DeFi Regulation: Practical Next Steps to Make the Industry Safer

DeFi Regulation: Practical Next Steps to Make the Industry Safer

The regulation of Decentralized Finance (DeFi) is a crucial matter, and it's high time we take action. The fact that DeFi operates without human intervention is a paradigm shift that has far-reaching implications for the future. Similarly, the use of Artificial Intelligence (AI) is a subject of debate that requires our attention. We need to put forward conceptual frameworks and take steps to make DeFi safer now, with basic AML/CFT standards and cybersecurity safeguards.

The first step in regulating DeFi is for the government and industry to agree on a baseline technical understanding of DeFi models and how they differ from centralized services. Moreover, we need to identify "red line" risks that all DeFi projects should seek to mitigate. Collaboration between the government, industry, academia, and civil society is crucial. Private sector participation is key to identifying risks and finding ways to address them.

We need to set industry-wide minimum standards to promote the development of high-quality DeFi applications and services that minimize harm and drive positive consumer outcomes. The time for action is now. We must identify and implement good practices and minimum standards to safeguard the future of DeFi and protect the interests of consumers.

Immediate Steps

1. Establishing basic Anti-Money Laundering (AML) and Counter-Terrorism:

Financing (CFT) standards and robust cybersecurity measures are imperative for the DeFi industry's growth and long-term success. Creating a shared technical understanding of DeFi models and their differences from centralized services is crucial. Collaboration between government and industry is non-negotiable in identifying "red line" risks that all DeFi projects should mitigate. Private sector participation is key in developing industry-wide minimum standards and promoting high-quality DeFi applications and services that minimize harm and drive positive consumer outcomes. It's time to take action and set minimum standards and good practices for the DeFi industry.

2. Cybersecurity Safeguards:

Regulators and the industry should collaborate to establish clear expectations for smart cyber hygiene in the DeFi space. This includes developing tools for visibility into smart contracts and their on-chain governance arrangements. Collaborative security standards, such as smart contract audits, bug bounty programs, and incident response firms, can help reduce the risk of hacking and improve overall security.

The REKT test is an excellent example of cross-industry minimum standards for participants championed over the last year. Despite the decline in the hacking of DeFi protocols, stolen funds remained at a staggering $1.1 billion last year, underscoring the urgent need for robust security measures in this space.

Long-Term Strategies

To gain better insights into the DeFi ecosystem, regulators and the industry must leverage blockchain technology's inherent transparency. This includes thoroughly analyzing on-chain data to understand user activity, asset and platform popularity, and risk concentration. By doing so, we can develop more robust regulatory frameworks that can effectively address the challenges posed by DeFi.

2. Self-Regulation and Best Practices:

The DeFi industry must take responsibility for its regulation by establishing robust best practices and standards for companies. Self-regulatory bodies like the Association for Digital Asset Markets are already gaining traction and will play a pivotal role in shaping the regulatory landscape. To maintain the integrity of the industry, these organizations must prioritize areas such as KYC/AML compliance for digital asset trading platforms.

3. Regulatory Clarity and Consumer Education:

Policymakers must provide unambiguous and unwavering regulations that safeguard consumers and drive innovation. This entails launching comprehensive education and awareness campaigns to enlighten users about DeFi's advantages and pitfalls. Given DeFi's intricate nature, it is imperative to balance regulatory supervision and minimal interference to promote innovation.

4. Addressing Challenges and Risks

Acknowledging the distinct challenges and risks associated with DeFi, including the potential for hacking, transaction processing delays, and the alarming risk of fraud and abuse, is absolutely critical. Regulators and policymakers need to consider these factors and develop regulations that are not only effective but also promote innovation. We must balance regulation and innovation to ensure the continued success and safety of the DeFi industry.

5. Balancing Innovation and Consumer Protection:

As the DeFi space expands, regulators must prioritize striking a balance between supporting financial innovation and safeguarding consumers, combating illegal activities, and maintaining financial stability. To address DeFi's trend toward disintermediation and promote a more open, interoperable, and competitive financial infrastructure, policymakers and legal experts must devise more innovative and effective strategies.

Looking ahead

Immediate steps must be taken in AML/CFT and cybersecurity, but regulators and the industry must also gain a broader understanding of the ecosystem to develop more robust regulatory frameworks. With blockchain technology's inherent transparency, on-chain data can provide valuable insights into the most popular assets and DeFi platforms, the activity of various types of users, the risk concentration within DeFi, and more.

For instance, when we compare the net inflow activity of DEXs and DeFi with CExs and other services over the past year (January 1st, 2023 – December 31st, 2023), we see that the DEX and DeFi category received the most value consistently, with a distinct peak of inflows in February and March. This translates to about $26.33 billion of net inflows compared to $15.28 billion for the next closest category, minting and burning. Moreover, many DeFi inflows come from centralized exchanges, indicating that people often use them to fund their DeFi activities. Ethereum dominates the DeFi sector, accounting for approximately 81% of net inflows during the period. Further analysis could reveal the top counterparties that control these inflows down to the specific transaction level.

Although regulating DeFi is a complex and evolving challenge, we must focus on practical, collaborative measures to achieve shared goals despite ongoing debates between regulators and industry players. Relying solely on regulation for decentralized systems will not suffice. To be effective, market-led initiatives and norms must be established to make the market safer for consumers.