DeFi compliance — ensuring decentralized financial systems are fair, transparent and robust

Decentralized finance (DeFi) is gathering significant publicity, investment and crypto development as a new model for numerous financial processes. As DeFi models, technologies and players are so unique, there’s been little involvement by regulators to date. However, regulators will not ignore the dangers of these unregulated financial markets for long; the DeFi industry needs to understand compliance obligations to build a path to wider user acceptance.

What is DeFi?

Traditionally, financial services relied on middlemen to broker transactions between different parties. These third parties would collect hefty fees for their ability to connect and mediate different sides of a financial need.

Consider a bank. On one side are people who want to save money and on the other, people who want to get loans. The bank acts as a central location for both savers and borrowers, deciding who to lend money to and making money off fees.

In a DeFi model, a smart (automated) contract replaces the bank. As opposed to an institution that controls who gets loans, the smart contract provides the loans based on its rules. The only overhead is to run the program; there are no branches, loan managers, or big profits to drive transaction costs up.

Without the middle man taking their cut, the savers get more interest, the borrowers get a lower-cost loan and the loan is processed much quicker.

Of course, this is a simplistic explanation of the complexities of providing trusted savings and vetting and managing loans. The main point is that smart contracts can perform functions that previously were the sole domain of financial entities. However, the legitimacy of these smart contracts is evolving and will require careful consideration by the legal system. To gain general acceptance, it’s vital that the coding is secure and works exactly how intended.

A phenomenal growth story

Over the past year, the interest in DeFi has skyrocketed. One measurement is to examine the Total Value Locked (TVL), the value of tokens stored in accounts used as collateral to secure transactions on various DeFi protocols. The TVL is comparable to Assets Under Management in the investment funds, as both are indicators of how much money is in the system.

In May 2021, the TVL was at an all-time high of USD $89.2 billion. While the market has cooled down and now (July 2021) is around USD $50 billion, that is still a remarkable climb from about USD $3 billion in July 2020.

This growth is even more astounding when you consider that DeFi is very technical, complex and volatile; users need to be crypto-literate, financially savvy and need to adapt quickly as new protocols arise or market situations change.

Of course, even partially replacing the massive traditional financial industry will require simplicity, convenience and security. If the general public can invest simply — with complete confidence — and receive much better economic outcomes, the future of DeFi is exceptionally favorable.

New markets on the block(chain)

DeFi is not theoretical; existing protocols are up and running and changing the way the financial world works. Decentralized exchanges (DEX) allow participants to exchange crypto tokens without using a central exchange. In one week in June, over USD $15 billion of crypto was traded using DEX.

While currently DEX only trades crypto, technically, any digital asset would be tradable using a similar model. And, since just about any asset is tokenizable, eventually, people might be able to buy almost anything using a DEX.

These tokenized assets can be leveraged either through staking or yield farming. Staking involves locking tokens into a protocol to help ensure that protocol runs securely; the tokens, in effect, act as a guarantor for the operation. For backing a protocol, staked tokens receive interest.

Yield farming involves lending tokens to provide liquidity to a financial process. For example, a DEX needs to have tokens available to sell to buyers. The DEX borrows tokens to ensure it can execute a trade and provides yield (interest) based on fees the DEX collects for the trade back to the lender.

These examples show some of the capabilities of DeFi for operating markets, offering loans and creating investment opportunities. By using digital assets, smart contracts, and blockchain, opportunities to replicate traditional financial processes (and create whole new ones) are rapidly developing.

It’s important to understand these markets are new and rely on the integrity of the protocol creator and the smart contract. Currently, the potential gains are enormous, but they come with significant risk.

Ensuring DeFi compliance

Many might think that by their very natures, decentralization and regulatory controls can never be in alignment. They point to the fact that DeFi code can exist without a prescribed location or person or entity behind it — and therefore can’t be under the rule of any jurisdiction. However, there are always entry or exit ramps to financials systems (which can be monitored and controlled), including app stores, domains or bank accounts.

Financial regulators have always been focused on protecting the integrity of markets, making sure they are fair and transparent. While technology leaps ahead, existing laws and regulations around financial activities still apply. While it might take some time for specific legal frameworks to be catch up to the technology, any industry player must understand the current laws and how they might evolve.

To help create a framework to help participants and regulators understand the risks and promises of DeFi, the World Economic Forum has created a DeFi Policy-Maker Toolkit. The toolkit states:

Open-source technology, economic rewards, programmable smart contracts and decentralized governance might offer greater efficiencies, opportunities for inclusion, rapid innovation and entirely new financial service arrangements.

On the other hand, DeFi raises considerations related to consumer protection, loss of funds, governance complexities, technical risk and systemic risk.”

Another global organization with significant insight into how DeFi fits into the fight against money laundering is the Financial Action Task Force (FATF). They have been doing annual reviews of the Virtual Asset Service Provider (VASP) industry and their 2021 update notes the need to start considering decentralized activities:

The FATF should further review its draft guidance to ensure it is providing a clear message on how to apply the standards to decentralized structures, including the definition of a VASP, taking into account the risks, limitations and size of this sector.

The FATF review notes an increase in the use of anonymity tools and methods, which is problematic in uncovering illegal financial activities like fraud and money laundering.

The DeFi industry can’t expect a free pass regarding compliance and should expect similar requirements to traditional financial organizations. If a DEX trades stocks (or tokens representing stocks), it should consider security laws and other conditions that stock exchanges face. Similarly, a DeFi payments company should look to laws that govern money service businesses.

One common regulatory requirement across financial sectors is the need to perform effective Know Your Customer checks. Any DeFi protocol that enables financial transactions without checking identity is a potential magnet for transferring criminally tainted funds sourced from such activities as bribery and corruption, fraud, ransomware, narcotics and terrorism.

Simply put, regulators will not accept these loopholes for criminals to transfer their money and any organization that provides these activities will face a harsh response, including fines, sanctions and/or outright bans.

For those companies that want to help grow the industry long-term and take part in the next phase of the fintech revolution, starting with the current legal requirements is a logical step.