How regulation could be the future of Decentralised Finance

The growth and adoption of decentralised finance (DeFi) has surged by nearly 6,600% in the last year: from a total value locked (TVL) of just over $600 million at the end of March 2020 to over $40 billion as of 17 March 2021. This incredible growth has given DeFi projects a much higher public profile and increased activity.

However, with this popularity comes complications. In the DeFi ecosystem, many projects use the Ethereum blockchain. But this is increasing congestion and causing rising Ethereum gas prices (the cost of performing a transaction), posing a challenge to scalability. The DeFi ecosystem is finding workable solutions for challenges like this. But there’s another growth-related challenge that won’t be so simple to address: regulation.

Within the traditional centralised finance (CeFi) crypto asset space, there’s a widely held belief that with regulation comes legitimisation. The DeFi community generally does not share this belief.

In decentralised finance, there is no central entity that acts as an intermediary between users. Instead, that role is automated via smart contracts. But this doesn’t mean parts of the DeFi ecosystem are beyond the reach of regulators. For example, in November 2018, the US Securities and Exchange Commission (SEC) penalised the operator of a decentralised exchange (DEX) – EtherDelta – for operating as an unregistered securities exchange.

DeFi platforms might attract increasing regulatory attention because of their potential appeal to money launderers – an unintended consequence of their underlying permissionless design. Instead of waiting for regulations to be imposed, DeFi projects should use this time as an opportunity to get ahead of the regulatory curve and build trust in the DeFi ecosystem.

A proactive approach will benefit DeFi

Those running DeFi projects can and should take a proactive approach to compliance. They can start by identifying the financial crime risks that face their projects now. By doing this, they can begin to think about appropriate financial crime controls that will mitigate risks and serve as the foundation for building a good compliance culture. DeFi’s should then be able to enhance their credibility by proactively developing a positive relationship with the regulators and educating them about these risks and controls.

For example, a control might be built into the underlying smart contract that would require an anti-money laundering (AML) check as part of the criteria for execution. DeFi projects could also look into integrating financial crime risk indicators and scores related to wallet addresses and/or transacting parties into their platform. In the same vein, the underlying smart contract could require an identity and verification check to be successfully completed before execution.

Another proactive measure could be to conduct an audit of the smart contract to certify the security and integrity of the underlying code. Such steps could build trust within the project itself. And they could help to normalise smart contract audits as an expectation of DeFi projects, and so raise standards within the entire DeFi ecosystem.

Financial crime compliance processes and procedures should not be seen as impediments. When implemented appropriately, they can be a value creator. And DeFi projects should look to compliance as a means of building trust with parties outside the DeFi ecosystem. There is no investment without trust.

What’s more, financial crime regulation of DeFi is very likely. The Financial Conduct Authority (FCA) has already granted registration to a DeFi entity, recognising it as an e-money institution. Ensuring the best outcomes will depend on proactive and constructive engagement with regulators around many issues: who the regulators seek to regulate, what form the regulation takes and how long it will take for the regulators to catch up. DeFi projects and stakeholders should engage early with regulators to maximise the effectiveness of any potential DeFi financial crime regulation.

Additionally, compliance should be baked into the design of new DeFi projects, so any regulatory requirements that might be imposed can be met with minimal effort. The DeFi ecosystem is fundamentally different from traditional centralised finance, and this necessitates new and creative approaches to compliance to mitigate financial crime risks.

The future of finance can be decentralised. However, we must build trust in this approach before society will be able to reap the rewards of DeFi.

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Finn Welch

Finn Welch

Senior Associate, PwC United Kingdom

Tel: +44 (0)7483 372400

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