Future of DeFi in a Regulated Crypto World

Over the years crypto grew, succumbed to speculative fevers, and invited regulation with its excesses. Meanwhile decentralized finance kept faith with the original intent of Bitcoin and early cryptocurrencies. The point of crypto at its inception was to provide people with a way to send and receive money, pay for things, and do business via the internet. Ideally this way of doing business would be free of middlemen taking their cut and government oversight. Crypto winter, a whole host of bankruptcies, and outright fraud have brought regulations crashing down on crypto. What is the future of DeFi in a regulated crypto world?

Why Regulators Are Looking at DeFi

As world regulators look at DeFi the issue is not the legitimacy of decentralized finance but rather the safety of customers and investors. Many crypto businesses, including decentralized finance businesses, went out of business during crypto winter. These folks did not fail because in some way there was a flaw in DeFi. They went under because they ran their businesses poorly, took too much risk, and believed in the crypto version of a free lunch. The mantra that developed in crypto as it grew was that token values would always go up even though there was a lot of dramatic market fluctuation. There were too many business models based on the assumption that you could borrow dollars, invest in crypto and then cash out your more-valuable crypto, pay off the dollar-based loan and have tidy profit. The idea was that you could do this again and again forever and ever. This was one crypto version of a free lunch and was never going to work. The bone that regulators have to pick with DeFi business in this regard has to do with investor and customer losses.

When Is a DeFi Business Like a Bank?

The ideal of decentralized finance is to facilitate person to person financial transactions such as loans, sales, and purchases. Unlike going to a bank to ask for a loan, a person using DeFi can do business with anyone in the world via the internet. The use of the blockchain makes unchangeable records of all transactions which adds to security. Risks in this system include hacking of DeFi blockchains as well as scams or fraud by those running the DeFi setup. When a DeFi loan operation accepts and holds assets for its customers it crosses the line from pure DeFi and starts to look like a traditional business, like a bank. Financial entities like banks, insurance companies, and stock exchanges are all regulated because in times past people lost huge amounts of money due to sloppy or illegal business operations. The point of regulation of such businesses is to protect customers and investors from fraud or painfully incompetent management practices that result in customer or investor losses.

Are Regulators Looking to Change How DeFi Operates?

Regulators are not concerned with two entities doing business with each other. They are concerned about money laundering, terrorism, and any otherwise-illegal use of the DeFi system. To this extent onramps and offramps for converting fiat currencies like dollars, yen, or euros into crypto may come under increased scrutiny. Stablecoins that are commonly used in DeFi transactions may be under increased regulations via exchanges. DeFi businesses that pay interest for deposits into crypto-based systems start to look like banks and will likely fall under rules similar to those of the US Federal Reserve for US banks or SEC to the extent that cryptocurrencies involved are considered securities. We do not see the basic nature of DeFi being changed by regulators. In all likelihood, cleaning up fraud and sloppy business operations throughout crypto will likely help legitimize DeFi. That will likely cause more business to be transacted via this system in years to come.

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