How Does Regulation Impact DeFi?

DeFi has made finance so much easier. Perhaps too easy.

Just a few years ago, crypto finance was complex. You had to submit paperwork, comply with regulations, and hope that the platforms keep your coins safe. But since DeFi, now anyone can access financial services within minutes, no matter who or where you are.

This also means it's never been a better time for crypto scams. Rug pulls, Ponzi schemes, and fake ICOs have become more and more common. Not to mention the many DeFi risks we're yet to discover.

Meanwhile, millions of new (inexperienced) buyers are joining crypto because it's so accessible. What happens when you bring mass adoption to the Wild West of DeFi? 

The worrying consequences have led regulators to step forward. The question is...

Can DeFi Be Regulated at All?

It's not that DeFi can't be regulated. It already is, except the laws and authorities are replaced by code and communities. For years, technology has been replacing people's jobs, and now something similar seems to happen to regulators.

The way DeFi works is autonomous and decentralized. Once the programs (smart contracts) are running, not even the developers can stop them. So how do regulators expect to control such applications?

The first step is to understand how it's different from traditional and centralized finance.

Overview of the DeFi Space

Decentralized Finance (DeFi) is the financial extension of public blockchains with smart contract functionality. There are different DeFi apps for every blockchain, the most popular ones being Ethereum (ERC-20 contracts) and BnB Chain (BEP-20 contracts). What they all have in common is a decentralized network of validators across the world and a consensus mechanism that prevents centralization.

All apps run autonomously on the underlying blockchain (so they're called decentralized apps or dApps), which is why they're so difficult to manipulate. To shut down the dApp, you would need to take down all the thousands of nodes that run Ethereum. That's as if the only way to take down a website were to shut down the Internet.

And big dApps often support different blockchains.

Since its inception in 2020, there are now hundreds of DeFi dApps offering diverse services. Namely:

• In staking, you lock tokens in a network to improve its security and earn interest rewards.
• In liquidity providing, you deposit tokens in a decentralized exchange (DEX) to improve its liquidity and earn fee revenue.
• In DEXs, you can exchange any token ever created in an instant.
• In peer-to-peer (P2P) lending, you earn interest rewards for helping borrowers with liquidity. Liquid P2P platforms have no lock-up periods and can automatically liquidate loans under risky conditions to protect lenders.
• Other DeFi applications include Web3 wallets, multisig wallets, NFT marketplaces, DEX aggregators, liquid staking, on-chain governance, blockchain bridges, and stablecoins.

Soon, these services lead to several DeFi use cases:

• Decentralized Autonomous Organizations (DAOs)
• Play-to-earn games
• Decentralized VPNs
• Decentralized websites and storage
• Decentralized domains and wallet names
• Illiquid asset tokenization
• Smart contract insurance
• Predictive markets

That's why DeFi currently has an average trading volume of $5B per day, a $50B+ market cap, and +$75B committed for the mentioned services (AKA total-value-locked, TVL). By far the most used dApps are Aave, MakerDAO, Lido, Curve, PancakeSwap, Uniswap, Convex, Compound, and Hex.

But DeFi also contributed to the +$11B lost in Web3 hacks and scams. The alarming incidents were the Ronin Bridge hack (+$550M, 2022), Poly Network Hack (+610M, 2021), and Wormhole exploits ($326M, 2022). Part of those billions come from countless rug pulls from smaller projects (the founders abandon the project and leave investors with a worthless currency).

Hence why the increasing regulation efforts.

Overview of the DeFi Regulation

Regulating DeFi is somewhat like regulating cash transactions. You can regulate it once the person exchanges it for electronic money, but you still don't see the countless trades that happened in the middle. Similarly, an Internet provider can see what pages you visit, but they can't look inside your online bank or website accounts.

Regulators can track centralized platforms to see what coins go in and out. They can also trace your non-custodial wallets (like Metamask) because most DeFi users were CeFi users once (which have legal identities). But now, anyone can join DeFi without verifying an identity (through P2P exchanges), which further complicates regulation.

There are two indirect ways to control DeFi: the Internet and crypto on-ramps.

Controlling the Internet is the least effective strategy because of proxies and VPNs, but it can discourage users from joining suspicious platforms. Maybe regulators can't take over blockchains like Ethereum, but they can restrict the country's online access. And there's no crypto without the Internet.

