DeFi vs. State: Regulation of Decentralized Finance (DeFi)

Decentralized finance (DeFi) poses an existential threat to traditional regulatory frameworks and state control over the financial system.

It has the potential to completely undermine the control of a sovereign over how money and finance work.

Despite all the reasons why decentralized finance and blockchain are empowering fintech solutions for the masses, they may not work out well with governments across the world and might just end up being utopian possibilities.

This is exactly what is playing out. Governments and regulatory authorities across the world have already expressed their scepticism about such disruptive technologies.

While some have even tried to restrict the change by imposing outright bans! Most are fuzzy about their stand and are on edge regarding their policies.

Countries like Qatar, China, Turkey, Thailand, etc. have either banned the use of cryptocurrencies or restricted their usage to a great extent. While others like India responded with high taxation rates and uncertainty!

While enthusiasts will argue that it is technically impossible to ban DeFi, such discouraging steps by the government would more or less make the ecosystem crippled.

Let’s start by understanding different aspects of DeFi regulation.

Also Read (opens in a new tab): What is DeFi? How does it work? & Need for Decentralized Finance [For Beginners]

Does DeFi need Regulation? State Control Over Finance

DeFi enthusiasts hate regulations!

Of course, that’s why they advocate the idea of a “decentralized” financial system.

They often try to scoff at or undermine questions of regulatory control. But let us be pragmatic, and think of it from a law and society angle.

Laws and regulations act as the basic guidelines of how a society functions and how people ought to behave to accommodate differences in individual and collective interests.

When it comes to finance, it becomes all the more important for the law to regulate financial activities and their implications on society at large.

The debate between laissez-faire and government intervention has been an age-old discussion in economics.

Keeping all the real-world shortcomings aside, ideally, state control over money and finance is important for rules-based transactions to protect the common public from frauds and scams and provide a redressal mechanism.

It becomes all the more important in crisis situations to have control over the flow of money into the markets, the interest rates, and foreign exchange.

So, is there a need for DeFi regulation?

Although decentralized finance presents a possibility to do away with mismanagement by financial institutions, by giving more control and ownership to the end-users over their assets, it is important that a blanket regulatory framework operates in order to control and ensure the true “decentralized” nature of blockchain-based fintech.

Cryptocurrencies, NFTs, and DeFi projects at the moment are evolving in a regulatory void fraught with scams and illegal transactions, that go unreported and unaccounted for.

Legal validation of the technology will not only do away with the DeFi regulatory risks and give the DeFi ecosystem a free hand to evolve, but also rein in such illegal activities.

Unless and until the law acknowledges and defines these new-age technologies, it might be impossible to seek redressal for scams and mismanagement of your assets.

Technology can make things simpler and more efficient, but at the same time, it can be a bane for mankind. Imagine living in a world with no control whatsoever over nuclear weapons!

However, instead of banning cryptocurrencies and other blockchain technology solutions, regulated and controlled research and development must be encouraged in the blockchain space.

Blockchain has potential answers to many of our current economic woes, including the likes of efficiency of the financial system, the inflationary nature of money, mismanagement by financial institutions, contractual liabilities, supply chain management, etc.

Can DeFi be Regulated? and Can the Government Ban DeFi?

DeFi is anti-regulatory by nature, hence “decentralized”.

The technology’s Unique Selling Proposition (USP) is its decentralized nature, without any central authority to govern and regulate the terms.

The power lies with end-users, who use its peer-to-peer financing solutions in absence of intermediaries like banks.

Read (opens in a new tab): What is DeFi? How does it work? & Need for Decentralized Finance

Governments across the world have tried to control piracy on the web, and failed miserably!

On similar lines, technically, it is impossible to “ban” DeFi.

Users can easily find solutions to “illegally” trade and transact on DeFi platforms, bypassing regulations and even taxation laws.

However, such a step by the government would discourage and virtually kill the DeFi ecosystem.

It would make it impossible for big businesses to come into the space, hence restricting billions of dollars of investments.

