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DEFI SERIES: BLOGPOST #1

2020 BECAME THE YEAR OF DEFI. WHAT REGULATORY CHALLENGES DID THAT BRING?

The year 2020 was no ordinary year.

It was the year when the Covid-19 pandemic stormed the world, causing an enormous loss of human life, grounding planes and forcing us to contend with a new normal. The year of masks, lockdowns and travel bans. The year without parties, holiday gatherings or celebrations. The year when we all felt at least a bit cheated out of the plans we had made.

And it was not only the pandemic. The death of NBA legend Kobe Bryant left a glaring void in basketball history. The United States faced the eruption of social unrest. A devastating explosion struck Lebanon. And China tightened its grip on Hong Kong.

But on the bright side, 2020 was also the year when many things went right. Renewables had a fantastic year, with more than 260 GW of renewable energy capacity added globally in 2020, beating the previous record by almost 50 per cent. In August, Kenya informed the world that its elephant population had more than doubled from 16,000 in 1989 to 34,000 in 2020. And the Global Terrorism Index reported that the number of deaths caused by terrorism had decreased by 59 per cent since 2014.

In the meantime, in the ever-evolving blockchain industry, 2020 was without doubt the year of decentralised finance (DeFi).

It is estimated that various DeFi platforms and protocols received $86.5 billion worth of cryptocurrency in 2020, which represents a 67 per cent increase compared to 2019. Since May 2020, the total locked value into DeFi platforms like Maker, Compound, Uniswap and Aave has grown from under $1 billion to a whopping $88 billion.

The DeFi hype has benefited trading volumes on decentralised exchanges as well. In January 2021, trading volume on DEXs soared to above $50 billion, surpassing the previous record of $26 billion from September 2020 by a wide margin. And the supply of stablecoins went beyond $26 billion, with $20 billion in stablecoins being added to the market over the course of the year.

Looking back on 2020, we can confidently say that it was a great year for DeFi.

A NEW VISION OF FINANCE

DeFi refers to a blockchain-based form of finance that doesn’t rely on centralised intermediaries such as exchanges, brokerages or banks. Instead, all operations are governed by predefined smart contracts on blockchains, the most common of which is Ethereum. Once specific conditions that match predefined rules are met, transactional processes can be executed automatically.

Some of the most popular forms of DeFi include:

  • Staking — an activity that allows users and crypto investors to lock crypto tokens for a specific period of time and receive rewards (interest) for it.
  • Lending — a process similar to traditional borrowing and lending. Users lend fiat currencies to borrowers, who pay interest to lenders in exchange. The borrowers then use digital currencies as collateral to make sure they are able to pay for the borrowed funds.
  • Yield farming — lets users scan through various DeFi tokens in search of opportunities for larger returns. Yield farming is suitable for knowledgeable and experienced traders who are willing to take on risk.
  • Liquidity mining — a popular form of yield farming that grants users the opportunity to lock their coins in DeFi pools and get free tokens in return.

RISE AND OPPORTUNITIES

DeFi gives different opportunities to different actors in the ecosystem. Decentralised protocols are based on open-source code, with smart contracts that can be reviewed, copied and adjusted by anyone. This means that new services and products can be built on top of existing ones.

For crypto enthusiasts and traders, it’s a new, lucrative way to invest and earn with a low entry barrier: the non-custodial business model of decentralised protocols has several advantages, including lower fees, faster transactions and — what can be quite appealing — lack of KYC (Know Your Customer) evaluations.

And this brings us to the topic of DeFi’s most common challenges.

SHOULD WE REGULATE DEFI?

To some extent, yes, definitely. With an established regulatory framework, consumers and investors will be more protected and the market will reach a certain stability. But we also shouldn’t forget that this industry is driven by innovation. Posing constraints on decentralised protocols or enforcing traditional regulatory provisions can seriously affect the groundbreaking nature of these projects.

With decentralised protocols, compliance requirements need to be adjusted for the all-happens-in-the-background nature. And that’s an endeavour that comes with many complex questions.

WHAT EXACTLY SHOULD BE REGULATED?

Decentralised operators, such as DEXs, are now coming to us, looking for a way to comply with at least basic AML requirements. Regulators, especially in Asia, are forcing them to find a solution that could be adopted to the specifics of DeFi. They know that in the near future, they won’t have a choice but to comply.

