Decentralised Finance, or DeFi, is the latest wave in the cryptoasset movement. DeFi refers to a wide range of blockchain-based projects that allow people to borrow and lend, speculate on derivatives, trade cryptocurrencies, insure against risks and earn interest on savings without the need for asset managers, banks or other financial institutions.
How does it work?
Like the blockchain technology on which it is built, DeFi projects are intended to operate without any central authority. Transactions take place on an open distributed ledger over which no single person or entity has ultimate control.
What makes DeFi different is its aim to completely remove intermediaries - exchanges, brokers, banks and insurance funds. By replacing third parties with software protocols, users can transact with total independence.
Or at least that's the idea. And it's an incredibly appealing one to many judging from DeFi's stratospheric growth. There are currently hundreds of DeFi projects and communities listed on the DeFi Pulse website which tracks and ranks DeFi protocols.
Since May 2020, the total value locked (TVL) in leading platforms such as Maker, Compound, Uniswap and Aave have grown from around US$1 billion to close to US$88 billion at the peak.
Computer says no
These rewards are not without risks.
In addition to their inherent volatility, DeFi platforms have multiple vulnerabilities including fake giveaways, anonymous hacks, cyber-attacks and pump-and-dumps in which stock prices are artificially inflated with false, misleading, or greatly exaggerated recommendations.
Yesterday the PancakeBunny platform fell victim to a flash loan attack that wiped 95% off its token value.
But who do you call when things go wrong? In DeFi there is no help desk or relationship manager. No risk disclosures. Protocols are not subject to capital and liquidity requirements that protect against loss of consumer funds and systemic risks. There are no anti-money laundering or identity checks.
Not surprisingly, regulators have taken note.
Is regulation of DeFi even possible?
Astraea Group's James Ramsden QC joined forces with other industry experts to tackle this question at yesterday's Crypto AM DeFi & Digital Inclusion Summit.
The view from the ground is that while regulation will be difficult, it is not impossible.
The US government's anti-money laundering agency, FinCEN, has proposed that crypto exchanges be required to file currency transaction reports for any transactions exceeding US$10,000 per day and collect data to enable identification of those transacting on the platform.
The UK, which currently requires businesses carrying out certain cryptoasset activities to register with the Financial Conduct Authority, is likely to follow suit. Other jurisdictions, notably Gibraltar, are opting for highly flexible, bespoke licence-based regulation.
As for the future, James predicts that the inherent tension between users who value their privacy and regulators and law enforcement who need an identifiable human target will lead to software developers getting caught in the crosshairs.
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