The development and growth of blockchain technology excite even those who are most suspicious of cryptocurrency and all it entails.
The potential of decentralized finance is so immense and diverse in its functionality that regulators are recognizing its value and starting to act accordingly.
As Defi expands and grows continuously, it is crucial to understand its underlying concepts and the risks involved in these systems.
A Defi system is an alternative financial system based on blockchain technology.
Defi is unique and attractive because it eliminates a third party involved in financial transactions. Such a platform enables users to participate in many types of transactions such as borrowing and lending by peer-to-peer means without the need for an intermediary entity.
All transactions are managed on a blockchain platform, whereas a traditional financing system would include the involvement of a central financial institution such as a bank.
A non-custodial design is central to Defi services. Assets on a Defi platform cannot be moved or transferred by anyone other than the account holders themselves. Due to the use of open-source codes, all the participants have direct access to protocols and can create competitive services based on what they observe.
The manner in which the programmatic components of Defi are assembled allows financial services to include numerous Defi protocols and services. This sets Defi apart from standalone digital assets and private services.
Decentralized finance uses decentralised applications and open protocols to execute transactions. Smart contracts are the driving force behind such protocols and DApps. Smart contracts are essentially online programs that run automatically when certain conditions are met. Smart contracts are typically built on existing blockchains.
Smart contracts are the digital replacements for centralized financial institutions as their codes are built into a blockchain, managing all transactions that occur on it.
There are many similarities between the products and functions of Defi and traditional financial markets. Many DApps that run on blockchains offer opportunities for users to obtain loans by posting collateral. This is comparable to traditional collateralized loans.
Other DApps enable users to deposit digital assets in exchange for an increased return. This service offers direct returns, while indirect returns involve the use of borrowed assets in other investment opportunities.
Various tools available on the web can help users identify the highest-yielding platforms to invest in. Some DApps allow users to earn simply by supplying liquidity. Some tokens are coded to track security trading prices on registered U.S. national security exchanges and can be used on various Defi apps. The technology underlying Defi is still relatively unfamiliar, but they resemble digital products and activities within the SEC's jurisdiction.
Investing serves as the primary activity on Defi platforms. The goal is not simply to generate new digital assets in the form of tokens. Smart contracts have been developed to allow users to lever their investments and move assets rapidly between platforms. Some projects display the potential for substantial increase regarding scalability, cost, transaction speeds, and customization.
Defi's development is particularly impressive when considering how young blockchain technology truly is and how much potential for evolution it is already presenting. Because Defi majorly centers around investments, various risks are involved in generating passive profits based on hoped-for token values.
There are significant risks that participants need to consider, despite the rapid growth of this open-source ecosystem. Defi has the potential to democratize banking and the financial world as we know it. Three main classifications of risks exist. These classes include technological risks, compliance risks, and asset risks.
All the technology-related risks that Defi currently has are because blockchain technology still has some limitations.
Many Defi protocols are built on the Ethereum blockchain. This is where the challenges arise as the Ethereum blockchain has its flaws. Because of the large amount of traffic Ethereum has been experiencing, it has been subject to multiple bugs, attacks, and network congestions. These issues can cause transactions to fail, increase fees, and clearance issues. In the past, these concerns have caused entire Defi apps to halt in functions, having damaging implications.
Apart from these scalability issues, Defi platforms also face cybersecurity threats. Although smart contract technology has improved substantially over the years, cyber attacks are still a very real threat. In 2020, 15 separate attacks led to $120 million in Ether being stolen. Since then many other successful attacks were conducted. Many hackers set their sights on the temporary defects that occur in flash loans. Other attacks take advantage of bugs in the protocol code.
One significant attack even resulted in losses of about $80 million when hackers stole a smart contract code from the founder's computer.
Other popular scamming techniques are known as "rug pulls." These scams are called exit scams, where the scammer will disappear, taking with them the initial coin offering offered by investors.
More traditional forms of fraud include team members promoting a large APY to retail liquidity providers on social media, only to withdraw all the funds as soon as enough funds have been locked into a smart contract.
Investors could experience major losses if there are any instabilities in the data security of this growing space. Because of these threats, insurance brokers have started to get involved to provide insurance against malfunctioning software and hacks.
Because more Defi apps are built on Ethereum, the collateral amounts that are pledged in transactions are commonly cryptocurrency. Because the values of cryptocurrencies are so unstable, the value of these collateral assets can drop substantially within the blink of an eye, leading to serious liquidity risks. When this happens, it causes a wider sell-off that can lead to "bank runs," which in turn causes a massive crash in token values.
