The future of regulation in the DeFi space - summary of MBA dissertation by Shriya Savlani

A summary of an MBA dissertation by Shriya Savlani of Warwick Business School exploring the future of regulation in the DeFi space.

The Future of Regulation in the DeFi space

Advantages of Defi:

-?????????Agile composability

-?????????Open-source/flexibility

-?????????Decentralisation

-?????????Accessibility/wider reach

-?????????Innovativeness

-?????????Interoperability

-?????????Two-sided market

-?????????Borderlessness/supranational

-?????????Lower cost

-?????????Higher speed

-?????????Transparency

-?????????Automation of business process/self-executing services

-?????????Finality

Current market landscape:

-?????????Four primary subsectors that make up the DeFi ecosystem: lending and borrowing; trading; asset management; and insurance.

-?????????Numerous new DeFi solutions have continued to appear across banking sectors after MakerDAO was introduced in 2015.

-?????????Decentralized exchanges and lending platforms have so far seen the most growth in the DeFi market, with other industries continuing to expand as the technology advances. DeFi value generation has varied across sectors. They form around 80% of the DeFi space.

-?????????DeFi is rapidly approaching a critical mass where the emerging ecosystem of protocols might begin to compete aggressively with established financial services companies.

-?????????At the conclusion of the third quarter of 2021, there were 3.5 million addresses using DeFi applications as a whole, a rise of almost 6x from the third quarter of the previous year. The quick increase in DeFi users is proof that customers want a new financial services experience.

Cyber attacks:

-?????????As the usage of DeFi increased 567% in 2021 from 2020, the illicit transaction increased just by 79%.

-?????????The two primary illicit activities on DeFi protocols have been money laundering and DeFi hacking. Digital assets worth $1.7 billion in total were stolen by criminals in 2022, with DeFi protocols accounting for 97% of the thefts.

-?????????The $300 million Wormhole attack in February and the $600 million Ronin bridge breach at the end of March were the two most significant robberies that contributed to the hoard. Cryptocurrency hacks have largely been security breaches in which the hackers have gained access to users private keys (Chainalysis,2022).

Other DeFi Risks:

-?????????Oracles

-?????????Privacy

-?????????Scalability

-?????????Centralisation risk

-?????????Smart contracts vulnerability risk

-?????????Operational security

DeFi’s self-regulation argument:

-?????????DeFi is decentralised and therefore does away with the need for a middleman.

-?????????Smart contracts are self-executing and immutable. This keeps the smart contract's parties secure from any sort of fraud throughout the transaction.

Current views about regulation in DeFi

-?????????The anonymous nature and borderless nature of DeFi makes it the perfect tool for money laundering and illegal trade.

-?????????Decentralised permissionless, non-custodial, and composable systems make it difficult to hold a specific person or entity accountable for any technological failure that could lead to the system's collapse, which also poses governance, legal, and operational risk issues with DeFi.

-?????????Liability allocation in smart contract transactions involving anonymous participants could be difficult, especially if they're being used to cover up fraudulent activity. Smart contracts may include problems.

-?????????Bugs have occasionally caused users to lose money by getting their money locked in smart contracts, which has happened on a few instances. Involvement in the DeFi ecosystem entails a risk that participants are willing to accept.

-?????????Currently, anti-money laundering (AML) and know-your-customer (KYC) regulations do not apply to DeFi protocols or decentralised app.

-?????????While KYC is a part of AML that enables an institution to validate and consequently verify the legitimacy of their customers, AML is an umbrella phrase for the variety of regulatory processes that organisations must have in place to prevent money laundering.

-?????????Recently, European Union released first draft of its first draft of its crypto-asset regulation (MiCA) where they have highlighted the delay in coming up with the guidelines saying?“despite the fact that certain supervisory authorities intentionally avoided this area to be regulated, EU authorities changed their approach towards crypto-assets and following problematic interpretations within both areas, capital markets as well as payments, they prepared first proposal for the crypto-asset instruments.” (Bo?ánek, M., 2021). The regulation focuses on 3 main areas in this space:

? Stable coins/asset referenced tokens: which is basically the cryptocurrencies whose value is tied to real world assets and real currencies

? Utility tokens: Cryptoassets whose main goal is to ensure access to a certain item or service while being available on DLT, rather than maintaining their value.(Bo?ánek, M., 2021)

? E-money tokens: cryptocurrency assets, whose primary function is as a medium of exchange. Due to their reliance on the value of fiat money that is considered to be legal tender, their value remains comparatively steady.(Bo?ánek, M., 2021)

-?????????They also mention that these regulations are just an add on to existing capital markets and payments regulations implying that the regular tradfi regulations will apply to similar DeFi based applications.

What is RegTech

-?????????RegTech is information technology (IT) that (a) enables compliant business systems and data; (b) aids in controlling and managing regulatory, financial, and non-financial risks; and (c) conducts regulatory compliance reporting.

-?????????RegTech also helps businesses manage regulatory requirements and compliance imperatives by identifying the impacts of regulatory provisions on business models, products, and services, functional activities, policies, operational procedures, and controls.

-?????????The emergence of RegTech can be owed to increasing compliance costs.

The whole dissertation can be read here