Monday, 12 July 2021

Swimming in regulatory uncertainty: DeFi – Part I

With regulators’ eyes fixed on the potential harms of an unregulated crypto sector, could DeFi be the next frontier for regulation? After the UK banned operations by crypto exchange Binance last month over concerns over loose regulation and high risk for retail investors, decentralized finance could be the next big headache for regulators. A sign of their growing concern: Reps of automated crypto exchanges such as Uniswap and other players in the fast-growing sector met virtually with the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission to bring them up to speed on developments in the decentralized finance (DeFi) space, the Financial Times reported. The event came on the heels of a global regulatory crackdown on crypto, though DeFi has so far avoided coming under the same harsh spotlight.

What exactly is DeFi? DeFi is an umbrella term for a raft of financial applications in cryptocurrency (mainly stablecoins), geared towards disrupting financial intermediaries and facilitating peer-to-peer transactions. Blockchains — typically Ethereum — are used in DeFi to create “smart contracts,” through which users can manage financial transactions such as lending, borrowing and trading outside the purview of traditional financial institutions such banks, brokerage firms and centralized exchanges.

So how does it work? Users interact with DeFi software protocols through unhosted wallets — non-custodial digital wallets that allow users to store their assets without having to depend on third-parties. The first DeFi application was created by MakerDAO, founded by a Dutch entrepreneur in 2014. MakerDAO is a decentralized autonomous organization that created a token pegged to the USD called Dai.

Interest in DeFi is picking up: As this blockchain-based financial infrastructure gains steam, CoinGecko calculated (pdf) the industry’s market cap at more than USD 90 bn as of this month. American entrepreneur Mark Cuban described DeFi as an industry with “the potential to explode” after the monthly volume of decentralized exchanges skyrocketed to USD 45.2 bn in January, from USD 39.5 mn during the same month a year before. The rise in the price of Ethereum, the most commonly used blockchain for DeFi contracts, is also attributed to increased interest in DeFi. In February, Bitwise Asset Management announced the launch of the Bitwise DeFi Crypto Index Fund — the world’s first-ever fund vehicle for accessing DeFi currencies, angling to usurp traditional finance.

So, what’s the problem with DeFi? In a nutshell, it’s decentralized: Unlike traditional banks, which can be sanctioned or shut down, regulators would face difficulty holding any particular person or entity accountable in this all-digital industry. In DeFi, users do not receive risk disclosures, and its open protocols are not subject to risk management requirements, such as capital and liquidity buffers, that protect against loss of consumer funds and other systemic risks. DeFi users may have little recourse should a transaction go foul.

This is further complicated by the fact that blockchain networks operate globally, meaning that participation in DeFi activities would not fall under any particular country’s regulated financial system or tax laws. And when regulatory standards are created for this sector in one country, platforms may gravitate to countries with less strict protocols. The fact that different countries are at varying stages of regulating the crypto sector is also a challenge, with most crypto-related regulatory frameworks in developing economies still relatively lax.

But wait, how is DeFi actually different from good old fashioned crypto trading? Though users of DeFi contracts handle cryptocurrencies, crypto exchanges are considered a form of CeFi, or centralized finance, in the sense that they are still run by centralized entities that match buyers and sellers, and are subject to KYC (know your customer) protocols, and anti money laundering practices. DeFi sidesteps all of this by facilitating trades through its blockchain hosted contracts. Another key difference is that DeFi facilitates the tokenization of real world assets, creating digital units of commodities, shares, or stock indexes.

Present regulation: DeFi does not refer to a predefined financial system or regulatory framework, but those that apply to cryptocurrency projects currently also govern DeFi, though they do not go into specifics. Present regulation assumes the presence of intermediaries in trades, which does not apply to decentralized DeFi digital asset classes. DeFi transactions conducted between individual users through “unhosted wallets” are also not subject to existing regulatory requirements. “The regulators are probably scratching their heads on how to handle [DeFi],” says crypto exchange Binance CEO Changpeng Zhao, “Do they regulate the guys writing code or do they regulate the blockchain? What’s there to regulate?”

Regulation in DeFi transactions could pose a radical challenge to modern finance: In its “Bitcoin’s Dirty Little Secrets” report in March, Bank of America analysts wrote that DeFi applications are “potentially more disruptive than bitcoin,” stressing that “nobody reasonably could claim that DeFi has at present been fully stress-tested. How hack-proof would DeFi be if the numbers involved were larger? We simply don’t know.”

We’ll explore how regulators around the world are proposing to pull the reins on the DeFi space in part II of our series, in tomorrow’s EnterprisePM.

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