Is regulation good for decentralized finance?
At the strike of the pandemic, investors were at a quandary as to where to hedge and protect their investments from dwindling stock values. Then what we saw was the spiking of cryptocurrencies never before seen in the nascent asset class. Institutional investors like Microstrategy, Paypal, Mastercard, and Tesla grabbed headlines by boldly taking steps to include Bitcoin part of their portfolio. Knowingly or unknowingly, DeFi was already riding high playing a huge influence in the all-time highs of cryptocurrencies.
DeFi, or decentralized finance, are digital financial services that allow people to borrow, lend, and invest directly via cryptocurrencies. Blockchain technology is its underlying infrastructure in storing records of digital transactions using automated peer-to-peer agreements called smart contracts, requiring no intermediaries like banks or lawyers.
Since the beginning of 2020, the DeFi market grew to become a multi-billion dollar industry marked by its efficiency in processing payments and money transfers across borders, including the provision of opportunities for the underserved to access financial services. These characters found DeFi a huge potential in international trade.
DeFi, by its nature of decentralization, however, can be its liability. While banks and regulated financial institutions are covered by sanctions and laws pertaining to the failure of its services, DeFi does not hold a particular entity or somebody to be held accountable in case a technical problem arises like a security breach, hacked data, stolen assets, or a systems collapse. This is mainly due to the fact that DeFi applications function on top of a decentralized platform (mostly on the Ethereum ecosystem) that employs distributed ledger technology. DLTs provide real-time transparent records to every participating computer around the world. These computers, called nodes, decide collectively for the overall behavior of the system. Its global transactional operations make DeFi uncoverable due to the differences in financial regulatory frameworks of each country, making international coordination difficult to achieve.
Thus, begs the question, can DeFi be regulated?
The global anti-money laundering watchdog, FATF, or Financial Actions Task Force, has rules for the cryptocurrency industry but it only covers service providers for digital assets and other centralized systems such as crypto exchanges that facilitate the trading between fiat and digital currencies. The requirements include know-your-customer (KYC) procedures to identify customers using their platforms.
But then, FATF rules only apply to centralized systems, but not on the financial activities of decentralized platforms. Buying cryptocurrencies from centralized exchanges and then using it to unregulated decentralized platforms can leave FATF regulation wanting in overall effectiveness.
Some would suggest building regulation into the source code of Dapps, which is a dangerous thing to do since softwares can be subject to code manipulation by developers at their whim running around regulatory oversight.
Meanwhile, there are legislative proposals to ban DeFi operations. Markets in Crypto Assets Regulation, or MiCA, as proposed in the European Union, and the US Stable Bill proposed in the USA.
For all its worth, banning by attacking decentralized systems on all fronts will end up governments and regulatory implementors in a complex hot pursuit of internet service provider cooperation, accessing IP addresses, physical tracing of users and activities, and utilizing police force to close down platforms. The limitations of jurisdiction will find it a very difficult endeavor given the sovereignty of each nation.
The required knowledge to fully understand DeFi and finally regulate it resides in concise education for all stakeholders, beginning from the users to the regulators. Regulators understandably want to protect the interest of their citizens from scrupulous individuals who are out to take advantage of the people’s ignorance about the crypto industry. Not only that, they also want to prevent the proliferation of fraud and theft and the financing of illegal and illicit activities including drug trafficking, gun running, piracy, and terrorism. Since DeFi is a neutral tool, it is subject to the maneuverings of its master, or say, controller. It may be difficult, but it has to start somewhere. DeFi is a good industry and to maximize its potential to benefit the greater majority, a cooperative regulation of a global scale needs to be in place to draw trust towards mainstream adoption.