Global securities regulators are set to crackdown on decentralised finance (DeFi) platforms as the IOSCO outlines their first blueprint to ensure those who participate in DeFi are held accountable, safeguarding market stability.
The IOSCO, the global umbrella body for securities watchdogs from across the world, has designed a framework for regulators across 130 jurisdictions covered by its membership to ensure investor protection and stable markets with DeFi, identify and manage risks, obtain clear disclosures and cross-border co-operation to enforce applicable law.
The watchdog explained that shocks in one part of the crypto market can trigger billions of dollars in outflows from Defi applications, evidenced by the collapse of crypto exchange FTX and of the Terra USD stablecoin during 2022.
DeFi platforms allow users to bypass banks and exchanges, the traditional gatekeeps of finance, using blockchain technology which allows from the lending, borrowing and saving of digital assets, however, issues have arisen around whether they are truly decentralised.
Ganesh Viswanath Natraj, Assistant Professor of Finance at Gillmore Centre of Financial Technology at Warwick, said: “The move to crack down on decentralised finance (DeFi) is a significant step in the evolving landscape of cryptocurrencies and digital assets, and it remains essential to strike a balance between innovation and regulation to ensure the long-term sustainability of the DeFi ecosystem.
The future of stablecoins and DeFi will likely depend on the maturity of individual economies and payment markets. Ultimately, the responsibility lies with authorities to navigate a path forward that fosters innovation while safeguarding the interests of investors and the stability of financial markets. Striking the right balance in regulating DeFi and stablecoins is a complex but necessary task in the evolving world of digital finance.”
A public consultation on the proposals, which fit with the proposals from IOSCO in May to regulate crypto assets themselves, runs until the middle of October before the framework is finalised nearing the close of this year.
Some member countries of IOSCO, like the US, have already begun looking at how DeFi fits into existing securities laws.
In this month’s Editor’s Question, we ask two experts: how is the DeFi industry’s rapid evolution impacting traditional finance, and what regulatory adaptations are being considered in response?
Paul Wood, Founder, C-PAID
The DeFi industry is undergoing a period of rapid evolution, fundamentally reshaping and challenging the landscape of traditional finance. Leveraging Blockchain technology, DeFi platforms offer financial services through smart contracts and without the need for centralised intermediaries, such as banks and financial institutions. This shift is both exciting and challenging, bringing a new set of opportunities and hurdles for the traditional financial sector, regulators and investors alike.
Impact on traditional finance
Traditional finance is finding itself at a crossroads, where it needs to adapt to the burgeoning DeFi landscape. DeFi platforms offer a level of global accessibility and inclusivity that is unprecedented, allowing a broader swath of the world’s population to access financial services. Moreover, the transparency and security afforded by Blockchain technology are compelling features that are drawing interest from a wide range of investors – indeed, this is proven by the billions of dollars that have been invested into DeFi projects.
From my perspective, overseeing projects like COG, I see a significant opportunity for traditional finance to integrate DeFi solutions to enhance their service offerings. For instance, embedding fiat lending services directly into DeFi platforms, thereby creating a more inclusive financial ecosystem. The rapid pace of DeFi development poses a threat to traditional financial institutions, potentially sidelining them if they fail to adapt and innovate, but it also poses a threat to itself due to the high risk of DeFi platforms being hacked and exploited, with investor funds at risk and usually unprotected. Sometimes DeFi platforms would do better to act more slowly, using the extra time to ensure that they do everything they can to minimise any risk to investors.
Regulatory adaptations
Regulatory bodies worldwide are grappling with the task of formulating frameworks to govern the DeFi space adequately. The decentralised nature of DeFi platforms presents a unique set of challenges, including the relatively high risk of fraud, hacks and other exploits, and with the lack of consumer protection mechanisms that investors have become accustomed to in traditional financial systems.
Personally, I have noticed a growing consensus among regulators to foster innovation while ensuring consumer protection and maintaining the integrity of the financial system. Regulatory adaptations are being considered to address the anonymity aspect of DeFi transactions, with proposals in motion to introduce more stringent KYC (Know Your Customer) and AML (Anti-Money Laundering) regulations – I welcome all attempts to improve the security of investor funds and to minimise the risk of fraud.
Robin Gonzalez Kristensen, Communications Manager, Concordium
DeFi is a game-changer in crypto that democratises and expands the horizon of financial services. It has become vastly popular in Web3 and beyond due to its many possibilities of earning higher interest on provided capital, providing open access to everyone and lowering transaction costs.
Users have many reasons to find DeFi attractive. For example, the elimination of intermediaries, lowering of transaction costs, versatility and interoperability between DeFi protocols allow for bigger yields. The many benefits of the estimated trillion-dollar industry have caught the attention of traditional finance and institutional investors.
The global equity market is estimated to have a capitalization exceeding US$100 trillion. In contrast, the total value locked (TVL) in Decentralised Finance (DeFi) is just above US$37 billion. While DeFi has the potential for significant growth, it requires additional liquidity to reach its full potential. Traditional Finance (TradFi), however, faces its own set of challenges when venturing into less-regulated markets like DeFi.
As more regulations fall into place across jurisdictions, institutional investors (TradFi) will feel more comfortable venturing into DeFi. This will also increase its adoption rate, benefiting retail investors on a larger scale than it currently is. However, with the entry of TradFi, DeFi can lose its inherent appeal of decentralisation. Additionally, there is a middle ground to be found here and Concordium provides this.
Concordium balances transparency and privacy as the most regulatory-ready Blockchain, enabling the deployment of business applications in a secure, reliable, transparent and compliant manner. Concordium has an innovative identity layer at the protocol level, which ensures that every user on the network is identifiable, thus adhering to Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations.
Over the past two years, regulators have been pulling their hammers globally, particularly in Europe. Now we are in a unique position to lead Web3 innovation due to more regulatory clarity and new legislation such as MiCa. Zero-knowledge proofs technology combined with Blockchain technology will have a significant impact when meeting future regulations and how this might affect DeFi and other Web3 verticals.
DeFi is a significant innovation in the world of finance, and as Blockchain continues to evolve, we can expect to see more improvements in DeFi. However, DeFi must become regulated to ensure its widespread adoption and truly witness its full potential. In our latest report, ‘A Brave New World: Regulatory-ready DeFi meets TradFi’, we explore the roles of DeFi and TradiFi in the global financial system of the future.