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More than a decade after its inception, bitcoin BTCUSD,
and other cryptocurrencies have failed to fulfill the dream of a new, widely used global currency free from central bank manipulation. Yet the nascent decentralized finance movement, or DeFi, has the potential to undermine the very foundations of central banking and financial regulation that have defined the U.S. financial system for more than a century.
DeFi is an alternative financial universe comprising countless applications that run autonomously, mainly on the Ethereum ETHUSD,
network, where users can deposit their digital assets and earn income, borrow or lend money and even buy and sell blue chip equity derivatives like Apple AAPL,
and Tesla TSLA,
For tech-savvy investors playing in this space, DeFi has become a boon, with the total market capitalization of DeFi tokens reaching nearly $ 150 billion at its peak in May and with $ 100 billion in total assets invested in them. DeFi applications, according to Defi Llama.
For financial regulators, DeFi represents at best an enigma and at worst an existential threat to public oversight of financial markets. Commodity Futures Trading Commission Commissioner Dan Berkovitz said in a June speech that a purely decentralized financial system that eliminates institutions like banks, brokers and stock exchanges threatens to turn the US economy into a “market Hobbesian where everyone watches over themselves, “because regulators cannot enforce bans against money laundering and fraud, and recover ill-gotten funds for consumers, holding intermediaries accountable.
Securities and Exchange Commission Chairman Gary Gensler also issued a warning to investors on decentralized exchanges last Wednesday, stressing that their activity is still “implicated” by securities laws and that the SEC will not hesitate. not to file a complaint against these participants.
Enforcing these laws in the DeFi space may not be that straightforward, Jai Massari, partner at law firm Davis Polk, told MarketWatch in an interview. She said regulating DeFi will be much more difficult than what the SEC and other regulators have had to do to bring some semblance of order to the crypto markets so far.
“DeFi can present much more difficult legal issues, as it can represent decentralization and disintermediation in a way that regulators have never faced before,” Massari said. “It’s a different challenge, a very different animal and a series of more difficult questions.”
Institutions are coming
Wouter Witvoet is CEO of a company called DeFi Technologies Inc. DEFTF,
which gives customers the ability to make money with DeFi, without having to learn how to access decentralized exchanges, securely store cryptocurrencies, or understand the rapidly changing dynamics between thousands of digital currencies, with new ones created every day.
DeFi Technologies invests in DeFi protocols, or sets of computer codes, earning valuable tokens awarded to users of those programs, and lending cryptocurrencies on these protocols to earn returns. It also invests directly in DeFi projects and businesses.
Witovet compared his company to publicly traded company Grayscale Bitcoin Investment Trust GBTC,
which allows investors to gain exposure to the price of bitcoin in their wallets. DeFi technologies do the same, but for DeFi activities.
“All you have to do is buy our stocks and they are then in your brokerage account alongside your Apple and Tesla stocks,” he told MarketWatch. “You know you will be exposed to cash flow and income from these DeFi projects. ”
DeFi Technologies is just one of dozens of regulated entities that wish to act as an intermediary between the general public and the DeFi markets. Companies like Shyft Network have designed protocols that help cryptocurrency companies comply with anti-money laundering and know-your-customer laws, while regulated entities like Current online banking announced plans to work with DeFi protocols to enable their clients to enjoy the high returns that can be achieved with cryptocurrency lending.
Even Goldman Sachs GS,
is trying to get into the game, asking the SEC for permission to issue an “Innovate DeFi and Blockchain Equity ETF” on Monday, although this does not involve direct investment in DeFi projects.
A clash of cultures
The institutionalization of DeFi has attracted venture capitalists en masse, but this trend is not necessarily suitable for devotees of decentralized technology.
Chris Blec, editor of the DeFi Watch website, is a bitcoin enthusiast who was drawn to digital currency due to his skepticism of central banks and large financial institutions, but frustrated that if he actually wanted to trade bitcoin or using it to buy things, it had to go through centralized and regulated exchanges.
“When I saw decentralized exchanges build, I saw the potential of decentralized services and the possibility of reimagining banking,” he told MarketWatch. “When you combine decentralized cryptocurrency with decentralized finance, you have the opportunity to reinvent the whole system from scratch.”
But Blec quickly turned to a critic of DeFi when he saw developers building governance structures into their protocols that could easily be manipulated by powerful VCs with an interest in integrating the technology, which would eventually mean regulation.
“Some of the DeFi applications under construction may be drastically modified to introduce know-your-customer and anti-money laundering laws and meet other regulatory demands,” he said. “These things can be changed by one to five of their biggest investors.”
He gave the example of Compound, a cryptocurrency borrowing and lending protocol, in which around $ 8.3 billion has been invested. Users are rewarded for their participation in the protocol with a governance token, and users can vote on changes to the protocol, in proportion to the number of tokens they own.
The venture capitalists were keen investors in Compound Labs Inc., which developed the protocol, and are now accumulating COMP tokens at a scale that could allow them to modify the protocol as they see fit, Blec said.
The path to follow
Even if traditional financial firms are to become major players in the DeFi space and use their influence to bring many popular protocols into compliance, new applications will proliferate that break the rules.
DeFi technology allows developers, many of whom remain anonymous, to post code that can function independently. Such applications may well develop into a shadow financial system where hawkers are free to promote fraudulent products and criminals can easily launder ill-gotten gains.
The complexity of DeFi is a factor that may well limit the reach of this parallel financial system, according to Sumedha Deshmukh, blockchain expert at the World Economic Forum and co-author of a June white paper on the regulation of DeFi. She said if DeFi spreads, it is likely that most people will interact with the technology through established institutions that have adopted it for the sake of efficiency.
For those who flout security laws on these platforms, Deshmukh expects there will be no “real-time accountability”, but that regulators will find a way to prosecute the most common scams. blatant and that the transparency of blockchain transactions has enabled law enforcement to track criminal behavior quite well so far.
Despite DeFi’s growth, people still cannot run a business or transact in the real economy without the use of fiat currencies like the US dollar, so regulators can still keep a close watch on the ‘ramps. entry and exit ‘between crypto and traditional economies. , she added.
That said, the issue of investor protection could remain difficult because financial regulators do not have the experience of tracking down anonymous scammers and because they cannot take action against computer code as they do for them. brokers and banks. “That’s the million dollar question at this point,” Deshmukh said. “How to find the right accountability mechanisms”.
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