licensing: Clearly define the licensing for the protocol’s code to manage usage, contributions, and forks.

Tax Compliance

• Tax Advisory: Engage tax advisors to understand and plan for the tax implications of protocol operations and tokenomics.

• Provide Tax Reporting Tools: Offer tools or integrations that help users report their transactions for tax purposes.

International Operations and Compliance

• Cross-border Compliance Strategy: Develop a strategy for managing compliance across different jurisdictions.

• Sanctions Check: Implement systems to ensure compliance with international sanctions and embargoes.

Risk Management

• Risk Assessment: Conduct regular risk assessments focusing on legal and compliance risks.

• Insurance Coverage: Explore and secure insurance coverage for various operational risks, including smart contract failures and regulatory fines.

Data Security and Management

• Implement Data Security Measures: Ensure strong data protection measures are in place, including encryption and secure storage.

• Data Management Policies: Develop policies for data management that comply with legal standards and ensure the integrity and confidentiality of user data.

Training and Awareness

• Employee Training: Conduct regular training sessions for employees on compliance, legal risks, and ethical considerations.

• Community Education: Provide educational resources to the community on compliance matters affecting protocol use.