We are all aware of the scale of crypto market volatility. This was displayed when the bitcoin value dropped by over 80% before rebounding again. The Defi market is subject to all kinds of external influences, such as social media. After Tesla CEO Elon Musk posted a tweet that was interpreted by many to mean that he was downscaling on his bitcoin holding, the bitcoin market dropped drastically. This was just another indication of how young this specific asset market truly is.
Just as a great influx of buyers will drive up the value of cryptocurrency, an efflux will act to crash this value. This is not a common occurrence with more traditional finance.
An example includes the loss of over 60% within 24 hours of the tokens Crypto Village Accelerator and Galaxium. Even more settled cryptocurrencies such as Uniswap experienced a decrease of around 7% in this same time frame. Although it may not seem like too much, it is actually quite extreme and once again points out the volatility of crypto assets.
Many investors are used to these changes and the risks involved. Many people prefer to use stablecoins as they are backed by another currency that is fiat money, more often than not. The instability of cryptocurrencies drove many people to rather put their faith in stablecoins as it offers, as the name suggests, much more stability to the user. Users that are more comfortable with traditional money choose to execute transactions with stablecoins, but this does not come without its downsides. Stablecoins are often associated with lower returns since low-risk investments have low returns.
Most services on a Defi platform are run by automated transactions, eliminating the middle man, which is the bank in most traditional financing services.
This results in an unpredictable regulatory environment. Compliance risk is brought about because of the lack of intermediaries and the existence of anonymous peer-to-peer transactions.
Defi platforms often encounter unclear compliance and legal obligations due to the lack of guidance from regulatory agencies.
Many investors, regulators, and experts have demanded more clarity on regulation in the Defi ecosystem to solve this problem.
Federal financial regulators and Congress are responsible for constructing a functioning regulatory regime. Much of the existing guidance provided focuses more on matters such as initial coin offering than it does on Defi itself. This can, however, change very soon if enforcement interest, public comments, and stablecoin conversations are any indication.
Defi promoters often disclose the risky nature of investments in that it can result in significant losses, but they cannot offer participants the access needed to assess the risk likelihood and extent. In many cases, a "buyer beware" approach is used. Investors are informed of the risks involved and make the decision to go ahead regardless.
It is advised that new participants and investors be cautious in their activities as nobody can deny the severity of the risks.
DeFi has proposed splendid alternatives for executing transactions, but it has not, however, rewritten the financial system entirely, and certain principles are true for DeFi as well as traditional financing:
Warning investors of risks is simply not enough to build a satisfactory foundation for a financial market. When a common set of expectations are absent, it allows for corruption, fraud, self-dealing activities, and a tendency towards information asymmetries. As a result, investors will, with time, lose confidence and trust in the marketplace.
Markets like the U.S. capital markets are well-regulated and, as a result, have the ability to grow and flourish because of their reliability and the presence of a minimum standard of disclosure.
DeFi has not implemented a regulatory framework that can offer protection. Securities laws found in traditional systems solve many of the above-noted problems, allowing markets to function much better.
A variety of federal authorities are likely to have jurisdiction over certain aspects of DeFi. In the U.S., these authorities include the International Revenue Service, the Financial Criminal Enforcement Network, and the Department of Justice. Specific aspects of DeFi might fall under the jurisdictions of state authorities as well.
Despite the involvement of these authorities, investors in the DeFi market will likely not receive the same level of disclosure and compliance that is considered normal in regulated markets.
It is expected of investors and other market participants to understand that opportunities offered outside of regulatory oversight are much riskier than in traditional markets where all participants adhere to the same set of rules.
Various regulators have attempted to set guidelines by which developers and users can utilize a DeFi platform optimally. Being decentralized, this is an especially difficult task. Setting rules on how to regulate DeFi spaces introduces a unique challenge, but the following regulators are putting forward their best attempts:
With the large variety of regulators that are involved in all the aspects of traditional financing, establishing a vigorous regulatory framework for DeFi will require a lot of coordination between regulators.
SEC Chair Gensler emphasised the number of challenges faced by investors and SEC staff alike when it comes to crypto lending platforms and other DeFi platforms. In his speech, he also stated that SEC would begin to take on cases involving crypto, fintech, and cyber.
DeFi has many characteristics that could bring them within SEC jurisdiction because of its close resemblance to banking in that the activity on DeFi platforms is centred around lending, borrowing, and, to a lesser degree, insurance. Gensler directly requested more access and power to oversee activities on DeFi and crypto lending platforms.
In addition to Gensler's remarks, SEC Commissioner Hester Peirce has publicly expressed his perspective on the matter. According to Peirce, if protocols aim to relate to asset management or imitate securities, they should be eligible to be overseen by SEC.
Being proactive about the matter, Peirce has put forward a three-year safe harbour proposal for the sale of tokens. This proposal has, however, not been instated as of yet.
