DeFi has emerged as a revolutionary force in the financial industry (especially highlighted by recent events where some traditional banks collapsed and others narrowly avoided a bank run), demonstrating in moments of distress and uncertainty that it continued to function like clockwork, providing financial services to people worldwide without intermediaries, accounts, or identification.
However, not everything is as rosy from a more institutional perspective, as among the influx of people entering the DeFi space, there were also bad actors with illicit intentions, raising concerns for regulators worldwide. TERRA and its algorithmic stablecoin skyrocketed, only to later collapse, resulting in billions of dollars in losses, while hackers from all corners of the world freely stole nearly $4 billion (speaking only of the year 2022) by exploiting numerous cryptographic protocols. In light of this situation, the U.S. Department of the Treasury took action, quickly issuing a statement to DeFi users, warning them that they consider it a real threat to national security.
As an industry in full development and acceptance, DeFi must find a solution to justify its use, improve the user experience, and initiate the next bullish cycle with the utmost security guarantees, thus paving the way for a long and successful journey.
Consumers, institutions, and regulators demand decentralized services that comply with regulations to ensure overall safety. At Belobaba, we are focusing all our efforts on building this path of understanding among financial systems (TradFi, CeFi, and DeFi) in order to empower the user.
Resolving regulatory concerns while preserving user privacy will mark the institutional beginning of DeFi, allowing for the execution of all financial applications on-chain and opening up new use cases. Regulation is not intended to hinder the creation process but, indirectly, it will endorse greater liquidity and composability for real-world tokenized assets, ultimately making finance more robust and accessible for everyone. None of this can materialize without the effort and engagement of all stakeholders involved in regulation. Consequently, new standards and laws will emerge, enabling programmable compliance with regulations and identity requirements.
WHEN ADVANTAGE BECOMES WEAKNESS
One of the main advantages of DeFi is its accessibility, as it eliminates traditional access barriers such as credit checks or minimum account balances, allowing anyone to access the various financial services that DeFi offers. However, it’s important to note that not everything goes, as without user protection, individuals are at risk of losing their entire capital.
Operating outside the traditional financial system increases the risks that users face, risks that they may not be equipped to handle. Fraud and scams (due to anonymity), vulnerabilities in smart contracts (Rug pulls), market manipulation (through pump-and-dump schemes or front-running), and liquidity risks are just a few examples of the risks that users constantly face. This is why regulators worldwide are paying increasing attention to DeFi and exploring ways to mitigate these risks while preserving the direct benefits that these new financial systems offer.
FOCUS AND IMPLEMENTATION
Under the premise that financial loss can create social, personal, and familial problems for affected users, let’s explore the types of proposals we are likely to see in the DeFi sector:
Licensing and registration: Platforms operating in DeFi will be required to obtain licenses or register with regulatory authorities in each country. This ensures that they comply with certain legal and protective standards.
Disclosure requirements: Platforms will be obliged to allocate resources towards providing accurate information about their operations, risks, and fees. This formal requirement frees users from biases, enabling them to make more informed decisions and reducing the likelihood of fraud.
Periodic audits of smart contracts: Platforms will be encouraged or mandated to conduct third-party audits of their smart contracts. This helps identify and address vulnerabilities before they can be exploited, preventing complex issues from arising.
Consumer protection measures: Implementing mechanisms such as dispute resolution processes or insurance coverage will provide more advanced tools to protect users from potential losses.
As a DeFi analyst and consultant, I believe that striking the right balance between innovation and regulation is crucial to ensure the stability of the emerging financial ecosystem, both in the traditional industry and the DeFi space.