DeFi and the decentralisation illusion

As decentralised finance (DeFi) continues to gain attention across the market, many are beginning to question the legitimacy of its claims to 'decentralisation' and 'democratisation'. In light of the risks posed, regulators are attempting to shape their response — and it seems the answer may lie in embedded supervision.

DeFi is a newly emerging way of providing financial services through automated software protocols (i.e., applications running on a public blockchain). It bypasses traditional intermediaries, and instead leverages distributed ledger technology (DLT) and smart contracts to offer direct access to these services. As a result, DeFi purports to 'democratise' the industry by removing middlemen and empowering everyday users.

However, the risks of DeFi and the validity of its claims to decentralisation, came centre stage in June when a prominent crypto custodial asset manager Celsius, froze customer withdrawals. Despite being a central entity, Celsius gave users access to many DeFi products and credited smart contracts and open ledgers with its ability to produce high yields. With Celsius now facing potential collapse, and other crypto firms defaulting on leveraged positions, regulators are calling for a comprehensive analysis of DeFi’s merits and deficiencies.

From the outset, market participants and regulators acknowledged DeFi's many potential benefits while also recognising inherent shortcomings.

On the positive side, benefits could include:

• Its ability to increase financial inclusion through permissionless and open-source protocols,
• Its ability to increase efficiency (and reduce intermediation costs) through programmable contracts that can automatically execute, and
• Its ability to increase transparency via blockchain's tamper-proof design

However, there are also significant negative aspects that need to be addressed:

• The use of high leverage in DeFi markets, which can amplify volatility and procyclicality
• The lack of internal shock absorbers (that provide liquidity in times of stress). This can increase the potential for stablecoin runs that could cut links across investors and platforms, eroding the 'networked liquidity' that is a defining feature of DeFi
• The high collateral requirements. Nearly all DeFi lending transactions require collateral of at least 100% of the value of the loan. These requirements greatly restrict eligibility for many types of loans — thus, casting doubt on the aforementioned claims of increased financial inclusion
• The difficulty in identifying decision-making entities (PDF 6.3MB) that can be held accountable for improper action
• The “decentralisation illusion (PDF 6.3MB)” — i.e., the tendency of blockchain consensus mechanisms to concentrate power. Although a DeFi network cannot be manipulated by a minority of participants, it still remains possible for a majority to 'band together'
• In fact, far from being decentralised, consensus mechanisms rely on validators (PDF 543KB) who must be incentivised to maintain the transaction ledger. Yet each validator (or 'miner') updating the blockchain can choose the order of transaction execution, consequently paving the way for front-running and other forms of market manipulation. According to the BIS, since 2020, total miner extractable value (MEV) has reached an estimated USD 550-650 million on just the Ethereum network. As such, regulators must decide whether this value extraction constitutes illegal activity — as it would in traditional markets (where regulated intermediaries are required to process trades in the client's best interest)
  

To date, pilot projects and regulatory frameworks addressing DeFi continue to be developed across several jurisdictions (notably, Abu Dhabi and Singapore's Project Guardian).

In Europe, DeFi is currently out of scope for the Markets in Cryptoassets (MICA) legislation. However, the Commission has committed to take another look at the issue in 2-3 years' time as part of a report on the effectiveness of the regulation. Therefore, DeFi could well feature as part of MiCA 2.0 legislation, which is expected in 2025.

In the UK, the Government has pledged to continue monitoring this fast-growing area of financial services, with HM Treasury consulting later in 2022 on its proposed approach.

As for the design of these future regulatory approaches, several options are possible:

• Regulators could simply begin by requiring improved disclosures for DeFi applications. Such disclosures could include governance token holding data and changes (similar to listed equity holdings)
• Regulators could employ the gatekeeper approach (PDF 6.3MB) — where supervisors regulate DeFi's entry and exit points (i.e., the exchanges). However, effectiveness is limited by the fact that this would only cover the first and last transactions, leaving all intra-DeFi activity unsupervised
• As smart contracts operate as substitutes for regulated intermediaries, regulators could target the programming teams (PDF 4.1MB) producing the underlying software
• Or regulators could consider using embedded supervision — i.e., a framework facilitating the direct supervision of transactions on the blockchain, by allowing regulators to participate as nodes in the network and / or intervene at the smart contract level

Embedded supervision (PDF 6.3MB) could provide access to all relevant DeFi data, given blockchain's transparent (albeit pseudonymous) nature. Or, in fact, the smart contracts within the protocol itself could be modified to directly include automated provisions for regulatory compliance.

It's also worth noting that the ability to extract transaction reports from the blockchain, would significantly reduce the compliance burden of market participants (who previously would have had to collect and deliver this data themselves).

The European Commission is already testing the ground in this area. It has tasked ESMA (PDF 4.1MB) with preparing a report on data collection approaches through DLT and is launching a pilot project specifically on embedded supervision later this year.

The market's increasing use of DeFi could be moving us towards a future of reduced middlemen and increased customer independence. Moreover, a subsequent uptake of the regulatory approaches described above would mark an important shift away from traditional entity-based supervision towards activity-based supervision, in financial services.

However, it remains unclear how plausible this DeFi future really is. We may instead be moving towards a future of permissioned proof-of-stake blockchains — an outcome that has been repeatedly predicted by international standard setting bodies, including the BIS and IMF (one, two and three). In fact, the BIS (PDF 1.3MB) has even suggested that the future monetary system will involve central bankers and the incumbent financial system adopting the best of the technology to offer many of the same services that crypto and DeFi participants are offering today.

For now, we will have to wait and see.