An investigation by the SEC's Enforcement Division led to a DAO Report in 2017, which states that federal securities laws can be implemented in the actions of digital assets. After that, there was a drastic increase in enforcement activity concerning initial coin offerings. In the years that followed, approximately 80 crypto-related enforcement actions were instated. Over 50% of these actions were related to initial coin offerings.
Since SEC got assiduously involved, they have only announced a single enforcement action which was focused on the misrepresentation of the operations on a certain platform. Further, SEC also professed unregistered sales of securities. As SEC is continuously getting more involved in DeFi projects, developers are advised to be well informed concerning SEC's approach to decentralization.
In 2015, CFTC first proclaimed jurisdiction over digital assets in its CoinFlip order. In this order, digital currencies were classified as commodities.
When digital assets are deemed as commodities, CFTC has the power to act against fraud and manipulation of virtual currencies that are traded for future delivery and traded as a commodity in interstate commerce.
Commissioner Dan Berkovitz stated in a public speech that decentralized finance markets need to implement contracts to be traded on a designated contract market. This has to be licensed as well as regulated by the CFTC.
Despite the fact that transactions are recorded on a public blockchain, DeFi investments are most certainly not transparent.
The lack of complete transparency gives rise to a market where expert investors can reap massive returns while retail investors have to take greater risks.
It is not often a disclosed topic for retail investors, but the underlying funding deals allow for great advantages for professional investors. This inequality offers expert investors more options, advisory roles, involvement in governance and operations, access to project team management, and the ability to distribute interests to allies.
Due to these advantages, retail investors will always be a step behind professional investors, never truly gaining access to these opportunities and potential for success.
An argument against this statement includes that DeFi is, in fact, very transparent because of the public accessibility of activity that the code allows for. It is worth noting that only a handful of people can actually read and understand this code.
The quality and protocols of these codes vary widely, and expecting investors to be advanced interpreters of this code is not a reasonable requirement in building a financial system. Most investors will not be able to assess the security and outcomes of their investments.
Professional investors have the available funds to hire technical experts and economists to analyse the relevant code and deliver an accurate prediction before an investment is made. Retail investors simply do not have this advantage as it isn't cost-effective to hire an expert to audit the code. They can only rely on information gathered by word of mouth, advertised data, and social media. There are not very reliable sources to base such a risky investment on.
Although these advantages and disadvantages are prevalent in all financial markets, DeFi undoubtedly enhances these inequalities.
As an intermediary is missing, there is no system to monitor operations and functions outside of its market protection regime. Retail investors are left with no middleman who can screen investments for legitimacy and quality.
DeFi markets are susceptible to manipulations that are difficult to detect. Blockchains can record and track transactions that take place on it, but it is limited in the information they can display about the participating parties. Due to pseudonymity, only the blockchain address of the receiver and sender of funds are made known but never the identity of the person itself.
Suppose users cannot effectively determine the identity of traders and owners of smart contracts. In that case, it is almost impossible to determine if the traded assets are legitimate or simply a product of manipulative trading.
Such manipulative strategies include one user using bots to run multiple online wallets as well as a group of users that trade collusively.
Pseudonymity makes it easy to hide manipulative activity. It is near impossible for users to distinguish normal organic trading activity from manipulative trading. This makes investors susceptible to unsavoury activity and great losses as a result.
The pseudonymity of DeFi has been a tool to obscure the identity of the real world and has been central to bitcoin and all other blockchains that followed in its footsteps. Investors have simply become accustomed to a system where they sacrifice their privacy to a certain extent in exchange for fair and orderly regulation where fraud and manipulation are not as prevalent as in the DeFi marketplace.
Retail investors are moving to DeFi most likely not due to privacy but rather motivated by the greater returns than they can find in other investment opportunities.
Many DeFi projects are dead set on conserving privacy, but those that solve the issues associated with pseudonymity are more likely to succeed. The reason for this is that investors can be assured that all assets involved in transactions accurately reflect real interests instead of just being the product of manipulation.
Decentralized tools were developed to be an alternative to traditional financial systems, which are based on trust and dependent on intermediaries to hold assets and execute transactions.
For DeFi to be successful, developers will surely find a way to build a sustainable framework of regulations in the absence of intermediary entities. Before investors decide to participate in DeFi investments, they need to consider the asset-specific, technological, and compliance risks involved.
DeFi app developers and platform users can follow the following steps to ensure that they can identify and solve problems associated with risks:
Regulatory scrutiny will become ever more present as the DeFi industry grows and evolves. This has been demonstrated in the drastic growth of the stablecoin space. Industry participants and developers should stay updated on all the risks and requirements associated with the DeFi environment and be sure to construct risk-based structures to adhere to.