Regulating DeFi Risk

The development of decentralized finance represents a material reconfiguration of financial intermediation rather than a peripheral experiment in virtual assets. DeFi enables trading, lending, borrowing, liquidity provision and asset management through blockchain based smart contracts, with continuous availability, programmable execution, global accessibility and reduced dependence on conventional intermediaries.

The FATF records total value locked at USD 86.644 billion in 2026, approximately 85 percent above the 2023 level, while institutional investors, virtual asset service providers and regulated entities are increasingly committing capital to DeFi arrangements. This track suggests that DeFi will not simply compete with traditional finance, but will progressively intersect with it through tokenized assets, settlement, payments, liquidity and market infrastructure.

The policy significance of that convergence lies in the need to preserve innovation without permitting functional substitutes for regulated finance to escape equivalent safeguards. Traditional finance provides legal accountability, prudential discipline, customer identification and institutional channels for enforcement, while DeFi contributes automation, composability, transparency of public ledger transactions, broader access and rapid settlement.

The future architecture is therefore likely to be hybrid: regulated institutions will use decentralized infrastructure where it produces efficiency, whereas supervisors will require comparable financial integrity outcomes whenever equivalent financial functions are performed.

FATF, the Financial Stability Board, IOSCO and the IMF converge on a technology neutral and function oriented conception under which substance, activity, control and risk prevail over labels or technological form.

The July 2026 FATF Targeted Report is consequently best understood as an implementation instrument that updates the 2021 Guidance in light of DeFi’s expansion. Its scope is to identify emerging money laundering, terrorist financing and proliferation financing risks, clarify when the FATF Standards apply.

It also provide practical tools for identification, regulation, supervision and investigation, develop criteria for identifying controllers or persons exercising sufficient influence, and recommend measures for public and private actors.

The report is expressly non-binding, but its analytical significance is substantial because it translates Recommendation 15 into a functional supervisory methodology for a market whose legal form, governance and territorial nexus are frequently indeterminate.

The defining characteristics of DeFi create both utility and vulnerability. Similarly, smart contract automation removes many conventional execution functions, open source and composable architecture permit rapid replication and interaction among protocols, algorithmic market mechanisms automate liquidity, pricing and liquidation, pseudonymous liquidity provision permits participation without conventional identification, permissionless access may eliminate customer due diligence, and reliance on oracles imports external data into automated decisions.

These characteristics permit rapid and complex movement of value but also allow illicit proceeds to be layered through liquidity pools, decentralized exchanges, bridges, swaps and multiple chains before supervisory or enforcement systems can react. The regulatory fragmentation, weak compliance, cyber vulnerabilities and diminishing dependence upon regulated entry and exit points further aggravate supervisory difficulty.

The applicable legal framework begins with technological neutrality. The recommendation 15 applies where a natural or legal person, as a business, conducts or actively facilitates activities falling within the VASP definition.

The software itself is not regulated merely because it executes a financial function, but persons exercising control or sufficient influence over a DeFi arrangement may fall within the regulatory perimeter.

FATF differentiates centralized arrangements with identifiable controllers, centralized arrangements in which control exists but controllers are difficult to identify, and truly decentralized arrangements in which no person maintains control or sufficient influence. The first two categories fall within the Standards, the third falls outside direct application, although it remains subject to alternative risk mitigation through adjacent regulated actors.

The principal implementation deficit is therefore institutional rather than conceptual. FATF’s 2026 survey found that only 26 of 142 responding jurisdictions had assessed DeFi risks, 132 had not identified qualifying DeFi arrangements operating in their territory, only four had implemented licensing or registration requirements, and only two had licensed or registered such arrangements.

The resulting supervisory gap facilitates regulatory arbitrage and demonstrates why national authorities must integrate DeFi into national, sectoral or virtual asset risk assessments, calibrated to materiality, domestic exposure, cross border activity, governance structures and actual financial crime threats.

The financial crime typologies identified by FATF demonstrate that DeFi risk is not confined to speculative misconduct. The fraudsters have used purported DeFi structures to misrepresent liquidity and divert investor assets, professional money laundering networks fragment funds across wallets and then use decentralized exchanges, bridges, mixers, swaps and chain hopping to obscure provenance, ransomware groups and hackers use DeFi immediately after compromise to convert and disperse proceeds, and proliferation financing actors have exploited governance weaknesses, oracles, bridges and limited compliance environments.

The policy concern is intensified by speed: automated movement can complete layering before authorities, intermediaries or analytics providers can identify the event, establish attribution and initiate restraint.

