Decentralized Finance Regulation: What are the Risks and Opportunities?

• Dunstan Andre
• 0 comment
• October 4, 2022

“Decentralized Finance” has been inspiring experts for some time as the next big development after Bitcoin and Ethereum. What’s behind it?

Decentralized Finance, or “DeFi” for short, stands for the idea of using the blockchain to organize even more complex financial services such as lending, secondary trading, insurance, or portfolio management decentrally and without financial intermediaries and to enable more efficient and cheaper financial services.

But aren’t more complex financial services such as lending or a stock exchange too “complex” to be able to do without intermediaries? Significantly, today’s dominant crypto exchanges and wallets like Metamask and Coinbase (check out Metamask vs Coinbase wallet comparison here), where cryptocurrencies can be traded, are primarily central intermediaries.

SEVERAL BILLION DOLLARS A WEEK

Until the invention of Bitcoin, many people could not imagine that digital money and securities transfers would be possible without banks. Today, around 13 years later, transfers of cryptocurrencies or security tokens without intermediaries are already part of everyday life in certain circles.

The number of DeFi applications is also growing steadily. DeFi exchanges, such as Uniswap, Sushiswap, or Curve Finance, have been around for several years now. They now process transactions amounting to several billion dollars per week and provide the functionality of exchange without a central intermediary.

And indeed, the most important decentralized exchanges have been functioning robustly so far. Even the extreme fluctuations of the crypto market this spring have survived the exchanges well.

SIZE DIVERSITY OF FINANCIAL SERVICES

On closer inspection, it is not surprising that it is possible to organize an exchange without human intervention via decentralized protocols. Even at central stock exchanges, computer-aided systems and rules are mainly used today. In this sense, decentralized exchanges are more of a consistent continuation of the development of the past decades.

It is to be expected that this development towards further DeFi applications will continue from a functional point of view and that we will see a greater variety of financial services in the future. But what does this development look like from a regulatory perspective?

REGULATORY PERSPECTIVE

Today’s financial market regulation is based on the supervision of financial intermediaries. But what happens when there are no more intermediaries? Who will be the addressee of the regulation?

We have seen an example of this type of problem in the area of anti-money laundering, which today is essentially based on the involvement of intermediaries. Some time ago, the Financial Action Task Force (FATF) proposed classifying software developers as financial intermediaries in decentralized structures and making them responsible for preventing money laundering, which has led to an outcry from the private sector.

CONCERNS OF INVESTOR PROTECTION AND PREVENTION OF ABUSE

The same problem arises for the concerns of investor protection and financial stability. In recent decades, governments have had to drastically expand the regulation and active supervision of financial intermediaries in order to maintain stability and adequately protect investors. Without intermediaries, supervisory authorities now also lack the most important lever for preventing abuse in the financial sector.

DEVELOPMENT COMES TO A HEAD

The development of DeFi is exacerbating a trend that has been observable for several years: Digitization enables new financial market applications that were of course not taken into account when formulating the laws. These fintech applications in the broader sense rub heavily against the applicable laws. In many projects, the assumption under the financial market laws is far from clear in practice.

As a result, the requirement for financial market authorities to interpret the laws appropriately has risen sharply in recent years. With DeFi – without a clear organization to supervise – this development continues to come to a head.

LOSS OF CONTROL AND RISK OF MISUSE

The big question now is how DeFi should be handled under regulatory law in the future. Although there would certainly be the option of not subjecting many DeFi applications to financial market regulation, it is to be expected that the supervisory authorities and, indirectly, the governments in many jurisdictions will not accept the associated loss of control and the possible risks of abuse.

It can therefore be assumed that the scope of financial market regulation will be increasingly extended to the DeFi sector in the coming years. Many countries will try to classify any form of activity in the environment of DeFi applications as a financial intermediary, as the FATF has proposed.

However, this approach is problematic: while it is undisputed that DeFi applications can be associated with risks, their risk profile is fundamentally different from intermediary-based activities.

UNNECESSARY COSTS

The application of an “old” regulatory system to DeFi means that the risks are not adequately addressed. In addition, the current form of regulation is necessary not only, but also because of the intermediaries. An intermediary-free system could therefore dispense with these parts of the regulation.

So when regulation forces the use of intermediaries that are not actually necessary, it leads to unnecessary costs. And it is precisely the increase in efficiency in the financial sector that is a central concern of every economy.

EXISTING SYSTEMS HINDER INNOVATION

Applying “old” regulation to DeFi hinders innovation, undermines the benefits, and ignores the real risks. Therefore, there is no way around a new form of regulation for DeFi: In order to make the most of the significant advantages of DeFi, a new and differentiated risk-based system is required to effectively combat abuse, which does not require intermediaries and does not impair the efficiency of DeFi through the use of technology.

However, the road to such regulation is long. It is best for governments and authorities to take a closer look at the technology, opportunities, and specific risks of DeFi at an early stage, to understand them and to be able to look at them in a differentiated way, and to learn to deal with them.

Even though the stock markets have recovered in the meantime after the shock in March 2020, the uncertainty for the global economy remains. It is therefore to be expected that investors will also be rather cautious in startups, venture capital, or private equity in the coming months.

