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As regulators circle above, how should the DeFi industry respond?

Forkast | Adi Ben-Ari | Oct 19, 2021

DeFi at crossroads - As regulators circle above, how should the DeFi industry respond?Recent intervention by regulators in the U.S. and China has made for difficult times for the decentralized finance DeFi sector, but it highlighted again the need to communicate the value that DeFi brings to business and finance, and to allay concerns about the risks.

DeFi is an exciting, rapidly growing corner of the cryptocurrency and blockchain world. It aims to remove human involvement from financial services by using smart contracts that democratize financial services, lower costs and improve access. Its popularity is growing sharply as organizations ranging from startups to traditional banking institutions recognize the value it brings.

Yet, as with all financial services, DeFi is accompanied by risk. The question is: how risky is DeFi and is that risk any greater than elsewhere in the financial services sector?

See:  Decentralized Finance—Risks, Regulation, and the Road Ahead

The regulators evidently see risk. Last month, the U.S. Securities and Exchange Commission (SEC) blocked a new digital asset product from Coinbase called Lend, having determined that it is a security and therefore under its regulatory authority. Later in the month, the People’s Bank of China cracked down on cryptocurrencies and crypto exchanges, declaring that all trading and other activities related to digital coins are illegal.

SEC Chair Gary Gensler commented that “a lot of people are likely to get hurt,” without investor protections of banking, insurance, securities laws and market oversight. His urging of Congress to allow regulators greater oversight of crypto exchanges suggests he wants a much tighter grip.

In China, meanwhile, the government clearly wants greater control as it paves the way for its own central bank digital currency (CBDC), the digital yuan.

Stablecoins support interconnection between DeFi and banking sectors

As Mr. Gensler considers the risks, particularly for small investors, it is incumbent on the DeFi industry to demonstrate that those risks are negligible — and certainly no greater than those elsewhere in the financial services sector.

If stablecoins eliminate the cryptocurrency risk, why all the fuss about them?  First of all, there’s no standardized way for stablecoins to disclose the assets that back them. Second, there are concerns about the providers of stablecoin solutions, private companies such as Tether and Circle, the two largest ones, both of which are under scrutiny over governance.

DeFi link to financial system crucial now, but set to loosen

We see a lot more money going into the tokens than coming out — this is evident in the prices. It looks as though a lot of investors and other organizations wish to stay in the crypto world as longer-term speculation, and to eventually conduct business through it.

See:  Kraken report: Crypto Yields – Deep Dive on DeFi

There are risks in the crossover between DeFi and traditional banking. If you want to cash out of crypto, you have to do so at an exchange — the same as when buying the crypto. The exchange can convert it into dollars or euros, for instance, but that ultimately will be through a traditional bank account. The risk is that the banks can decline their services to crypto exchanges — they have done so before. One reason would be if they don’t know where the money comes from, an important factor as they try to clamp down on money laundering and other nefarious activities.

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