How DeFi can be regulated
Janus Digital | This Week in Web3 | #13
Intro
Gm friends,
Hope you are having a great week.
In this week’s topic, we are explaining our thoughts on how decentralized finance can be regulated and the challenges involved.
Enjoy,
Gustaf Baavhammar and the Janus team
Topic of the week: How DeFi can be regulated
Decentralized finance (DeFi) has exploded in popularity over the last two years as people demand more complex financial services without the need for a central counterparty, in particular, for the borrowing and lending of crypto assets. Today, around $40bn is locked in DeFi protocols – down from $180bn at the peak of the bull market in 2021. As there is no centralised entity in DeFi, their role is automated with smart contracts. But that doesn’t mean that the DeFi ecosystem is beyond the reach of regulators. In fact, while its structure is different from centralized finance (CeFi), it involves multiple risks that are similar, including hacks, scams and the potential for manipulation of protocols. DeFi will certainly be more challenging to regulate than CeFi, thus we have shared some of our thoughts on the topic below.
DeFi projects must start developing relationships with regulators. For example, they should proactively start identifying the financial crime risks hidden in the protocol, and then proceed to incorporate controls to mitigate them. This will serve as a strong foundation for eventually start incorporating the compliance mechanisms in their smart contracts, which will create a standard for the DeFi ecosystem and facilitate the discussions with the regulators.
Regulators must employ highly technical people to understand the nuances. DeFi comes with a new set of problems, including how to tackle data gaps and understand which data points are relevant to ensure proper regulation. Moreover, a critical challenge is distinguishing between principles of accountability vs. the decentralized nature of most DeFi platforms as they are governed by DAOs (decentralized autonomous organizations) without clear executive roles. Hence, the best technical people must be employed in order to find a solution that is reasonable for both parties.
It needs to be regulated on a global scale and with the same goals. For example, regulators need to agree on the purpose of the rules - is it meant to promote the underlying technology, protect consumers or support the market function? If some regulators focus more on a specific area, there might be loopholes which will easily be taken advantage of given the global nature of crypto.
Web3 News
Bitcoin and Ethereum have their ups and downs. Bitcoin rose 2.7% early in the week and was trading at around $17,000. Ethereum (ETH) rose a significant 6.7% and traded for $1,285. The top cryptocurrencies seem to have made a fair recovery after last week's news about China’s civil unrest toppled the market. Moreover, the market also struggled last week due to BlockFi filing for bankruptcy following the collapse of FTX. Following the upward trend and recovery early in the week the cryptocurrencies then dipped again as Bitcoin failed to float above the $16,900 mark and similarly, Ethereum fell below $1,240.
MetaMask Reduces Customer Data Retention to 7 Days After Community Backlash. Metamask recently released its new data retention update, reducing the amount of time it will keep user data (wallet and IP addresses) to 7 days. This is after ConsenSys updated its privacy policy in late November saying it will collect user-provided data, which was met with heavy criticism from the crypto world. This resulted in significant concern about on-chain privacy. "The update ignited a variety of public and internal conversations around how we could better prioritize the privacy of MetaMask and Infura users," said ConsenSys in their latest announcement.
DeFi Protocol Ankr Suffers Infinity Minting Bug. Ankr is a DeFi, cross-chain infrastructure that enables staking and dApp development. Ankr was exploited for costs amounting to over $5 million due to a bug in their system that enabled unlimited minting of its token. In a recent tweet, the company said their aBNBc token had been abused and asked exchanges and liquidity providers to stop trading and remove liquidity. The bug was found to be in the protocol’s smart contract allowing the attacker to mint six quadrillion aBNBc tokens. It seems that hacks and scams continue to be prevalent in the crypto world with Binance also announcing the suspension of deposits and withdrawals from its BNB chain in early October after it identified an unauthorized transfer of BNB coins worth around $568 million.
Palantir Co-Founder Says ‘Most’ Crypto Companies Will Crash. Palantir co-founder, Joe Lonsdale, raises suspicion that the crypto meltdown could become worse in the future as he claims that most crypto companies will become bankrupt. During an interview with Fox News, Joe said many crypto tokens were Ponzi schemes and so we can expect to see a lot of companies crash in the future. He was still adamant that blockchain technology will uphold an important role in the years to come. Joe also claimed that crypto initiatives have been "valued not based on cash flows, not based on creating value in the economy, but based on what people would pay for it". These are very unstable grounds to build upon, which is why he believes they will all come crashing. This take from Joe Lonsdale is likely spurred by the collapse of FTX which shook the industry entirely.