The decisive supervisory question is the identification of control or sufficient influence. FATF treats control as the practical ability to determine or materially influence key operations, service delivery or economic benefits.

The relevant indicators include authority to modify or pause smart contracts, alter protocol parameters, control oracles, administer treasury assets, determine participation, appoint key actors, receive material fee flows, control governance votes, operate public interfaces, manage corporate entities, determine development priorities, control essential infrastructure, or direct branding and communications.

No single indicator is conclusive. Additionally, authorities should combine public blockchain evidence, governance records, audits, service provider information, financial intelligence and investigative material, and should assess economic reality rather than formal claims of decentralization.

The assessment of control must remain continuous because governance can migrate from a company or foundation to a decentralized autonomous organization without relinquishing substantive authority. The concentrated governance tokens, delegated voting blocs, special proposal rights, veto powers, administrative keys, clustered wallets and continuing receipt of protocol revenues may disclose retained control.

On the contrary, a genuinely decentralized arrangement, after independent assessment, falls outside direct FATF obligations because no accountable person can be identified. That conclusion does not equate to absence of risk.

The authorities should instead influence stablecoin issuers, regulated VASPs, financial institutions and controlled application interfaces, whereas encouraging digital identity, embedded customer due diligence and blockchain analytics within genuinely decentralized environments.

The licensing and supervisory consequence is straightforward for centralized arrangements. The legal person controllers should be licensed or registered where the arrangement is created, natural person controllers where their business or residence is located, and jurisdictions may also regulate persons that promote or facilitate services to domestic customers.

The supervisors should undertake perimeter reviews, trace governance and wallet relationships, use financial intelligence and regulated institutions as information gateways, and reassess unidentified controllers over time.

The effective supervision should avoid mechanical compliance testing and instead use proportionate requirements, independent smart contract audits, embedded AML and CFT controls, transparent emergency powers, oversight of interfaces and oracles, blockchain monitoring, governance transparency and, where useful, regulatory sandboxes.

The interaction between DeFi and traditional regulated finance is the central policy bridge and financial institutions and VASPs should assess the DeFi products with which they interact, conduct customer due diligence on centralized arrangements, determine licensing and supervisory status, examine the adequacy of AML and CFT controls, and apply Recommendation 13 where correspondent relationships arise.

Where controllers cannot be identified or an arrangement is truly decentralized, regulated entities remain responsible for the integrity of their own systems and should apply proportionate controls to underlying customers, including identity verification and ongoing blockchain monitoring. The institutions should decline relationships where applicable FATF obligations cannot be fulfilled.

The enforcement architecture must match the velocity and technical complexity of DeFi. FATF calls for blockchain analytics capable of tracing funds across chains, bridges, mixers and smart contract interactions, mapping wallet relationships and detecting layering patterns, whereas recognizing limitations arising from specialized networks and pooled smart contracts.

The domestic coordination should combine supervisors, financial intelligence units, cybercrime authorities and law enforcement through operational procedures, shared analytics and specialized task forces. The asset freezing should focus on legally reachable control points, including stablecoin issuers able to freeze or reissue tokens, VASPs serving as custodial exit points, controlled interfaces capable of rejecting illicit assets, and persons holding administrative or multi-signature powers capable of pausing vulnerable protocol functions.

The international dimension ultimately determines whether domestic regulation will be effective. The FATF urges supervisors and financial intelligence units to exchange information concerning controllers, governance and illicit flows through established channels, whereas law enforcement should supplement formal mutual legal assistance with expedited secure exchange of blockchain intelligence because decentralized transfers can traverse multiple jurisdictions in seconds.

Additionally, public private cooperation is equally indispensable, VASPs, financial institutions, analytics firms, developers and DeFi arrangements can assist authorities in identifying control structures, developing typologies, strengthening digital identity, improving incident response and embedding compliance into programmable infrastructure.

The policy objective should therefore not be to force decentralized finance into the institutional form of traditional banking, but to impose equivalent accountability wherever financial functions, control and economic benefit exist, by constructing proportionate external controls where genuine decentralization removes the conventional regulated intermediary.

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Dr. Ikramul Haq, Advocate Supreme Court, specializes in constitutional, corporate, environment, media, ML/CFT related laws, IT, intellectual property, arbitration and international tax laws.  He holds an LLD in tax laws with specialization in transfer pricing. He was full-time journalist from 1979 to 1984 with Viewpoint and Dawn. He served Civil Services of Pakistan from 1984 to 1996.

