We are approaching a major regulatory inflection point for digital assets in general, and decentralized finance (DeFi) may end up being the ultimate battleground. The push to regulate exchanges is nothing new, nor is the increased scrutiny on the space. What seems to be changing in the U.S. is the broadening of regulatory scope – or perhaps a reweighting of focus towards DeFi, stablecoins, and even Proof of Stake (PoS) assets.
For a bit of background, both SEC Chair Gary Gensler and Acting Comptroller of the Currency Michael Hsu have made several commented on digital assets recently. Here are our high-level takeaways: (1) The SEC looks ready to debate which assets will be classified as securities. (2) The push for exchanges to register will intensify. (3) Stablecoins are concerning, seen as “casino chips,” evoking comparisons to the 2008 financial crisis. (4) Lending practices (centralized and DeFi) are moving to the frontline. And (5) lending might be conflated staking, a big concern for Proof-of-Stake assets, including Ethereum.
The bottom line is that we see the potential for two diametric outcomes, both of which undesirable, but many possible shades in between.
- Overregulation: impairing the rails that may be necessary to take us to the next technological era, and the inevitable economic and social transition deeper into to digital realm.
- Underregulation: lack of pre-emptive action leading to a build-up of systemic risks and suboptimal outcomes for users and governments that will prove hard to undo, like the early days of the Internet.
In the end, DeFi may prove the ultimate regulatory battleground, especially when central bank digital currencies come in play. DeFi is a mechanism for resource allocation through the usual channels, including trading, money markets, and insurance, amounting to some $80 bln of locked value. It’s probably the sector farthest away from regulatory purview, yet it might have the greatest overlap with traditional financial services – sometimes even called a shadow banking system. With spreads and yields magnitudes larger than conventional markets, and easy cross-border mobility, it’s easy to imagine how it could one day impact monetary policy transmission. It’s also no surprise that regulators and many of us in financial services may feel both drawn to it and threatened by it at the same time.
DeFi has a unique set of risks and disruptive potential that differentiates it from both the traditional financial industry or a shadow banking system. Here’s a summary of what we think are the main reasons why:
(1) DeFi replaces credit risk with smart contract risk.
(2) Lack of credit risk, widespread over-collateralization, and other safety mechanisms significantly reduces contagion and systemic risks in DeFi, perhaps rendering protocols anti-fragile.
(3) Like FinTech, DeFi is both complementary and in direct competition with the traditional financial system.
(4) Illicit activities in the digital assets space seems to be declining, but proportionately more of it is happening in DeFi.
(5) DeFi is a Darwinian sandbox for battle-testing the ideas that could shape the economic model, governance, and property rights of a future digitally native society. Failing to get the incentives right could mean long-lasting suboptimal outcomes, as was arguably the case for the Internet.