In the rapidly evolving landscape of decentralized finance (DeFi), regulatory oversight has emerged as a crucial issue. Polygon, a leading platform in the DeFi space, has put forth a groundbreaking proposal aimed at addressing regulatory concerns while ensuring the integrity and security of DeFi protocols.

Authored by Polygon’s Chief Legal Officer, Rebecca Rettig, in collaboration with Michael Mosier from Arktouros, the proposal seeks to classify “genuinely decentralized” DeFi protocols as critical infrastructure. This move comes in response to the unique challenges and risks faced by the DeFi ecosystem, including cyber threats, system management risks, and illicit finance activities.

The proposal outlines a comprehensive framework consisting of three key components. First and foremost, it defines the concept of “independent control” to distinguish truly decentralized protocols from those with centralized intermediaries masquerading as DeFi platforms.

The paper begins by offering a clear definition of DeFi and emphasizes the unique risks associated with illicit finance in this space. Unlike traditional finance, DeFi introduces novel risks such as cyber threats, system management challenges, and usage risks. By delineating these risks, the authors set the stage for a comprehensive strategy to combat illicit finance within the DeFi ecosystem.

The proposed framework comprises three key components. Firstly, it introduces the concept of “independent control” to identify smart-contract-based financial protocols with centralized intermediaries that may inaccurately label themselves as “DeFi.” This distinction aims to separate genuine DeFi protocols from those that may not meet the criteria.

Secondly, the authors propose classifying these DeFi protocols as “critical infrastructure” and subjecting them to oversight and security coordination by the Office of Cybersecurity and Critical Infrastructure Protection (OCCIP), a branch of the US Treasury Department. While OCCIP lacks regulatory authority over financial institutions, its purported expertise in managing critical infrastructure is deemed valuable for ensuring the secure operation of DeFi systems, according to Polygon’s representative, Rebecca Rettig.

Secondly, the proposal advocates for the classification of DeFi protocols as critical infrastructure, subjecting them to oversight and security coordination by the Office of Cybersecurity and Critical Infrastructure Protection (OCCIP), a division of the US Treasury Department. While OCCIP lacks direct regulatory authority over financial institutions, its expertise in managing critical infrastructure can contribute to the robustness of DeFi systems.

Lastly, the proposal introduces the concept of “critical communications transmitters” (CCTs), businesses responsible for facilitating communications related to DeFi transactions. While not classified as financial institutions under existing regulations, CCTs would be required to adopt enhanced risk management practices to promote financial integrity within the DeFi ecosystem.

The overarching goal of the proposal is to mitigate illicit finance risks and bolster the resilience of DeFi systems. By classifying DeFi protocols as critical infrastructure and engaging OCCIP in oversight activities, Polygon aims to strike a delicate balance between regulatory compliance and the decentralized nature of DeFi.

According to Rebecca Rettig, Polygon’s CLO, the involvement of OCCIP can enhance existing cybersecurity frameworks and promote information sharing initiatives within the DeFi community. Moreover, the recognition of CCTs as key touchpoints in the DeFi transaction flow underscores the importance of managing illicit finance risks at various stages of the process.

In recent days, the native token of Polygon, MATIC, has demonstrated significant price movement, reflecting the market’s anticipation of regulatory developments in the DeFi space. Despite experiencing a period of sideways trading, MATIC has witnessed a notable surge of over 9% in the past week, indicating growing investor confidence in Polygon’s proposed framework.

Overall, Polygon’s proposal represents a significant step towards establishing regulatory clarity in the DeFi sector. By addressing illicit finance risks and promoting responsible governance, the proposal aims to foster trust and stability within the burgeoning DeFi ecosystem.