– Jacek Trzmiel, Senior Business Development Manager at Coinfirm

Which aspects of a decentralised protocol should be regulated? Governance token holders? Smart contract developers? Administrators liable for the correct functioning of the platform? Should we regulate code?

Here is what definitely should not be regulated: the underpinning technology. First, that wouldn’t do the job and second, it limits the innovative power that technology can have.

Instead, regulatory frameworks should focus on preventing illicit behaviour and penalising those who perform or enable such behaviour. Shady outgoing transactions can be stopped, suspicious incoming transactions can lead to freezing funds and the corresponding analytics can be gathered and sent to relevant authorities. However, a downside of this approach is that it requires the involvement of third parties, industry-level collaboration and the setting of common standards. And with DeFi, that’s currently hard to achieve.

Regulating DeFi products is another smart approach. In fact, this is the area where centralised and decentralised financial services can collaborate and combine their unique strengths and capabilities. Centralised finance (CeFi) could support the decentralised industry with knowledge, expertise and processes on regulatory frameworks such as KYC and AML.

WHO IS YOUR COUNTERPARTY?

In the traditional financial industry, there is a need-to-know counterparty for a variety of reasons, including assessing default risk/trust, AML/CTF requirements and transparency.

However, knowing a counterparty requires an end-to-end approach. Yet, with DeFi, transactional processes are cut into pieces and no central entity controls the parties involved. In such an environment, it is difficult to implement an end-to-end approach. For instance, a centralised crypto exchange can’t know who are borrowers in the liquidity pool, and thus can’t monitor funds end-to-end.

As a result, DeFi platforms’ share of stolen funds more than doubled in 2020 — with roughly 33 per cent of all cryptocurrency stolen in 2020 — and DeFi platforms were victims in nearly half of all individual attacks.

Stolen cryptocurrencies have often been laundered on decentralised protocols. For example, in September 2020, the notorious Lazarus Group attacked crypto exchange KuCoin and stole roughly $275 million worth of cryptocurrency. The perpetrators then used DEXs such as Uniswap and Kyber to launder these funds.

CAN WE APPLY WHAT’S ALREADY THERE?

The EU has already taken action to regulate digital assets. The 5th Anti-Money Laundering Directive (AMLD5) came into effect on January 10, 2020, obliging crypto-related businesses, such as exchanges and custodians, to comply with a number of AML requests. Some countries, like Germany, France and Malta, adopted a different set of rules, while other countries didn’t adopt any. As a result, this made the industry even more fragmented and put the EU at a business disadvantage compared to the United States or Asia.

Then on September 24, 2020, the EU Commission published a proposal for regulating crypto-assets called the Markets in Crypto-Assets Regulation (MiCA), in an attempt to create a fully harmonised and comprehensive legal framework. The MiCA, once adopted and in force, will become EU law, regulating crypto-assets in all member states.

According to the proposal, the issuance of any type of digital asset in the EU requires publishing a white paper, registering a legal entity and reporting to a relevant regulatory body. DeFi protocols like Uniswap, Kyber Network and MakerDAO would clearly struggle to comply with these demands. First, they are not bound to a certain jurisdiction where they can register. Second, with decentralised protocols, it’s hard, or even impossible, to specify who is the subject of a certain right or legal obligation.

However, at the time MiCA was drafted, DeFi was not as widespread as now, so many related specifics and challenges weren’t taken into account.

CONCLUSION

So, should we regulate DeFi? Yes, absolutely. At the very least, basic regulation is necessary to reduce risk, push the industry towards mass adoption and protect consumers. Consumer protection is another — due to lack of regulation — challenge for DeFi, since a high level of both financial and technical knowledge is necessary to understand some of these services and protocols, which needs to be simplified.

What needs to be understood is that regulating DeFi protocols requires a different approach. Both policymakers and ecosystem participants need to understand how decentralised protocols work, under which rules and conditions, how they are governed and how they facilitate activities. The industry should work on establishing common standards and extending the regulatory frameworks we already have in place to cover some of these new markets.

Finally, we need to consider how long it will take before DeFi scales beyond digital-only assets and starts incorporating physical assets in its fold. Not too long, if you ask us here at RIDDLE&CODE. Unlocking the industry of real-world assets, valued at trillions, could be an appealing target for DeFi. And this brings new regulatory challenges that need to be addressed. But that’s another topic. For another post.

Stay tuned…

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