How Will Crypto Regulation Affect Decentralized Finance?

January 4, 2023 Profitable Investing Tips

Crypto had an awful year in 2022 and, in fact, the trouble started in late 2021. Bitcoin and the rest peaked in value in November of 2021 and by the end of 2022 had lost nearly three-fourths of their value in US dollars. Along the way, there was a wave of crypto bankruptcies by Voyager Digital, Celsius, and others terminating in the collapse of the world’s second largest crypto exchange, FTX, with subsequent charges of financial fraud. These sorts of bad headline news about the crypto world have also tarnished the reputation of the emerging world of decentralized finance and hastened the likely introduction of regulations across the crypto world including the world of DeFi. That having been said, how will crypto regulation affect decentralized finance?

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What Is Decentralized Finance?

At its most basic, decentralized finance is a financial system built from blockchain technology and uses cryptocurrencies. Since it runs on the internet it is potentially accessible from anywhere on earth that one can get an internet connection. Although DeFi, as decentralized finance is called, is relatively new, it offers the promise of connecting many more people to financial services than are currently serviced by banks and other parts of the financial network. DeFi lets people access financial services like loans, buy and sell things, and even invest without needing a middleman like with a bank. At least that is the promise. As with the broader crypto system, a lot of bugs have crept into the system with key figures acting like 19^th century robber barons like John D. Rockefeller. Like Rockefeller and his Standard Oil Trust crypto businesses including companies doing decentralized finance are in the sites of government regulators.

What Is Financial Regulation?

Financial institutions are regulated because their function is vital to consumers, savers, businesses, and the economy in general. The point is to ensure safety of financial assets, fairness of systems for commerce, trading and investing, and to prevent the use of these systems for illegal purposes like money laundering or terrorism. Regulation refers to the laws and rules with which banks, insurance companies, credit unions, asset managers, stock exchanges and listed stocks, and financial brokers must comply. Regulation also refers to the ongoing compliance, oversight and enforcement of these laws and regulations. In the USA stock exchanges are overseen by the Securities and Exchange Commission, commodity trading by the Commodity Futures Trading Commission, banks by the Federal Reserve, and insurance companies are regulated by agencies in the individual states. While states regulate insurance companies, federal antitrust laws apply for issues not covered by state laws, the federal government has the power to pass laws that supersede state laws, and federal laws bar insurance companies from acts of intimidation, coercion, and boycott. So, this is the world that may soon descend on the crypto realm in general and decentralized finance in particular.

How Decentralized is Decentralized Finance?

In theory, in DeFi there is no one involved in a financial transaction except the buyer and seller. But who sets up and manages the blockchain software system that facilitates these transactions? How do they make money to stay in business? In the dollar and cent world one person loans money to another and there are no regulators involved. But when a bank or other lender gets involved that is a “centralized” entity. As a rule, these centralized entities are presenting themselves as able to provide a service which commonly has financial value. They are subject to tort law when they do not function as promised and when that lack of functioning causes physical or financial harm. And they generally become subjects of government regulation.

How Decentralized Are Smart Contracts?

When one uses an Ethereum smart contract it is simply coded on the blockchain with only buyer and seller involved but it requires an account with Ether tokens to function. When setting up and using smart contracts there is a tradeoff between functionality and degree of decentralization. Regulators are not all that interested in one person doing business with another but with business entities that operate like crypto banks, taking deposits, and loaning money. Railroads were common subjects or tort law claims in the 19^th century. They collected money for selling you a ticket and with the promise to carry you from point A to point B at a given time. Also implicit in that “contract” was that they would do so safely so that you did not die in an accident along the way. Laws and regulations followed and the same pattern worked out in the business and financial sectors where the capacity to do physical and/or financial harm was present.

Capacity of DeFi to Do Financial Harm and Potential for Regulation

If the multi-headed business entity that is (or was) FTX, people used their tokens because they were led to believe that those tokens would safely and reliably hold financial value. Business entities loaned money to FTX believing it was a sound and well-run business. In its bankruptcy proceedings those who loaned to FTX are looking for damages and may achieve some relief. Folks who trusted in their tokens are out of luck. At the root of these issues is the fact that FTX used people’s money, which ought to have been held as collateral, for personal use. To the degree that FTX might have been regulated, both financial collapse, and fraud might have been avoided. That scenario should be kept in mind by those wondering how crypto regulation will affect decentralized finance.