Another alternative asset class – platforms and companies that specialize in financing SMEs via security tokens – is also likely to have a long dry spell ahead of it. This is all the more unfortunate as the security token industry had developed dynamically just before Covid-19.

Can the security token industry cope with this dampener? Or will Covid-19 even give it an extra boost? Tokenization offers important alternatives in financing and investment right now. From an economic point of view, there are two arguments in favor of giving the asset class a further boost.

ALSO READ: How Bitcoin Losses Translate to Taxes

INCREASED NEED FOR FINANCING

On the one hand, existing companies will have an increased need for financing. Companies that emerge as winners from the pandemic will seek growth capital, while others will need liquidity to maintain their operations. Large companies use the classic capital markets or bank loans for this, but for SMEs, the high administrative burden and the high implementation costs for access to the capital market compared to the relatively small volume are usually too high and bank loans are difficult to obtain.

For them, the blockchain basically offers the possibility of carrying out the process of issuing tradable digital securities much more cost-effectively and quickly. This makes security tokens an attractive instrument for obtaining own or external funds. In addition, it is to be expected that the digitalization boost triggered by Covid-19 will also promote innovation. As a result, – hopefully – new projects or companies will be launched that want to be financed by “classic” stocks, bonds, or even innovative new financial products.

BASIC MARKET NEEDS

Security tokens also offer a fast and in principle more cost-effective way of refinancing. A fundamental market need would therefore be given if all legal requirements and the availability of capital for such products were met.

The second aspect concerns the emergence of a sufficiently large market for financing via security tokens. An economic crisis may not be the right moment to try out new forms of investment. But given the ongoing period of low-interest rates, investor interest in alternative investments is expected to increase as global economic uncertainty eases.

Security tokens can put the process from generation to storage to secondary trading on a completely new foundation and thus help to make investments for which access to the financial sector was too expensive “bankable”. Security tokens thus expand the investment universe for investors, whereby the basic processes have a similar level of security to the “classic” financial infrastructure.

UNIFORM LEGAL FRAMEWORK

In order for this to be implemented in practice, however, the legal and supervisory system must also evolve accordingly. Liechtenstein, for example, has already created an instrument that gives investors comprehensive legal certainty with the so-called Blockchain Act (Act on Tokens and VT Service Providers, TVTG), which came into force on 1 January 2020.

Here it is now possible to generate digital securities directly and without a detour via physical security. For investors, this step means that both the ownership and civil transfer of security tokens can have the same legal certainty as we know from the traditional financial market.

RULES FOR SAFEKEEPING

Another aspect is the rules for the safe keeping of security tokens by service providers. For an investor, it is important that the securities are also separated from the bankruptcy assets in the event of the service provider’s bankruptcy. With the entry into force of the TVTG, all tokens, i.e. not only security tokens but also cryptocurrencies or utility coins, are separated from the assets of the service provider by law. In addition, the TVTG includes some other rules to improve legal certainty around blockchain applications.

However, European providers of security tokens are not only confronted with national civil and regulatory issues. Rather, in the future, some essential questions regarding the treatment of security tokens in connection with European financial market law must be clarified, for example, the very basic one, which token exactly is to be qualified as a financial instrument. This has not yet been conclusively and, above all, uniformly clarified in all countries.

Especially in view of the innovative design possibilities of tokens, however, this is of great importance. Also still unclear are the rules as to when a platform in the context of primary issues of securities must qualify as a financial service provider. As long as there are no answers, a cross-border issuance of security tokens in Europe is associated with major legal risks for companies.

HIGH HURDLES

The same picture emerges in secondary trading: the regulatory framework for financial service providers around securities issuance and trading was created for the traditional financial market. The requirements for financial service providers are therefore relatively high and reflect the traditional, comprehensive business models. For security token service providers, who usually only do a small part of the activities of a traditional intermediary, these hurdles are usually much too high and not appropriate in view of their focused business model.

They therefore often try to position themselves outside the financial sector, combined with corresponding regulatory risks in the European internal market. The distinction between the regulated and the non-regulated area is not really easy in view of the variety of forms of design made possible by the technology – neither for the regulator nor for the companies. It is therefore not surprising that this differentiation is still unclear and heterogeneous in many countries. As long as there is no legally secure and at the same time efficient and cost-effective secondary market for security tokens, the demand from investors will remain within narrow limits.

REGULATORY RISK

Security token service providers have been put on the back burner in recent months, not only from an economic perspective. Rather, the regulatory risk in Europe for players in this sector has not diminished. In some cases, it has even increased, as many states have now developed their own interpretation of the financial market laws with regard to tokens.

For the development of the security token industry in Europe, it is therefore essential that, on the one hand, the existing uncertainties regarding financial market regulation are eliminated as quickly as possible and, on the other hand, the financial market laws are adapted in such a way that service providers are regulated on a risk- and activity-related basis. Without these two steps, the development of the security token industry depends on the established financial service providers, who usually have only a limited interest in the issuance of security tokens.

However, positive development of the security token industry is in the interests of the economy as well as investors. It is therefore to be hoped that the EU Commission will quickly solve these problems and thus lay the foundation for a prosperous security token sector in Europe. Then the time delay caused by Covid-19 would have been well used.