Companies would not be able to scale and will have to operate discreetly.

And let’s be real, other than a section of tech enthusiasts, no one would see it as an investment option anymore. No one would want to risk their life savings by investing in something illegal.

To cut the chase, the government can very well choose to kill DeFi! And this is what is meant by DeFi regulatory risk.

However, it will hurt the state as well, and this is why most countries are still on the fence and trying to figure out things before making a move.

Is DeFi the future?

Well, only time will tell that!

However, what we do know is that decentralized finance (DeFi) can empower the end-users of financial resources, and give more control and ownership to the masses over their assets. It can do away with the drawbacks of traditional finance.

So, how should DeFi be regulated?

The way ahead for authorities would be to develop a collaborative framework where they can monitor and encourage research and development activities in the blockchain space.

Blockchain technology is being regarded as a revolutionary tech that will reshape how finance, business, and the internet work in the coming decades, and hence it is important for a country like India to encourage start-ups and research activities in the field instead of creating an environment of fear and uncertainty for all stakeholders.

The Blockchain market size is projected to grow from USD 4.9 billion in 2021 to USD 67.4 billion by 2026, at a Compound Annual Growth Rate (CAGR) of 68.4% during the forecast period, and a country like India cannot afford to overlook such an opportunity.

Further, at this point, crypto might just be “too big to ban”, although that’s not a strong argument! But considering bitcoin itself once had over 1 trillion dollars in market cap,  any government would have to have some strong reasons to ban it and face the public outcry.

Legal Challenges of DeFi

Laws are needed to regulate society, to ensure the greater good for a greater number of people.

Especially when it comes to money and finance it is important for the sovereign to have control (to an extent!) over financial aspects such as the flow of assets, currency, etc.

Thus from a legal point of view, DeFi is a challenging development for the authorities as it can potentially destabilize the entire financial setup which has been in place for much of the last two centuries.

It has the ability to completely take away the control of the sovereign from financial and money matters.

Yet another major legal challenge posed by decentralized finance is in terms of jurisdiction.

The DeFi space is evolving at a rapid pace with applications and software coming up from all corners of the world in absence of a global regulatory regime.

At the same time, there are untracked frauds happening every now and then.

Blockchain analysis firm Chainalysis in its report ‘The Chainalysis 2021 Crypto Crime Report’ claimed a whopping $14 billion was lost by investors in crypto-related crimes in 2021.

Now the problem lies with jurisdiction over such crimes. 

Blockchain technology promises a financial world without political boundaries, and it is already taking form. It is difficult for authorities to keep track of cross-border transactions in the crypto space.

Now, this poses a serious challenge as to who has jurisdiction over such crimes, and sadly most of these crimes are going unreported and unaccounted for.

All that governments across the world are doing as of now, is warning retail investors against diving into the crypto space, but to no avail.

This rapidly developing field calls for a collaborative approach by governments across the world to form regulatory and legal frameworks to control and track the decentralized finance space.

Regulating decentralized finance will not only reduces instances of scam but also encourage innovation.

From an economic point of view, if we look at the current state of the traditional centralized finance it is fraught with the failure of financial institutions and the regulatory regime.

End-users, usually those with limited resources and power have to face the brunt of such mismanagement.

An RTI reply by the Reserve Bank of India stated that there were around 229 banking frauds a day in 2020-21, with a recovery rate below 1%.

Decentralized finance and Blockchain technology are potential answers to the woes of traditional finance.

However, this will only be possible when there is a global collaborative regulatory and legal framework, with all stakeholders including developers, government bodies, and financial institutions in it.

Such a framework has to ensure a proper balance between the economic utility of such disruptive technologies and their legal viability.

Anything more than that will render the basic purpose of blockchain technology, which is to empower the end-users, pointless.

Let me know what you think about the regulatory risk of DeFi, and how should DeFi be regulated? or should DeFi be regulated at all?

I would love to hear your thoughts 🙂