Canada: OECD Publishes Report On Implications And Policy Considerations Of Decentralised Finance (DeFi)

On January 19, 2022, the Organisation for Economic Co-operation and Development (the "OECD"), an intergovernmental organization founded to stimulate economic progress and world trade, published "Why Decentralised Finance (Defi) Matters and the Policy Implications" (the "Report"), a report on the growing application of decentralised finance ("DeFi"), and its increasing interconnectedness with traditional financial markets. The Report outlines some potential benefits of DeFi and describes why, in the OECD's view, DeFi presents an "urgent challenge for policy makers".¹

Evolution and Current State of DeFi

The Report defines DeFi as a development in the crypto-asset space seeking to replicate the traditional financial system in an "open, decentralised, permissionless and autonomous way" based on the use of blockchains, typically built on the Ethereum blockchain network. The key defining features of DeFi projects include:

• "non-custodial nature", which implies the absence of a central authority accessing or controlling participants' digital assets;
• "community-driven governance", whereby markets rely on participants for decision-making; and
• "composability", through which components of DeFi can be pieced together to create new products.²

The Report observes that collateralised lending, which accounts for more than half of the value of crypto-assets locked in DeFi applications,³ is the fastest growing DeFi product. The Report finds that DeFi lending activities try to mirror market-based lending, such as securities lending and repurchase agreements, rather than traditional retail bank lending.⁴ While most DeFi market activity involves collateralised lending, the Report notes that uncollateralised lending is possible in DeFi through flash loans, through which borrowers make and repay a loan in the same single transaction.⁵

The Report's findings suggest that the total value of crypto-assets locked in DeFi applications built on Ethereum blockchains as of November 2021 reached US$100 billion from less than US$2 billion in July 2020, a 50-fold increase.⁶

A significant driver of lending activity in the DeFi space is yield farming, by which users lock their crypto-assets in a lending protocol (i.e. the system that enables lending and borrowing through smart contracts) to provide applications with liquidity in exchange for crypto rewards in the form of transaction fees. The Report identifies this as a key difference of DeFi as compared with traditional lending activity, as it allows the borrowing of assets leveraged by other DeFi users.

Other prominent DeFi applications identified by the Report include decentralised exchanges (DEX), derivatives and synthetics, asset management, insurance, payments and prediction markets.

Although the size of the DeFi market itself is still small, the Report notes that DeFi is rapidly growing and suggests that DeFi and DeFi adoption are worth studying because of the increasing participation of both retail and institutional investors and the potential benefits of this market.

Potential Benefits of DeFi

One of the primary potential benefits identified in the Report is DeFi applications' potential to provide financial market participants with higher speed of execution and lower transaction costs. This is created through distributed ledger technology ("DLT") innovation and disintermediation of third parties, which are replaced by software code, as DeFi allows the transfer of value without the need for trusted centralised intermediaries and through more efficient automated processes. Given the open-source nature of blockchain protocols, DeFi may promote innovation in financial services and could have potential to promote financial inclusion and a more equitable participation of users in markets by allowing market participants to review and further develop the code underlying the protocols. The decentralised nature of DeFi and dispersion of financial service providers through a DeFi system is expected to increase diversity of financial industry participants in the financial system and reduce the concentration of service providers.

The Report suggests that DeFi could enhance security in markets, as decentralised systems may be more resilient to cyber risk than highly centralised systems.⁷ It may also promote market transparency, considering that custody chains in DeFi applications are typically shorter than in traditional asset holding.

Most of the DeFi benefits examined in the Report are part of the broader potential benefits of DLT-based applications in finance and relate to efficiencies, transparency, and resilience. The Report cautions, however, that these benefits are still to be proven for all types of blockchain-based financial applications and that it is difficult to assess both whether these purported benefits will be achieved and, if so, whether these potential benefits would outweigh potential risks.

Key Risks of DeFi

The OECD's analysis shows that DeFi markets and applications give rise to a number of risks, some inherent in DLT-based systems, and others stemming from innovations in the architecture and operations of such markets.

• Unlimited leveraged lendingand re-hypothecation risks – One of the main risks identified in the Report is the potential to engage in almost unlimited leveraged trading and re-hypothecation of crypto-assets through DeFi. The lack of limits on leverage and re-hypothecation could be a significant issue if asset value decreases significantly.
• Consumer protection and market integrity risks – According to the Report, numerous DeFi applications are involved in the non-compliant provision of regulated financial services and products reserved only for licensed entities, thereby exposing participants and markets to risks related to market integrity and consumer protection.
• Anti-money laundering risks – As outlined by the Financial Action Task Force (see our related blog post here), DeFi also raises money laundering and terrorist financing risks due to the lack of money laundering and terrorist financing checks in some DeFi applications.
• Financial stability risks – The Report notes a number of financial stability risks associated with DeFi including potentially new forms of concentration risk relating to, for example, reliance on the Ethereum network and developers within that network. The Report also points out that, as crypto-asset activity becomes increasingly mainstream, the boundaries of the decentralised and traditional systems become more porous and the increased interconnectedness of DeFi with traditional financial markets may give rise to contagion risk from DeFi markets to traditional financial markets.

