Posted By Jessica Weisman-Pitts
Posted on January 26, 2022
Decentralized finance, or “DeFi” as it’s popularly known, is a virtual assets phenomenon that initially gained steam in 2020. Currently, the market capitalization of DeFi protocols on the Ethereum blockchain is $96 billion, with decentralized protocols such as Maker, Curve Finance and Convex Finance having $17.09 billion, $14.68 billion and $12.26 billion locked in the smart contracts.
The function of DeFi is to provide access to traditional financial instruments and services without the need for intermediaries. This is made possible by the underlying blockchain technology and virtual assets. Since many of the capabilities built on DeFi platforms disrupt centralized financial systems, there are regulatory concerns around DeFi apps.
To elucidate, the amount of money lost in DeFi hacks in 2021 amounted to an astounding $1.3 billion. DeFi hacks were also said to constitute 76% of the overall global hacks that took place in 2021. With these statistics, it is evident that there is a need to find the right approach to regulation to ensure the growth of these protocols, protect against other risks, and ensure investor protection.
This article will break down what DeFi Is, the regulatory issues it faces and the way forward for the industry.
Regulatory Issues and Challenges with DeFi
For all the benefits that DeFi protocols may provide, there are also a number of dangers and issues, legally and otherwise, that come along with novel and untested applications. To begin with, one of the most common concerns surrounding DeFi is market manipulation. Now market manipulation is unique to DeFi. It is prevalent in equity markets as well. However, traditional markets have years of evolved regulations that have over time reduced the incidences of such happening, whereas, with DeFi, it is a largely unregulated market. This leads to things like “Pump and Dump”, “Rug-Pulls”, and other incidents that leave retail investors facing huge losses. Compared to more traditional options, DeFi programmes give customers more profits, but with higher yields comes greater danger, which the user may not be aware of. Increasingly, as the segment grows, both consumers and use cases must be educated on the hazards and potentials, and the use cases must be defined.
Additionally, some DeFi apps are not necessarily really decentralized, and a single person or organization might still control even those that appear to be decentralized. Such an organization may be offering unregistered securities and risk a regulatory backlash in this situation. The SEC threatening to issue a subpoena against Coinbase for wanting to launch its “Lending program”, where it would allow users to lend select virtual assets, shows how in the absence of decentralization, the risk of an organization being perceived to be engaging in securities aka “investment contracts” increases and makes it more likely to face legal hurdles.
Lastly, there are substantial worries regarding money laundering and terrorist financing because given the pseudonymity virtual assets possess coupled with money laundering processes like tumbling and mixing. It is entirely possible to use these technologies for masking the origin of illicit gains or funding terrorist ventures. This is a very prominent concern, not just for retail investors but for regulators around the globe.
Regulating DeFi – Financial Action Task Force (FATF) Perspective
Money laundering has been the foremost criticism of virtual assets in general. With the advent of DeFi, regulators are even more concerned and are struggling to find effective ways to combat this issue. The FATF is the global watchdog that sets standards and guidelines regarding combatting money laundering and terrorist financing. It periodically publishes various reports and guidelines for financial institutions to follow. Recently, in October 2021, it released its updated guidance on its risk-based approach to virtual assets and Virtual Assets Service Providers (VASPs). Inter alia, the FATF spoke about the approach to DeFi. It stated that DeFi protocols were not VASPs given that they are merely software and thus not subject to the purview of the guidance (as the guidance dealt with virtual assets and VASPs only). However, it laid down a crucial “owner-operator” test for distinguishing those truly decentralized projects versus those that are not. It states that those creators of the DeFi protocol that maintain control/influence over the protocol regardless of its purported decentralization were VASPs and thus liable to comply with money laundering regulations. A creator of the protocol cannot be absolved of liability to comply with money laundering regulations merely because the protocol is governed by self-executing smart contracts and do not need human intervention. If the creator will continue to collect fees or realize profits, regardless of whether the profits are direct gains or indirect, then such a creator is VASP and required to comply with the FATF guidelines. Appropriate measures have to be taken in order to mitigate the risks of money laundering. Several blockchain analytics companies such as TRM Labs, Chainalysis, Scorechain, etc., provide solutions to help protocols comply with regulatory compliances. This is the necessary direction the industry must go in in order to ensure the balancing of the interests of all stakeholders.
Apart from the owner-operator test, the FATF guidance also clarifies that stablecoins, in general, will be covered by the FATF standards as either a Financial Institution or a VASP. The FATF standards apply to stablecoins and their service providers either as virtual assets and VASPs or as traditional financial assets and their service providers.
Therefore, it is risky for entrepreneurs and investors to assume that DeFi protocols exist entirely outside the scope of regulations. In the coming times, we will see regulators adopting these recommendations, bringing DeFi protocols under the ambit of the regulation and compliance. The way forward is for protocols to ensure that their compliance is in place beforehand- from sufficient decentralization to implementing blockchain analytics tools etc., rather than waiting for regulatory scrutiny to arise.
Conclusion
DeFi can help democratize access to credit, give easily accessible proof of asset ownership, and allow the vast majority of people to engage in the financial system freely. It is critical for regulators to safeguard investors and consumers, but it is also essential to enfranchise small businesses, the poor, and anybody who cannot meet the standards of the current centralized system. The actual difficulty in achieving the potential of DeFi and the virtual assets industry will be striking a balance between these opposing goals.