Digital regulation – information overload | Article

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Crypto and Decentralised Finance

Another area with rapid developments is the crypto-universe. No doubt helped by persistently low interest rates and high stock market valuations, interest for crypto assets among clients (both retail and wholesale) has increased over the past two years. Moreover, “decentralised finance” (DeFi) has rapidly become more popular.

Where the original aim of Bitcoin was to take out the middle man in payments, the aim of DeFi is to take out the middle man in other financial services, starting with saving, investing and borrowing. Yet with Bitcoin, things have turned out differently so far. The middle man has not disappeared, he just changed roles. Where in traditional payments, money is held in bank accounts and transferred between them via various methods, the crypto-universe saw the emergence of wallet providers and exchanges. In principle, it is possible to use cryptocurrency for payments without an intermediary. Yet in practice, many people, for now, choose to use an intermediary after all, for security or ease of use.

With Bitcoin, the middle man has not disappeared, he just changed roles

We expect similar developments in DeFi. In principle, it may be possible to use decentralised platforms to invest or borrow without the intervention of an intermediary. But the number of people willing to spend the time to do their own research, for example, vetting borrowers, and with the ability to, for instance. review smart contract code for bugs or scams, is likely limited. The majority of people may prefer to rely on a trusted intermediary to do the vetting for them. Roles of intermediaries may include offering credit assessment, contract code verification, curated portfolios, risk hedging and other aspects of asset management. Intermediaries may also help individual or corporate borrowers to obtain the best rate and conditions on DeFi markets.

The majority of people may prefer to rely on a trusted intermediary

From a regulatory perspective, a key issue is that regulation and supervision is inherently built around entities. Licenses are handed out to registered businesses, and supervision relies on registered businesses that can be supervised, visited, fined or sued when in non-compliance. An open-source DeFi platform, not owned by a particular business or person, and run on a decentralised blockchain, does not fit such an entity-based approach; it cannot be licensed, fined or shut down without going after each individual user running the software.

Regulation and supervision are inherently built around entities

While this is a fundamental problem yet to be resolved, it is not a problem for banks – or other intermediaries, wishing to become active in crypto or DeFi. Entity-based supervision works perfectly well for them. Indeed European policymakers are negotiating the “Markets in Crypto Assets” regulation (“MiCAR”), while the Basel Committee is considering the prudential treatment of crypto-assets on bank balance sheets. Getting further clarity on regulatory requirements, be they from a consumer protection, market integrity or prudential perspective, is a key prerequisite for regulated financial institutions to take further steps in the crypto- and DeFi-space.