Decentralized Finance (DeFi) represents a fundamental shift in how financial services can be carried out, because the ecosystem relies on internet-based, open source protocols on public blockchains rather than traditional brick and mortar intermediaries like banks.
However, questions remain over the long-term viability of DeFi, and if “full” decentralization can actually be achieved especially in the face of looming regulation. Regulators themselves might also face significant hurdles, as regulatory standards designed for centralized intermediaries cannot be easily applied to a decentralized environment.
At the recent TechLaw.Fest 2022, panelists discussed their views on the emergence of DeFi and how regulation should be developed and effectively implemented to keep pace with this dynamic industry.
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“With Web3, we’re talking about a borderless space where transactions are not country specific, which brings about its own complexities,” said Joyce A. Tan, managing director at Joyce A. Tan & Partners LLC.
“There is a lot of disintermediation going on in an increasingly integrated environment, and regulation has been challenged and is much more agile,” she noted.
Regulating decentralisation and anonymity
The promise of decentralisation is alluring, with many users attracted by the high returns that the protocols offer. According to data from The Block, DeFi TVL (total value locked) – the overall value of assets deposited in DeFi protocols – rose from US$700 million in December 2019 to over US$200 billion at the start of 2022 prior to the recent market crash.
However, DeFi protocols may not be as decentralised as they claim to be. According to Magnus Jones, Nordic Innovation lead at Ernst & Young, “nothing” is decentralized right now, and hence the challenge for regulators at present is trying to identify the people behind these projects.
“There’s no such thing as a smart contract creating itself..There’s always a physical person or a link towards it,” he said.
“You can’t just create a monster and get away with it and have no obligations if you are identifiable,” he added.
Just a rich nerd’s pipe dream?
While the idea of DeFi is viable and even noble (it’s often marketed as a more equitable form of finance due to the lack of the high barriers to entry imposed by traditional financial institutions), a global financial system developed by a handful of programmers and supposedly managed by the masses isn’t something that governments and financial institutions around the world would easily agree to, which means that more regulation is inevitable for DeFi.
Regulation also means that that an intermediary is going to have oversight over these “decentralized” protocols, and will be able to dictate their dos and don’ts, which inadvertently makes DeFi just another form of CeFi for now, but with the added complexity of blockchain technology.
“I think we’re a long way from from regulators decentralizing…We have fantastic centralized bodies,” William Hallat, partner and co-chair of global financial regulatory practice at Gibson Dunn & Crutcher LLP, told Blockhead on the sidelines of the conference, when asked if DeFi can still be “decentralized” if it’s regulated.
“If you don’t have a centralized entry point for regulation, and essentially it’s [DeFi] borderless and anonymous in certain ways, then how actually do you effectively regulate and enforce your regulation?” he explained.