The Decentralized Finance Initiative (DeFi) is blockchain-based financial alternative system. It provides decentralized financial services that can be accessed from any location in the world. They are non-custodial financial products that are different from the centralized options. Because they are managed by groups of people through decentralized organisations, users have greater control over their money.
With decentralized finance taking over the financial industry, here’s a comprehensive look at DeFi regulations, the risks involved, and its future in finance.
Overview
Decentralized finance (also known as DeFi) is an expanding system of financial services that works independently of traditional, centralized banks. DeFi creates an independent financial system without the use of banks or traditional financial institutions. There are however many risks.
DeFi protocols are built using networks such as Ethereum or Binance smart chain and employ self-executing contracts written into code, called smart agreements. The decentralized financial system facilitates multiple financial transactions such as investing, borrowing and insurance.
DeFi: How Does It Work?
DeFi is a collection of decentralized applications (also known as dApps), which perform financial operations on blockchains.
Transactions between investors are done directly through cryptocurrency, DeFi protocols and smart contracts, instead of intermediaries like traditional assets exchanges or crypto exchanges.
Smart Contracts
The smart contract replaces banks in transactions and runs on open-source software developed by developers. Smart contracts cannot be modified and run exactly as they are programmed. Transactional protocols will automatically execute based upon predetermined conditions.
DeFi Protocol
What is DeFi protocol then? DeFi protocols can be described as self-determining programs that aim to decentralize finance, replacing traditional institutions like banks and brokerages. DeFi protocols run on blockchain networks and use smart contracts (computer code). Anybody can access the source code of many of the DeFi projects. Anyone in the world can audit and view all of the transactions. The blockchain data can never be changed, which creates a trusted financial system that is not dependent on code. Decentralized Exchanges are an example of such a system.
The DeFi Applications (dApps), provide worldwide permissionless access and mitigate counterparty risk. They also interoperate well with other apps to allow more advanced financial products. DeFi applications (dApps) allow you to trade on a decentralized exchange, earn fees and provide liquidity, and lend money using a lending protocol.
DApps can be accessed via an app or browser extension. CoinStats is one example. It allows users to track crypto currency prices and connect to various protocols. Users can also directly manage digital assets such as Bitcoin and Ethereum via digital wallets. CoinStats also lets you trade between multiple exchange wallets and accounts, which acts as DeFi. It facilitates buying, selling and loaning, borrowing and swapping cryptocurrencies to their equivalent trading pairs. For example, Bitcoin can be traded for Ethereum.
There are risks involved
DeFi’s popularity has grown tremendously over recent years. It is able to make a huge impact on the banking and financial industry. Investors still need to be aware of the risks involved in entrusting their assets to DeFi. There are three types of risks: compliance, legal and technological. Let’s look into each of them.
Asset
With the crypto market being extremely volatile, inconsistent, and speculative, an unexpected change in market opinions can cause a decline in an asset’s collateral value and result in associated liquidity risks. This can lead to wider sell-offs that can cause instability and uncertainty which could result in token prices plummeting.
Bitcoin’s worst losses were suffered in 2018, when its value plummeted by over 80%. This was the most severe bear market Bitcoin has ever experienced. The crypto market’s performance is strongly influenced by external factors such as social media. One example is the drop in Bitcoin’s value after Elon Musk tweeted, a crypto-loving CEO at Tesla, expressing concern about Tesla’s regulation of its Bitcoin holdings.
Volatility and inherent risk aren’t something that only experienced investors can avoid. Some investors seek to minimize risks by using stablecoins, where the price is designed to be pegged to an asset (usually fiat currency). Stablecoins have underlying assets, such as U.S. dollars and their equivalents to collateralize them.
Technological
DeFi is not without its technological challenges. The public Ethereum Blockchain Foundation powers nine major DeFi projects. However, it is not foolproof. Increasing adoption has led to increased network congestion and bugs. One example: In 2020 network congestion led to a major DeFi app going down, which caused cryptocurrency in excess of $8.32 million being auctioned.
The DeFi apps can also face problems with liquidation, failed transactions, high transaction fees, and other challenges. Defi platforms – like other financial services – face critical security threats and scalability issues. Due to large transactions, individual investors are vulnerable to losses. The security of smart contracts has improved significantly since 2016’s hack by the Decentralized Autonomous Organization (DAO), which saw hackers steal Ether valued at $50 million. DeFi deals are also being made possible by insurance brokers who offer insurance to investors for hacks and malfunctioning software.
Compliance/Legal
DeFi services can be provided by certain independent entities which operate in a way that is not covered under traditional financial regulations. These services often use software programs to authorize transactions and replace traditional banks’ intermediary roles.
DeFi platforms could face confusing and complex compliance and legal requirements. They can also be subject to anti-money laundering or consumer protection considerations. Experts, regulators, and investors have invoked extensive regulatory clarity for DeFi to resolve these problems.
DeFi Regulations
DeFi’s unique characteristics make it difficult to regulate. Regulators must answer complex questions about how, who and where to regulate. The other problem with DeFi is misguided and premature regulation. This could hinder innovation and grow the business.
DeFi challenges financial regulation through the replacement of traditional financial intermediaries by autonomous smart contracts. The best way to deal with the DeFi’s regulatory problems is to use the existing model, while looking for innovative frameworks. Due to the large number of regulators responsible for overseeing financial services, a solid regulatory framework will likely require a great deal of coordination between regulators.
SEC
Although many DeFi activities are very similar to lending and borrowing, there could be other elements that put them under the SEC’s jurisdiction. DApp developers need to consider decentralization in the SEC’s eyes and not be subject to scrutiny by the SEC, which is suspected to be closely investigating DeFi projects.
CFTC
The CFTC has also been interested in DeFi projects, some of which are under its regulatory jurisdiction. However, the CFTC does not have the same jurisdiction as the SEC for digital assets.
Last Thoughts
DeFi’s innovation explosion is creating a huge market, raising many regulatory and security concerns. Firstly, it’s important to determine whether a DeFi application has been audited before using it. Other questions should be asked by users before they interact with the protocol or invest in its governance token. Before investing in DeFi or using its network, it is important to consider the compliance, asset-specific and technological risks.