Last month, the Bank of France published a discussion paper on decentralized finance (DeFi) that proposes ideas for regulation of this space. DeFi has experienced significant growth and innovation in recent years, and offers an alternative to many aspects of traditional financial services. The paper sheds light on many of the important aspects of DeFi and offers potential insights into its future. In our response, we make several recommendations to help ensure that users and investors are protected without inhibiting the ability of DeFi protocols to innovate.
First, we believe that any attempt to regulate public blockchains should be done in the way infrastructure/utilities are regulated (to guarantee fair, safe access to users and require public disclosure of relevant information including network activities, related parties transactions, etc.).
As a matter of principle, regulation should be technology neutral. This framework should not impose a higher or lower burden on public blockchains compared to private blockchains that would make public blockchains more expensive and difficult to run.
Smart contracts and DeFi in general should only be subject to regulation when they engage in regulated activities. The security standards should be set by market participants and the interaction with "uncertified smart contracts" should not be prohibited, but discouraged when it comes to regulated activities.
Access to financial products should follow the "same activity / same risk / same regulation" principle and not differ from traditional finance regulation. DeFi is not more complex than other financial products and should not be treated as such. The focus should be on disclosure of risks so consumers can make informed decisions.
Finally, any regulatory framework should include proportionality requirements pursuant to the same activity / same risk / same regulation principle, meaning that small players should not face the same regulatory burdens as bigger players, and that non-regulated activities should not face the same burdens of more complex or sensitive sectors.
Additional Hashdex recommendations
Defining DeFi and assessing decentralization
The paper proposes a good definition for DeFi and specifies a handful of criteria which generally apply to the DeFi architecture. The topic of decentralization in DeFi is mainly explored through the lens of protocol governance, with the authors correctly highlighting the concentration of governance power prevalent in most major protocols in existence, where the majority of governance tokens are usually held by VCs, early protocol developers, and early users. We believe the authors could have dived deeper into other decentralization factors, such as which blockchain(s) host the majority of applications and capital in DeFi.
DeFi “primitives” and real-world applications
The authors provide a comprehensive list of what we can refer to as “DeFi primitives” or use cases. These include collateralized lending, decentralized insurance, and yield farming. We suggest three examples of applications to be further explored: (i) widespread usage of fiat-backed stablecoins, (ii) tokenization of real-world assets, and (iii) atomization of settlements.
Concentration in DeFi
In response to a question from the authors about concentration in DeFi, we note that while there currently is concentration in a few major blockchains and protocols, this doesn’t imply that the system is less decentralized. Rather, the market has chosen to mainly use and allocate capital to those protocols and blockchains which exhibit a longer track record without major bugs and exploits, and whose maintainers have an established commitment of bringing innovation and more security to their architecture.
Scaling solutions and Layer-2s
We observed that the term “Layer-1” is used somewhat inaccurately throughout the text and in the schematic representation of DeFi's layered structure. This is because, conventionally, the term “Layer-1” refers to the base layer of a public blockchain—those that can store and execute general purpose smart contracts (such as Ethereum, the BNB Chain, Cardano, Solana, etc.). Assuming this is the correct interpretation of the authors’ intended meaning, it is true that more performant networks demand higher hardware requirements for the operation of their nodes, leading to more centralization and less security. Furthermore, as is the case of Solana, there’s no fee market in place (that is, fees don’t go up with more transaction demand), meaning a malicious actor can cast a huge number of transactions and bloat nodes with too much information to be handled at the same time. This leads to downtime events and less security and reliability. The second possibility of base layer scaling solution is sharding, which, if properly implemented within a Proof-of-Stake system, shouldn’t exacerbate the security issues of a blockchain infrastructure. Layer-2 solutions come in different flavors, such as sidechains and rollups, and the authors provide a good picture of the trade offs made if base layers are to scale using such solutions. Rollups, in particular, bundle multiple transactions into a batch to be executed in conjunction, meaning there may be some loss of traceability that would otherwise be possible if every transaction were to be executed in isolation.
Risks in DeFi due to the open source nature of smart contract code
The open source nature of the application layer of DeFi is a two-edged sword: it does make it possible for attackers to have full access to the code behind a given application, while at the same time it gives the opportunity for independent observers to audit the code. While it is true that numerous hacks, “rug pulls,” and exploits mark the history of the DeFi ecosystem, the industry is evolving to a state where blue-chip applications on the ecosystem, prior to releasing new functionalities and upgraded smart contracts, go through an extensive period of tests and audits carried out by entities with high expertise on security and smart contract auditing. This significantly reduces the risk that any such exploits could be present when the application eventually goes live on a blockchain mainnet.
The Terra/LUNA fallout in mid-2022 is cited a number of times in the paper (rightfully so). However, it’s worth stressing that it was caused by poor design of the protocol itself, which issued a so-called algorithmic stablecoin, TerraUSD (UST), without any collateral and in which its parity with the dollar was maintained by pure arbitrage involving the native token of the Terra blockchain, LUNA. This design is known to be flawed and be subject to so-called “death spiral events,” in which both tokens can go down in price in an ever increasing snowball, until their market value is completely wiped out. This situation was further exacerbated by bad incentives within a DeFi protocol called Anchor, which offered unsustainable annual yields of roughly 20% on deposited UST. This particular instance is not descriptive of the whole sector, and should rather be used as an example of “what to avoid in DeFi.”
Leverage in DeFi
The issue of high leverage is indeed present in DeFi, but it’s also prevalent in traditional finance. Furthermore, it’s worth stressing that the protocols that offer this possibility are highly niche and don’t dominate the ecosystem. Nonetheless, just as is the case in traditional finance, this level of leverage should perhaps only become available (if they ever were to become available) to an investor if they possess a good track record of trading in a DeFi protocol that offers such products, something that could be used as a “leverage score” that would grow higher as more experienced (and successful) an investor becomes.
Crypto regulation continues to progress
As our team noted in a recent article about the EU’s approval of the Markets in Crypto Assets (MiCA) regulation, regulatory clarity will help drive this market forward and give investors and businesses more confidence in this technology. The Bank of France report is a step in this direction by demonstrating the importance of regulatory understanding of key aspects of DeFi such as its decentralized structure, risks, and scalability solutions.
Our primary goal at Hashdex has always been to give global investors regulated access to the crypto economy, including the DeFi protocols that are disrupting traditional finance. We look forward to continuing to be part of the regulatory discussions that are so important to the development and acceptance of crypto as an important asset class.
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