How states could sensibly regulate Decentralized Finance (DeFi).

DeFi is now turning this model inside out again. Smart contracts replace intermediaries and different parties can trust each other due to rules written in codes that both parties have to agree to.

This innovation not only lays the foundation for a renaissance of peer-to-peer trading. Smart contracts give anyone with capital and an internet connection access to a range of financial applications that go far beyond simply replacing banks.

In addition, new investment opportunities such as liquidity mining, staking or liquid staking offer completely new methods with which investors can let their capital work for them.

DeFi is a thorn in the side of regulators

These novel financial applications pose gigantic challenges to governments around the world. Truly decentralized DeFi protocols are beyond the reach of authorities as there are no legal entities to be held accountable.

Truly decentralized DeFi protocols are more like collectively available tools on the internet. Anyone can use these protocols and use them for both legal and illegal activities, much like the Internet.

Supervisory authorities are therefore faced with major challenges: How can money laundering be prevented? Who is responsible for DeFi hacks? How can terrorist financing be stopped? How to create transparency and security for DeFi users?

The European Union’s answer to this question is that DeFi should be squeezed entirely within the framework of the traditional financial system; that fiat-to-crypto on and offramps providers like Coinbase, Binance or Kraken are not allowed to carry out any future crypto transfers to unverified wallets.

De facto, this meant that users are only allowed to interact with crypto wallets verified by crypto exchanges and thus indirectly also with DeFi protocols. This would nip DeFi in the bud, as exchanges could not guarantee this verification 100 percent. Unhosted wallets – or rather: wallets created by users themselves – cannot be controlled by a crypto exchange or authority, similar to a physical wallet with cash.

It would therefore be likely that crypto service providers would be forced to drastically limit the transfer of digital assets. The DeFi sector would therefore only be accessible to EU citizens with major restrictions and the majority of the DeFi industry would have to say goodbye to Europe.

According to Peter Grosskopf, co-founder of Unstoppable Finance, such tough regulation would be a huge economic, financial and social setback for Europe.

The big question now is: how could governments enforce regulations that do not depend on the presence of intermediaries (legal entities)? And how could laws protect both the fledgling DeFi industry and its users?

How can you regulate DeFi sensibly?

DeFi has many goals that governments around the world share:

• Creation of broad access to financial services,
• transparency
• equal opportunity
• Efficient financial system

Equal access to capital is not only a key concern of the crypto community. Governments around the world are striving to provide as much of their population as possible with access to financial services. DeFi can help states with exactly this and above all offer countries with ailing financial infrastructure comprehensive access to finance.

DeFi has the potential to create fairer, more transparent and liquid markets that are more efficient, resilient and equally accessible through entirely new mechanisms.

Establishing proper regulation could thus bring many benefits to a society and should therefore be of key importance to governments around the world.

It is therefore important not to intervene too quickly in the DeFi space. Decades-old laws that work in traditional finance don’t translate 1:1 to Decentralized Finance. If states want to benefit from innovation and growth in DeFi, then they need to rethink.

New technologies require new regulatory rules and procedures. It’s not enough to apply decades-old laws to an entirely new technology – but what would be sensible actions that states could take?

1. Cooperation with blockchain analysis companies

Instead of banning all privacy in the DeFi space, regulators could rely on working with blockchain analytics firms and crypto exchanges. The transparency of blockchains makes it possible for every transaction to be publicly visible.

Since strict KYC guidelines already apply to crypto exchanges, supervisory authorities could use this data and cooperation with Blockchain analytics company track where individuals have transferred their digital assets.

As a result, it would not be necessary to suspect private wallets and the use of DeFi in general. In addition, international standards for combating money laundering and terrorist financing could be complied with, criminals could be stopped and the DeFi industry could continue to flourish – a win-win situation.

2. State-monitor DeFi protocols

Unlike the opaque inner workings of many traditional governance systems or the coordination flaws found in free markets, blockchains and DeFi protocols are transparent and smart contracts immutable. This means that anyone with sufficient technical understanding can verify how a DeFi protocol was programmed. Everything is open source and in theory anyone can know exactly what they are getting themselves into when using a specific DeFi protocol.

States could therefore conduct state audits and give a kind of legitimacy stamp to certain DeFi protocols that are considered sufficiently decentralized and secure. For the largest DeFi projects (Uniswap, Anchor, Aave, …), such regular smart contract audits have been common for some time.

Check companies like Trail of Bits, OpenZeppelin or ConsenSys Dilligence periodically the code of various DeFi protocols and then publish reports that educate about risks. They thus assume a similar role as accounting firms in the traditional business world, as they legitimize DeFi protocols and educate investors about risks.

3. Do more education

Arguably the most important point to protect investors from the risks in DeFi is education. For example, one could ask the stock exchanges to create a questionnaire for investors that asks about knowledge and clarifies risks.

Only those who can answer the questions correctly may withdraw their capital to an unhosted wallet or invest in certain tokens. The same procedure has crypto exchanges like Binance already introduced in leverage trading. It would therefore not be particularly complicated to extend this to DeFi space and unhosted wallets.

Another possibility would be the targeted promotion of DeFi education in schools and universities. In the South Korean city of Gyeonbuk, students already have since March the opportunity to take courses on cryptocurrencies or decentralized finance. On the state learning platform Yeep, South Korean students can already learn, for example, how to use digital tokens for online crowdfunding can perform.

Conclusion

Decentralized finance is far from perfect, nor does it offer a solution to all the problems of traditional finance. Nonetheless, DeFi has the potential to fundamentally transform and enhance our current financial system.

With DeFi, more people can be brought into the financial system and many financial processes can be automated, while reducing red tape and increasing tax revenues.

However, all of this requires the correct handling of these new technologies. Well thought-out regulation is therefore essential and could be decisive for the economic success or failure of states.

States should therefore set clear goals and create regulation that paves the way to the new financial world, without simply being satisfied with a faster version of today’s regulations.