How Regulation takes shape as DeFi goes mainstream
DeFi has grown exponentially in the past year. What does this growth mean for financial institutions? Will DeFi successfully conquer mainstream finance? What are some of the hurdles and regulatory issues that the DeFi movement faces and how can these issues be tackled? In this article, we discuss these questions and share our perspective on them. To get an overview on DeFi and its popular use cases, read our previous article.
GROWTH
In the past year, DeFi has seen unprecedented growth. Since March 2020, the Dollar value of Crypto collateral locked across DeFi increased over 4000% to reach $39.49B at the time of writing. Of this, lending services have the highest total value locked (TVL) of $16.84B followed closely by decentralized exchanges (DEXs) with the TVL of $15.28B. Derivative trading platforms have a TVL of $3.06B. Other assets and services constitute $4.31B.
Although these numbers are nothing compared to the value locked into the traditional financial system, this rapid growth has indeed turned financial institutions’ attention towards the movement. With the current rate of innovation in DeFi, it may be a matter of time before DeFi products could compete with their Centralized finance (CeFi) counterparts.
KEY TREND
Lending protocols hold a lot of promise for the future of financing as they allow users to borrow without the need for any background checks. Theoretically, this makes borrowing accessible to anyone with a smart device and an internet connection who otherwise could not access traditional financing. The downside for such arrangements is the requirement for over-collateralization to protect the lenders from volatility. But this problem is tackled by another innovative product called a flash loan. This is an advanced loan that can be taken without any collateral but must be repaid in the same transaction. Among other use cases, flash loans are mainly used for arbitrage or collateral swapping. Derivative trading has also been a growing sector within DeFi. Synthetix, the most popular protocol in this area, offers synthetic assets or ‘synths’ which derive their value from another asset like a fiat currency, a cryptocurrency, precious metal or another commodity. Protocols like Opyn and Hegic allow users to trade-in options. Apart from these popular offerings, there are other innovations like tokenized real estate that sell properties in the form of tokens. Buying a token would give you partial ownership of the property and entitle you to get returns in the form of rent.
MAINSTREAM ADOPTION
With DeFi offering such a diverse range of financial products, traditional financial institutions are left wondering if they should participate in the DeFi movement or not. Even if they decide to participate in it, they need to figure out to what extent they should do so.
In any case, if the financial institutions decide to do nothing about it, they may risk missing out on a good investment opportunity. Whereas their extent of participation will depend on how DeFi matures. If it continues to grow in the future as an alternative to the traditional system, FIs can benefit greatly by diversifying into this market and introducing some of their own DeFi products. This will allow them to capitalize on DeFi’s growth and potential. On the other hand, if DeFi shows promise to become the norm, it will require a greater investment of resources. Although the former is the most likely scenario, the path to DeFi cementing itself as a legitimate alternative to the traditional system has several roadblocks.
The major problems faced by DeFi can broadly be classified into technical and regulatory issues. One of its technical issues is scalability. The Ethereum blockchain can currently only handle 15 transactions per second. The growing user base means that this leads to network congestion and exorbitant gas fees (the fee that is payable upon transacting on Ethereum’s blockchain). Apart from this, hacks resulting from smart contract vulnerabilities also plague DeFi. These problems are likely to diminish in the near future as Ethereum gears up to launch Ethereum 2.0, which will tackle its scalability issues and developers would hopefully learn from the hacks and plug all the vulnerabilities which would eventually make these smart contracts foolproof.
REGULATORY
Regulatory issues, on the other hand, are harder to deal with. The DeFi movement’s insistence on user anonymity being protected brings the risk of money laundering along with it. A glimpse of this was seen when a part of the $200 million proceeds from the Kucoin hack was laundered on the popular DEX Uniswap. The fact that the DeFi ecosystem is built on blockchain technology helps the movement in tackling such issues.
BIG’s analytics platform, QLUE™, visualizes the blockchain so that users can follow the transactions and see where the funds went. Law Enforcement and Virtual asset service providers (VASPs) worldwide use QLUE™ to ensure that their platforms are not used for nefarious activities.
Despite the roadblocks, DeFi is growing rapidly. The movement is optimistic that it can overcome these temporary hiccups without compromising its ethos. DeFi presents a great opportunity for financial institutions to diversify and use this technology to create new financial products and services for their customers.
In this effort, QLUE can be instrumental in providing a safe, compliant environment for the users of such products. Find out more about how BIG can help you meet your regulatory requirements. Contact us today.