He established Huzaima & Ikram in 1996 and is presently its chief partner. He studied journalism, English literature and law. He is Chief Editor of Taxation.  He is country editor and correspondent of International Bureau of Fiscal Documentation (IBFD) and member of International Fiscal Association (IFA).

He is Visiting Faculty at Lahore University of Management Sciences (LUMS) and member Advisory Board and Visiting Senior Fellow of Pakistan Institute of Development Economics (PIDE).

He has coauthored with Huzaima Bukhari many books that include, Tax Reforms in Pakistan: Historic & Critical Review, Towards Broad, Flat, Low-rate, and Predictable Taxes (third edition, 2024),  Pakistan: Enigma of Taxation, Towards Flat, Low-rate, Broad and Predictable Taxes (revised/enlarged edition of December 2020), Law & Practice of Income Tax, Law , Practice of Sales Tax, Law and Practice of Corporate Law, Law & Practice of Federal Excise, Law & Practice of Sales Tax on Services, Federal Tax Laws of Pakistan, Provincial Tax Laws, Practical Handbook of Income Tax, Tax Laws of Pakistan, Principles of Income Tax with Glossary and Master Tax Guide, Income Tax Digest 1886-2011 (with judicial analysis).

He is author of Commentary on Avoidance of Double Taxation Agreements, Pakistan: From Hash to Heroin, its sequel Pakistan: Drug-trap to Debt-trap and Practical Handbook of Income Tax. Two books of poetry are Phull Kikkaran De (Punjabi 2023) and Nai Ufaq (Urdu 1979 with Siraj Munir and Shahid Jamal).

He regularly writes columns/article/papers for many Pakistani newspapers and international journals and has contributed over 3500 articles on a variety of issues of public interest, printed in various journals, magazines and newspapers at home and abroad.

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Abdul Rauf Shakoori, Advocate High Court, is a subject-matter expert on AML-CFT, Compliance, Cyber Crime and Risk Management. He has been providing AML-CFT advisory and training services to financial institutions (banks, DNFBPs, Investment companies, Money Service Businesses, insurance companies and securities), government institutions including law enforcement agencies located in North America (USA & CANADA), Middle East and Pakistan.

His areas of expertise include legal, strategic planning, cross-border transactions including but not limited to joint ventures (JVs), mergers & acquisitions (M&A), takeovers, privatizations, overseas expansions, USA Patriot Act, Banking Secrecy Act, Office of Foreign Assets Control (OFAC).

Over his career he has demonstrated excellent leadership, communication, analytical, and problem-solving skills and have also developed and delivered training courses in the areas of AML/CFT, Compliance, Fraud & Financial Crime Risk Management, Bank Secrecy, Cyber Crimes & Internet Threats against Banks, E–Channels Fraud Prevention, Security and Investigation of Financial Crimes. The courses have been delivered as practical workshops with case study driven scenarios and exams to ensure knowledge transfer.

His notable publications are Rauf’s Compilation of Corporate Laws of Pakistan, Rauf’s Company Law and Practice of Pakistan and Rauf’s Research on Labour Laws and Income Tax and others.

His articles include: Revenue collection: Contemporary targets vs. orthodox approach, It is time to say goodbye to our past, US double standards, Was Due Process Flouted While Convicting Nawaz Sharif?, FATF and unjustly grey listed Pakistan, Corruption is no excuse for Incompetence, Next step for Pakistan, Pakistan’s compliance with FATF mandates, a work in progress, Pakistan’s strategy to address FATF Mandates was Inadequate, Pakistan’s Evolving FATF Compliance, Transparency Curtails Corruption, Pakistan’s Long Road towards FATF Compliance, Pakistan’s Archaic Approach to Addressing FATF Mandates, FATF: Challenges for June deadline, Pakistan: Combating the illicit flow of money, Regulating Crypto: An uphill task for Pakistan. Pakistan’s economy – Chicanery of numbers. Pakistan: Reclaiming its space on FATF whitelist. Sacred Games: Kulbhushan Jadhav Case. National FATF secretariat and Financial Monitoring Unit. The FATF challenge. Pakistan: Crucial FATF hearing. Pakistan: Dissecting FATF Failure, Environmental crimes: An emerging challenge, Countering corrupt practices .

The recent publication, coauthored by these writes with Huzaima Bukhari is:                       

Pakistan Tackling FATF: Challenges & Solutions, available at:

https://aacp.com.pk/book-detail/pakistan-tackling-fatf-challenges-and-solutions-35

https://www.amazon.com/dp/B08RXH8W46