Introducing regulations on DeFi: Is it a Wise Step?
In the past couple of years, DeFi has transformed from a domain only a certain niche of people knew about to one that is familiar to every Tom, Dick, and Harry. Locked-up assets have risen from less than $1 billion in 2019 to more than $100 billion in just two years, drawing at least one million investors. The DeFi business is predicted to grow to $800 billion in 2022 as a result of a rising prevalence of institutional investors entering the market.
Even with all of the benefits that DeFi technologies provide, there are still risks. A blockchain-based contract can’t be changed after it’s been published. A small coding error can have catastrophic consequences, and there have been multiple cases when tens of millions of dollars have been lost. In addition to human mistakes, the DeFi world can be perilous in other ways.
With the growing importance of DeFi, there’s a call to impose regulations on the decentralized nature of things in which DeFi works. Although decentralization should technically mean that there should be no regulations, experts have deemed that adding regulations will help mitigate risks till a certain point.
There’s a shift in the finance world
DeFi has ushered in a slew of new DeFi concepts that are reshaping the financial environment. DeFi staking, DeFi trading, and DeFi farming are some of the more well-known examples. Let’s talk about these concepts.
- Staking
DeFi staking entails entrusting one’s crypto tokens to a smart contract in the hopes of receiving more tokens in return. Consider it a decentralized version of putting your money in a fixed deposit at a bank. DeFi staking has arisen as a new way to benefit from your crypto assets with the emergence of bitcoin and Decentralized Finance.
- Swapping
Swapping is a mechanism for exchanging assets in DeFi. In essence, a token swap is a mechanism that allows investors to exchange their existing tokens for new ones. Token switching is only possible with a DeFi protocol, such as a decentralized exchange, which, unlike centralized exchanges, uses the AMM (Automated Market Makers) method, in which the smart contract code is written in a way that allows for token swapping. Token swapping is managed completely by smart contracts.
- Farming
In DeFi, yield farming entails lending or staking your cryptocurrencies or tokens in exchange for transaction fees or interest. This is comparable to earning interest on a savings account or lending to a borrower on modern (but centralized) P2P marketplaces.
The Global board warning
Martin Moloney, secretary-general of the International Organisation of Security Commissions (Iosco) is planning to publish a 43+ page document citing the more than a dozen risks identified in the DeFi market.
The board of Iosco wrote, “Most DeFi protocols rely on centralization in one or more areas, and there are protocols that have a hidden centralized authority and are decentralized in name only.”
While grappling with the larger question of how to govern the bitcoin ecosystem, regulators have taken limited attempts to rein in the DeFi industry. Many developers have stated that once open-source software tools have been published to a community of users, they cannot be held liable.
Regulations… but how?
DeFi covers a wide range of financial services that, in some aspects, are similar to those provided by regulated financial intermediaries. On the other hand, it also rejects the traditional frameworks on which regulatory systems are based, in different ways.
Financial services regulatory systems were not designed with DeFi in mind.
While some legal frameworks are being updated to include digital assets, the focus has so far been on establishing the digital asset as a tradable investment product and authenticating those who deal in it — rather than what the network does or how it runs.
In the case of traditional finance, the service is usually provided by a business and/or persons. That intermediary is legally competent in taking on legal and regulatory responsibilities and complying with them. Licensing systems are designed to allow such businesses and/or persons to operate.
However, with a genuinely decentralized system based exclusively on smart contracts, there may not be a clearly identified “person” delivering financial services. Furthermore, the parties’ legal connection is not always obvious. Should individuals who have engaged in direct contractual agreements with one another be considered the ones delivering services? If that’s the case, how would regulators enforce any restrictions imposed by the regulatory framework on anonymous investors working through a DeFi platform?
So what’s ahead?
Previous experience with digital assets implies that authorities are typically cautious to licence financial market innovation until they fully comprehend the activity.
But we have platforms like XinFin taking the first step. In September 2021, Xinfin partnered with London-based software company, Tradeteq, to launch the world’s first trade finance-based NFT transaction. This is the first end-to-end transaction to be completed in accordance with a unique set of regulatory norms and trade finance criteria.
The product makes use of XDC Network’s enterprise-grade blockchain technology to convert trade financing assets into non-fungible tokens, which Tradeteq repackages and distributes. These tokens, which represent the value of an off-chain asset, can be bought and sold by institutional investors. This grants token holders legal ownership of an asset or set of assets.
It’s important to realize that managing DeFi protocols necessitates a distinct strategy. Both policymakers and community participants need to know how decentralized protocols work, what rules and circumstances they operate under, how they are controlled, and how they facilitate activities. To cover some of these new areas, the industry should concentrate on developing common standards and expanding the regulatory structures already in place.
There is a long winding road ahead, but one full of rewards and improvements.
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