The rapid development of DeFi has become one of the biggest cryptocurrency stories in 2020. The total value of the DeFi agreement has risen sharply throughout the year, with the total value in September tripled on a monthly basis to more than $26 billion. Although there was a slight decline in October as a whole, weekly data shows that its value will begin to rise again by the end of the month.
However, under the bank secrecy law, securities law and other regulations related to compliance and security, how to deal with the problems of DeFi platform is everywhere. In theory, DeFi platforms can operate autonomously without human intervention, and usually never escrow funds, which makes some people think they are unlikely to be regulated. In fact, many DeFi platforms are very centralized, so the team behind them can prevent risky transactions and take other actions to combat potential criminal activities, which shows that they can be regulated like other cryptocurrency platforms.
Below, we will discuss the development of DeFi so far and some issues of decentralized platform supervision obligations.
Break the explosive growth of DeFi
DeFi is an abbreviation for decentralized finance. Most DeFi platforms are built on blockchains with rich smart contracts-mainly decentralized applications (dApps) on the Ethereum network. dApps can implement specific financial functions under the domination of underlying smart contracts, which means they can automatically execute transactions, loans, etc. when specific conditions are met. Most dApps build liquidity by raising funds from users who believe in the project, and use these funds for production purposes governed by the agreement. Without the need for centralized infrastructure or human governance, dApps allow users to perform financial transactions at a lower cost than other financial technology applications or financial institutions.
Decentralized exchanges (DEXs) are the most popular type of dApp, as we can see in the figure below for DeFi growth by platform. DEXs allow users to directly buy, sell, and exchange different tokens built on a specific blockchain (also mainly Ethereum) between each other’s wallets to obtain greater privacy and security.
Most of the growth in DeFi this year can be attributed to four platforms, namely Uniswap (including V1 and V2), Kyber, Curve Finance and 1inch Exchange. These five are all DEXs, and 1inch Exchange is an aggregator that allows users to obtain various assets on several different DEXs.
The data shows that most individuals who send funds to the DeFi platform are retail users, because the vast majority of transfer transactions are in cryptocurrency under $10,000. However, actual professionals really promote the development of the market. Because most of the transactions sent to the DeFi platform come from transfers of more than $10,000, and 47% of the total comes from transfers of more than $100,000.
The data shows that compared with the entire cryptocurrency ecosystem, the risk of illegal activities on the DeFi platform is relatively small. In the “Crypto Crime Report 2020”, we found that 1.1% of all cryptocurrency transactions were sent and received from addresses related to illegal activities. In general, in 2020, only 0.05% of all funds received by the DeFi platform came from addresses related to criminal activities, and 0.07% of all funds sent by the DeFi platform went to such addresses.
What are the regulatory responsibilities of the DeFi platform?
Most cryptocurrency platforms keep users’ funds in custody, and have a team to manage existing funds, maintain orders, and solve customer problems. This model is very similar to traditional financial institutions. On the other hand, DeFi platforms are at least theoretically managed by self-executing code, which means they can run on their own without any team or company maintenance. They generally do not keep the user’s funds throughout the process, but route between wallets according to the underlying protocol of the platform. Because the DeFi platform is not an active intermediary like other cryptocurrency platforms. Therefore, they are not regulated like traditional money service companies, such as the Bank Secrecy Act, securities laws and other compliance requirements.
Of course, even if this kind of decentralized operation is implemented on the DeFi platform, there may still be issues that regulatory authorities need to explain and clarify. So who will audit the code of the DeFi platform? Who will deal with the loopholes? Who will help victims of DeFi-related fraud and other forms of financial crime? This is why some people believe that regulators are likely to explore other means to enforce law on DeFi platforms, regardless of whether they are associated with formal companies.
However, as cryptocurrency researcher Ryan Selkis pointed out in a recent communication, this kind of argument is meaningless at the moment. Because most DeFi platforms do have a core team that is constantly updating the agreement to freeze user funds or block transactions when necessary. This became most obvious after KuCoin was hacked in September, when cybercriminals tried to launder money by exchanging stolen funds on DEX such as Uniswap and Kyber. The team behind these projects has frozen some funds controlled by hackers, which shows that these platforms are not as decentralized as some narratives claim.
Ultimately, the regulator will decide how to enforce existing regulations on the DeFi platform, or formulate new regulations when necessary to protect the integrity of the financial system. Compared with other parts of the cryptocurrency ecosystem, DeFi’s illegal activities are low, and DeFi enforcement may not be a current priority. Nevertheless, given that the largest DeFi platform has the ability to freeze funds and other activities, and is willing to take actions to prevent the occurrence of malicious cyber crimes (such as the KuCoin hacking incident). All this reflects the team’s ability to take preventive measures and cooperate with law enforcement. And DeFi teams that implement some form of transaction monitoring, Know Your Customer (KYC) agreements and other elements of traditional compliance programs are likely to be in a better position on the day when regulators come to knock on the door.
