Author: @gkoupi Translation: Good Oppa, LianGuai

No one said hitting the bullseye accurately was easy

Why do we need to take action on anything?

The decentralized finance (DeFi) ecosystem has become a disruptive force in the financial world, aiming to achieve democracy, transparency, and financial inclusion. Blockchain technology enables peer-to-peer financial transactions, eliminating intermediaries, thus eliminating costs, long waiting times, and associated risks.

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DeFi platforms come with many new (and old repackaged as new) financial products and services, targeting a wide range of users. The broader their coverage, the higher the concerns for consumer protection and unknown risks, which contrasts sharply with the highly complex products and regulations in the traditional financial sector.

When authorities attempt to control DeFi and decide how to regulate it, an important question arises: how to protect consumers while supporting innovation to ensure the industry’s sustainability and success. The difficulty of this task lies in the unknown. It is an ecosystem based on open-source protocols that should be self-regulated through user incentives.

But does it really work?

What capabilities does DeFi have?

The Good

As the debate goes, decentralized or disintermediated finance is a true transformation in the financial field because it offers the same services as traditional finance, such as lending, borrowing, trading, and other novel services like yield farming, without the need for traditional financial intermediaries. Instead, these activities are automated through what is called “smart contracts.” Efficiency improves when we cut out intermediaries, especially for those who lack bank accounts and banking services, who previously had no access to these services because entry and exit from this market are (currently) free, and geographic barriers are reduced or eliminated.

In addition, DeFi is based on open-source protocols, which means it fosters financial innovation beyond the capabilities of centralized finance, as it attracts developers who can collaborate, build new products based on existing protocols, and integrate them with other platforms or dApps.

The Bad

Some challenges and risks of DeFi have caught the attention of regulatory bodies, and for good reason: without intermediaries, consumers face higher risks, from losing private keys to liquidity crises and smart contract vulnerabilities, all of which can result in partial or total loss of funds. In centralized systems, people receive assistance from intermediaries and/or hold them accountable. Regulatory bodies are also able to oversee rules set by intermediaries and require corrective measures to protect consumers.

Ugly

What’s even more challenging is that all layers of the smart contract, dApp, and DeFi stack are relatively young industries with limited maturity and lack of sophisticated controls and security measures. The way smart contracts are written needs to be able to withstand hacker attacks, audits need to be conducted to discover such vulnerabilities, and protocol development needs to ensure that the code does not leave any loopholes. Malicious actors and ecosystems need to ensure that money laundering and fraudulent behavior will not be tolerated – which has not yet happened…

Although the industry has recognized these needs and is working towards them, by observing the latest hacks, frauds, and attacks, we can confidently say that the industry has not yet achieved this goal, and consumers are mostly left unprotected when such events occur.

Regulating DeFi: It’s time to give this statement a good connotation

If we want mass adoption, we need to be able to protect consumers, create a stable environment that inspires trust, and work with regulatory agencies to balance innovation and protectionism. DeFi has great prospects, but the industry will only scale if more people use it.

Key Pillars of Work

• User and participant education: Perhaps the most important factor. It is crucial to ensure that users understand the situations they face and are able to protect themselves from risks.

• Smart contract auditing: DeFi protocols should undergo regular and independent audits to identify vulnerabilities and potential security risks. If the audits are insufficient, they should be suspended. There should be globally agreed-upon smart contract standards and minimum requirements that all protocols must adhere to.

• Implementation of licensing and compliance frameworks for DeFi platforms: The platform is just an automated, peer-to-peer interaction. We need to comply with anti-money laundering (AML) and know your customer (KYC) regulations. We need to be able to trace illegal activities and bad actors to protect the society we live in. It’s as simple as that.

• Disclosure and transparency: Disclosing risks and fully transparent operation of the platform should be an absolute certainty for all DeFi protocols to ensure that consumers understand the risks and are able to protect themselves and make informed decisions when using DeFi services.

• Capital adequacy requirements: Decentralized autonomous organizations (DAOs) should be treated as companies with completely different governance and decision-making processes. They are community-driven and should implement capital adequacy requirements to protect users.

• Data privacy: It’s difficult to talk about data privacy on public platforms. But just because we haven’t reached that point yet doesn’t mean we won’t get there. DeFi platforms have and should protect sensitive user data, so fully implementing data protection regulations is crucial.

• Regulatory agencies and the industry should engage in dialogue, find common ground, and build this ecosystem together. Innovation and consumer protection are equally important, so breathing space and inspiration from new ideas should be given while conducting inspections. Some methods that help facilitate this collaboration are regulatory sandboxes and soft regulatory approaches (encouraging experimentation without harshly punishing mistakes).

How to Strike a Balance?

No one can say for certain how the DeFi industry will develop or how regulations will impact it. Both sides face significant challenges, and even with clear solutions, definitive outcomes cannot be guaranteed. One example is regulatory on/off ramps, which are seen as exit/entry safeguards for authorities to identify individuals and amounts entering and exiting the crypto ecosystem (control over the on/off ramp). This approach is widely used but seems to have little impact on preventing or addressing significant fraud, money laundering, terrorist financing, or other illicit activities.

So, are traditional financial means sufficient to solve the problems of web3? By establishing collaboration among regulatory bodies, DeFi platforms, and other stakeholders, it is possible not only to determine how to best adapt existing measures to the new system but also to find new answers to new problems and provide a regulatory framework that protects consumers while preserving DeFi’s potential for innovation.

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