Internet connections are somewhat centralized, and authorities can take down websites through the companies that provide them. In response, more developers are using decentralized VPNs (e.g., Orchid) and data-sharing platforms (e.g., IPFS). For example, the US government shut down Tornado Cash by September 2022, but the app still works perfectly from the IPFS browser URL.

The second method is on-ramp regulation, AKA crypto-fiat exchanges. The logic is that most DeFi money comes from people buying crypto, and by regulating those exchanges, you can control how much money goes into DeFi. Once you know who legally owns a custodial wallet, you can link users to their other non-custodial destination wallets.

This wouldn't work for a few reasons:

• Users can go around on-ramp platforms through P2P exchanges (or cash for crypto).
• DeFi is gaining more and more volume from its revenue (Yield farming, P2E games, NFTs), not just fiat exchanges.
• As more businesses accept crypto payments, fiat currency becomes unessential.

How Can Regulation Impact DeFi?

As you can see, DeFi remains decentralized even if you regulate the Internet and on-ramps. The closest attempt was to regulate crypto through KYC, taxation rules, and bans like China's firewall. But regulating cryptocurrencies is very different from regulating DeFi.

Now, is regulation something we should avoid or look forward to?

The Positive Impact Of DeFi Regulation

It's no secret that crypto regulations have bad connotations for many investors. Yet, that doesn't mean that everything about it is (or at least not as bad as the risks of DeFi). Regulation can be the answer to security problems so that users take advantage of DeFi and not the other way around.

• If regulations increase the entry barrier, we'll see fewer rug pulls and cyberattacks.
• If the worst happens, regulators can protect consumers by enforcing or insuring reimbursements. For example, FDIC institutions insure US depositors for up to $250,000 if banks fail to repay. And if clients fall for investment fraud, governments can prosecute business owners and impose penalties.
• When regulation leads to increased adoption, DeFi gets more trading volume, DEX liquidity, a richer dApp ecosystem, and higher prices.

But crypto adoption can be disastrous without regulation. By September 2021, El Salvador bought over 2,000 BTC, which in 2022 is worth around 60% less. The truth is that citizens won't regain losses even if they hold, because by now, thousands lost all their coins in crypto scams.

The Negative Impact Of DeFi Regulation

You could think that by regulating more, people would lose less crypto. And they still would, just differently. Because regulating DeFi has its risks and opportunity costs:

• The restricting countries would hinder their financial development. Governments can't just say No to DeFi. Citizens can still use those platforms because borderless technologies don't have such limits. Banning DeFi will only motivate people to hide it. Not only are these controls futile but also hurt innovation, entrepreneurship, and competitiveness.
• Regulations can threaten your ownership rights. If governments could somehow surveil and control all DeFi, what would stop them from taking away your coins? That's one reason many are against centralized blockchains like CBDCs. The authority can impose penalties for disobedience or confiscate crypto assets.
• Blockchain may no longer be immutable. If governments could delete or create new smart contracts, protocols would look a lot like traditional legislation. Eventually, there are thousands of laws with complex loopholes that no one understands. And by controlling smart contracts, authorities could also decide how to spend coins from the treasury.

Is Regulation The Solution To The DeFi Risks?

If by that we mean risk management, then regulation is the solution to the DeFi risks. By definition, regulations involve rules enforced by an authority. And it's almost second nature to associate them with laws and governments.

It doesn't need to be that way.

Firstly because such a model doesn't work in DeFi, as shown before. Secondly, because DeFi is already regulated, except those rules and authorities are the smart contracts and community. Only users know what regulations work best for them, and code is the only "law" that you can enforce internationally.

The point of DeFi is to give people control of their finances, from their assets to their platforms. It's an example of how alternative regulation can be as effective, if not more than traditional governments. The question is, how do we know these "contracts" won't lead to exploits someday? How do we know that this "community" is making the right decisions?

That's why at LiquidLoans we strive to offer the best knowledge in DeFi. The first step to making good decisions is to understand crypto, and educated investors make the most thriving communities. Education, along with intrinsic participation incentives and a reliable consensus model are the foundation for collective regulation.