Why has DeFi violated the basic principles of decentralization?
As we have mentioned in the previous article, Decentralized Finance (DeFi) is a revolution in the financial sector and crypto industry, and it tries to solve many problems regarding traditional finance. This article focuses on how the cryptocurrency market, even if decentralized, is not risk-free and whether it is possible to regulate decentralized finance.
The months of May and June have been devastating and have jeopardized the entire crypto industry. The collapse of Terra Luna and the subsequent bankruptcy of Celsius Network has sparked a wave of fear, uncertainty, and doubt across the whole sector, commonly known as FUD. Many users and supporters of both saw their savings burn.
But let’s take a step back and understand if the DeFi really means “decentralization”.
What are the risks of Defi protocols?
The innovation carried forward by the DeFi ecosystems is the interaction among multiple parties without a centralized intermediary or a central authority.
Decentralized Finance has a lot of benefits and solves particular issues featuring traditional financial systems. The biggest problem that DeFi solves is that it removes the mediators or third-party, reducing the problem of trust. It replaces a mediator with a smart contract, pieces of code able to execute transactions, which is entirely automated and requires fewer fees.
But DeFi is so much more; it also increases accessibility so unbanked people can operate on DeFi; they only need a stable internet connection.
Indeed DeFi solves many problems, but it also has its downsides regarding technological, financial, and regulatory risks.
Cyberattacks as the exploitation of a protocol-specific bug.
Rug pulls, a phenomenon in which some malicious developers of the protocols succeed in appropriating the tokens locked in the smart contract and stealing them, suddenly abandoning the project.
Anonymity, characterized by peer-to-peer transactions without intermediaries, represents the most challenging problem regarding money laundering and terrorist financing.
For all these problems and to protect the people who use dapps and operate in the world of DeFi, it is essential to regulate this crypto sector as soon as possible.
Gradually we are moving in the right direction. Some countries and continents are putting in place a regulatory plan. Let’s find out more!
Europe implements the regulatory framework for crypto assets
“When in Rome, do as the Romans do”
This proverb emphasizes that every country has its customs and laws. And the same goes for crypto assets.
For example, China has essentially banned the use of DeFi and private digital assets, and Russia is debating whether to take a similar approach. However, for now, it is still an unresolved matter.
Instead, the European Commission introduced in September 2020 a proposal for a regulation on Markets in Crypto-Assets (MiCA) as part of its digital finance strategy, now updated in June 2022.
The Markets in Crypto-Assets regulation has four essential objectives:
Ensuring legal certainty by establishing a sound legal framework for crypto-assets in its scope that are not covered by existing financial services legislation;
Supporting innovation and fair competition to promote the development of crypto-assets by instituting a safe and proportionate framework;
Protecting consumers, investors and market integrity in consideration of the risks associated with crypto-assets;
Ensuring financial stability, with the inclusion of safeguards to address potential risks to financial stability.
The entry into the application of the MiCA regulation was initially expected by mid-2023. It is, however, likely to be delayed to 2024 as 18 months is foreseen to allow level 2 measures to be adopted before the application of MiCA.
The MiCA regulation is not an isolated initiative. The European Commission’s digital finance strategy relies on the DLT Pilot Regime and the Digital Operational Resilience Act (DORA), not only above MiCA.
Here, you can read the press release of the agreement on European crypto-assets regulation (30th June 2020).
How should DeFi be regulated?
“DeFi has the potential to create fairer, more transparent, and more liquid markets through completely new mechanisms, helping everyone to reduce fraud and front-running, resolving fragmentation, and creating markets that are efficient, resilient, fair, and equally accessible to all — not just participants that have the right connections.” Techcrunch.com
A lot of DeFi protocols are not controlled by a central entity, and for this reason, they cannot be identified. As we have seen, some of them may already fall under current EU financial legislation, but further steps will require to better regulate gaps without escaping financial legislation.
An internationally coordinated approach is needed to mitigate DeFi risks before they pose a risk to the entire financial stability. It’s essential to put into practice appropriate legal actions and enforcements that can fight against the nature of DeFi. The development of DeFi remains uncertain, but we need international coordination to ensure a consistent regulatory approach.