Other key risks considered by the Report include:

• potential gaps in the regulatory and supervisory framework, and therefore increased prudential risk, which may stem from the novel characteristics of financial service provision in DeFi systems;
• the lack of traditional regulatory safeguards for investor protection and market integrity existing across financial services regulation;
• potential new forms of concentration in service provision, which could give rise to financial stability vulnerabilities;
• anonymity of users and lack of customer due diligence;
• speed with which high levels of over-collateralisation required for DeFi loans can turn into under-collateralisation based on crypto-asset valuations; and
• sophistication of the technological innovation involved in DeFi.⁸

Such risks are exacerbated by the extreme price volatility of main crypto-assets, which has contributed to the fragility of the DeFi market.⁹ The incidence and magnitude of theft through exploiting loopholes and logical errors in smart contracts in DeFi applications further add to such fragility. According to the Report, it is estimated that an approximate US$1.4 billion was taken from DeFi protocols through exploits and bugs in the period of January-November 2021.¹⁰

Policy Considerations

The Report notes that DeFi activity can be broken down into its components and, in concept, existing financial regulation and policies can be applied for the same activity irrespective of the technological means through which they are provided, given the technology-neutral approach adopted by regulators in most jurisdictions with active markets for tokenised assets. However, the Report signals that when DeFi applications or activities fall outside of the regulated space in some jurisdictions, they raise risks that are left unaddressed by existing rules.¹¹

As the existence of intermediaries is contrary to the essence of decentralised finance, the Report observes that some of the characteristics of DeFi may be incompatible with existing regulatory frameworks, particularly given that current frameworks are largely designed for a system that has financial intermediaries at its core.¹² Considering the difficulty of identifying accountable entities that can be assessed or regulated, supervising DeFi applications with existing oversight frameworks may prove challenging.

With the appearance of new types of risks as a result of the development of novel characteristics in DeFi systems, regulatory arbitrage opportunities may emerge for market participants. The Report favours the introduction of additional rules to cover for the technological novelty of decentralised systems. For instance, auditing the code underlying the smart contracts used in DeFi by neutral and trusted external parties could help address the challenge that non-technical expert participants may face when required to trust software developers. Considering the technical complexity of DeFi systems, the Report proposes that supervisory authorities and international standard setters contribute to raising awareness of risks involved in DeFi and consider putting forth soft law instruments designed to assist users, such as guidelines, standards, and codes of conduct. According to the Report, improved disclosure in DeFi applications, including with respect to governance of token holding and admin key data, could have a role in mitigating market integrity risks and providing greater protection to participants.

The OECD sees a role for supervisory authorities and international standard-setters in assessing the risks of DeFi, exploring how existing rules may be enforced in DeFi applications and addressing regulatory gaps.

The OECD concedes that the regulation and oversight of DeFi applications may be challenged by their global reach and operation, given that their activities often have no defined jurisdiction or geographical location and may be accessed virtually anywhere in the world.¹³ The Report encourages greater international policy collaboration and discussion to help overcome such challenges at the cross-border level and deter regulatory arbitrage. The Report also calls for policy makers to include the engineering and software developing communities in stakeholder discussions, as the code embedded in DLT systems could inform the appropriate oversight of DeFi.

Canadian Perspective

Greater collaboration among OECD countries, and local attempts at supervision of DeFi may follow. In Canada, the Superintendent of the Office of the Superintendent of Financial Institutions ("OSFI") recently noted the emerging risks of digitalization and stated in particular that "[a]long with other financial regulators, [OSFI] are watching the continued rise of crypto currencies as well as the broader ecosystem of decentralized finance" and that they were "starting to look at [their] "regulatory perimeter" and how best to develop a policy approach to deal with the emergence of innovators", while seeking to avoid a "two-tiered system, with some participants heavily regulated and supervised and others lightly regulated and supervised." ¹⁴

Footnotes

1. Organisation for Economic Co-operation and Development, Why Decentralised Finance (DeFi) Matters and the Policy Implications, (OECD Paris, 2022), at p. 3.

2. Ibid at p. 18.

3. Ibid at p. 17; online: DeFi Pulse (defipulse.com). As cited at ibid, p. 9, the Report noted that DeFi market data are provided by unverified industry sources.

4. Report, supra note 1 at p. 17.

5. Ibid.

6. Ibid at p. 31.

7. Ibid.

8. Ibid. at p. 43, 45, 58-60.

9. Ibid at p. 23.

10. Ibid. at p. 10; Tim Copeland, "DeFi exploits total $680 million so far in 2021", The Block (November 2, 2021).

11. Report, supra note 1 at p. 58.

12. Ibid at p. 42.

13. Ibid at p. 43.

14. online: Sustaining Canadian Financial System Resilience Through Uncertainty and Volatility (osfi-bsif.gc.ca/Eng/osfi-bsif/med/Pages/op20220203.aspx).

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