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Decentralized Finance—Risks, Regulation, and the Road Ahead

JDSupra | King & Spalding | Sep 1, 2021

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Even those who are most suspicious of the rise of cryptocurrency will likely admit that the underlying blockchain technology and its potential uses are exciting. One use of this technology, decentralized finance, or DeFi, is on the cusp of major growth. Regulators are aware of this growth and are moving to act accordingly. As a possible preview of the coming regulatory efforts, this past spring Treasury Secretary Janet Yellen urged regulators to accelerate their establishment of a regulatory framework for stablecoins, a rapidly growing class of digital currencies which, among other things, can be used on DeFi platforms to temper pricing volatility.1

See:  Inside Jack Dorsey’s Next Big Bet on Bitcoin, DeFi

Since Secretary Yellen’s comments, Securities and Exchange Commission Chair Gary Gensler has made it clear that the regulation of DeFi platforms and stablecoins is on the SEC’s agenda.2 Earlier this month, he wrote to Senator Elizabeth Warren that both should be among Congress’ legislative priorities, adding that “[r]egulators would benefit from additional plenary authority to write rules for and attach guardrails to crypto trading and lending.”3 The SEC also brought its first enforcement case against a DeFi platform this month.4

DeFi Overview

DeFi describes blockchain-based alternative finance systems. DeFi platforms enable users to engage in traditional financial transactions like lending and borrowing through direct peer-to-peer exchanges, eliminating the role of traditional financial intermediaries by directly mediating the transfer of value. Transactions are settled on a public blockchain, rather than through a bank or other central institution. DeFi services use a non-custodial design, meaning assets issued or managed on DeFi platforms theoretically cannot be moved or expropriated unilaterally by parties other than the account owners.5 The use of open-source code—meaning code designed to be publicly accessible—allows participants to view and verify protocols directly as well as create derivative or competitive services.6 The composability7 of DeFi’s programmatic components allows financial instruments and services to incorporate multiple DeFi services and protocols, which distinguishes DeFi from private services or standalone digital assets.8

To effectuate transactions, DeFi uses open protocols9 and decentralized applications, or DApps.10 These protocols and DApps are powered by smart contracts—programs that automatically run when certain conditions are met, which are generally built on existing blockchains such as Ethereum.11 Smart contracts replace the intermediary role of centralized financial institutions with self-executing lines of code built into a blockchain.12

See:  The Intersection of Ecommerce and NFTs: How NFT Technology is Changing DeFi

DeFi has experienced fast-paced growth since mid-2020. As of August 2021, the “total value locked” in DeFi sits around $75 billion.13 This value represents the amount of assets that are currently being staked across all DeFi protocols (i.e., pledged, loaned, or otherwise provided to the network to fund DeFi transactions). And even that figure may only be a fraction of its future potential.14

DeFi Risks

Despite DeFi’s rapid growth, its open-source ecosystem with the potential to democratize banking and finance, and its potential efficiencies, there are significant risks for industry participants to consider. These can be categorized into three buckets: technological risk, asset risk, and compliance/legal risk.

Technological Risk

Many DeFi protocols are powered by Ethereum, including nine of the largest DeFi projects.15 The Ethereum public blockchain infrastructure is far from infallible: increased customer adoptions of DeFi has led to a corresponding increase in attacks, bugs, and network congestion. These can lead to high network transaction fees, failed transactions, and liquidation issues. In some cases, extreme network congestion has led DeFi apps to stop functioning altogether.  In addition to scalability challenges, DeFi platforms—like other forms of financial services operations—also face major cybersecurity threats.

See:  CipherTrace August 2021 Crypto Crime Report: Crypto Fraud Dips as DeFi Hacks Grow

Many of the major DeFi “hacks” have been so-called “flash loan attacks”21 that sometimes take advantage of temporary defects in price feeds.22 Other examples have seen attackers exploit bugs or flaws within a protocol code.23   And beyond hackers, investors risk being targeted by exit scams, such as “rug pulls.” DeFi rug pulls are a new form of exit scam where a developer abandons a project and leaves with the funds.25

Asset Risk

DeFi applications are often built on the Ethereum blockchain, and the collateral pledged in DeFi transactions is typically cryptocurrency. Given the volatility of digital assets, it is possible for the value of that collateral to decline sharply, causing associated liquidity risks. This, in turn, can fuel a broader sell-off, and this uncertainty and instability can lead to catastrophic “bank runs” that send token values plummeting.  Some individuals have sought to use stablecoins, which are backed by an asset (often fiat currency), to minimize this risk.

Compliance Risk

Most of the services in the space are software programs that automate financial transactions and replace the traditional role of the bank as an intermediary. This creates several risks and results in an uncertain regulatory environment. The lack of intermediaries, the anonymity of peer-to-peer transactions, and the global reach of DeFi present potentially amplified compliance risks for participants in the space. In the absence of clear, direct guidance from regulatory agencies, DeFi platforms face potentially vast and confusing compliance and legal obligations. Their operations can implicate a host of considerations, ranging from anti-money laundering to consumer protection.

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NCFA Jan 2018 resize - Decentralized Finance—Risks, Regulation, and the Road Ahead The National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada's Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org

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