Regulating DeFi Apps with Galactica Network's Compliance Solution

Feb 12, 2024

In our last release of the Trinity series, we discussed the role of exchange regulations in the absence of centralised entities. This time we’re moving on to Galactica’s specific implementation of regulation at the dapp level.

Decentralized Finance (DeFi) has revolutionized the financial landscape, offering borderless, privacy-focused, and censorship-resistant solutions. However, as this innovative space continues to grow, policymakers and regulators are grappling with the challenge of striking a balance between promoting innovation and ensuring compliance with market infrastructure regulations. Let’s explore how Galactica Network’s RegTech stack provides a viable solution to achieve compliance for profit-generating decentralized applications (dApps).

Our approach relies heavily on a16z crypto’s seminal work, titled “Regulate Web3 Apps, Not Protocols” [10]. We present Galactica Network’s RegTech stack here as a solution to achieving compliance with market infrastructure regulations, specifically with regard to profit-generating decentralized applications (dApps).

While researchers continue to debate the burden of compliance, the text suggests that automation and open-sourcing can reduce costs for new dApps entering the space. In other words, building the infrastructure for standardizing and reusing compliance primitives can prove to be essential for striking the middle ground between emerging regulatory requirements for dApp compliance and resistance to it on the side of the wider industry substantiated by claims that such requirements could prove to be detrimental for innovation in the space as burden of compliance can be excessive.

The core theses of the a16z crypto articles are summarized, emphasizing the idea that regulating web3 apps instead of protocols is a more effective approach. The architecture for dApp compliance can be designed on the app level while preserving the underlying protocol as is. As is evident from the preceding discussion, market structure legislation, which aims to limit trading of illicit assets, protect users, and sustain innovation in web3, has been a key focus of policymakers and regulators in 2022.

Use Case #1 — Compliant DAO

Description:

In this use case, we outline a design for a DAO that complies with regulations to avoid involvement in illicit activities. This design includes a mechanism for segregating funds, reducing governance risks, and outlining a legal entity structure that interfaces between DAO members, the treasury, and the regulator. This model can be applied to dApp building on Galactica, ensuring a privacy-focused, censorship-resistant, and jurisdiction-aware solution that, most importantly and at all times, maintains compliance with the required set of regulations.

Explanation:

In order to design a DAO that is compliant, the following key steps can be undertaken:

Create mechanisms for clean treasury and income: Ensure that the treasury and its income streams can distance themselves from illicit activities. This can be achieved by implementing a Default Value Accrual (DVA) model (see a16z article for reference), where earnings are split into default and blacklisted pools. On regulator request or DAO vote, the blacklist can be updated to turn off illicit earning streams without removing fees altogether.
Minimize Governance Risks: Risks of non-compliant governance changes can be minimized by limiting the decision-making power of the DAO, for example, deciding on parameters such as the fee percentage. Absolute DAO control over smart contract updates could lead to non-compliant changes.
Establish a Legal Entity Structure for DAO: It’s important to have a well-defined interface between DAO members, treasury, and government. A sound legal entity structure will provide this interface.

This compliant DAO design [10] can be applied to dApp building on the Galactica platform with certain goals:

Segregate Funds: Create a similar segregation of funds at the treasury level.
Geographical Segregation of Inbound Transactions: Make geographical segregation of inbound transactions more effective.

A hypothetical dApp utilizing DVA on Galactica could be a compliant DEX. It would only accept legitimate funds and be jurisdiction aware. The DAO would only generate income from compliant activity. This ensures user privacy and makes the protocol censorship resistant, even in jurisdictions with overly strict regulations. Technically, this is feasible on Galactica, which uses the Ethereum Virtual Machine (EVM).

To achieve these goals, the DEX could be based on the Uniswap AMM model with trading pairs, factory contracts, a front-end, etc. Compliance checks on users and fund origins would ensure legitimacy. Earnings would be managed using the DVA mechanism with fees collected for all swaps. Jurisdiction awareness would be ensured by providing factory contracts to create interface contracts to the base DEX. So each trading pair instance could be tailored for a specific jurisdiction, such as US, EU global, etc. Galactica’s compliant transaction feature makes the segregation of funds efficient and feasible because it automates who is able to access which pool. Users can be required to provide zero-knowledge proofs about living in the jurisdiction a trading pair instance is made for. Therefore good and bad funds in the DVA model can be separated in a verifiable and automated way. User privacy would be maintained by hiding personal details through zkKYC and separating addresses from other on-chain activity. Censorship resistance would be achieved by ensuring that blacklisted users, funds and interfaces still function, with earnings for the DAO and liquidity providers being burned for users from blacklisted jurisdictions.

In order to mitigate complexity and the risk of non-compliance, certain features like automatic pool expulsion for trading securities without jurisdictional limits may not be implemented. Instead, a more practical solution could involve the ability to blacklist pools on regulator request.

The Regulatory Trinity

As we conclude our exploration of how Galactica Network’s RegTech stack offers a compliance solution for decentralized finance (DeFi) applications, it’s clear that navigating the regulatory landscape requires innovative approaches. By leveraging automation, open-sourcing, and thoughtful design, such as the compliant DAO model, Galactica provides a blueprint for integrating compliance without stifling the revolutionary potential of DeFi.

In our next discussion, we’ll delve into the nuances of securities laws, examining how they apply to Web3 initiatives and exploring strategies for navigating these legal frameworks. We’ll aim to demystify the complex terrain of securities regulations as they pertain to the burgeoning Web3 industry. Understanding these regulations is crucial for developers, investors, and regulators alike to ensure that the digital finance ecosystem remains vibrant, secure, and compliant.

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