Viewpoint丨How should the rapidly developing DeFi respond to regulation?

Author: Chainalysis Team

Translation: Olivia

The rapid development of DeFi has become one of the biggest stories in cryptocurrency in 2020. The total value of DeFi protocols has risen sharply throughout the year, with the total value in September tripling month-on-month to over $26 billion . Although October saw a slight decline overall, weekly data shows that its value will begin to recover by the end of the month.

However, questions abound about how to handle DeFi platforms under banking secrecy laws, securities laws, and other regulations related to compliance and security. In theory, DeFi platforms can operate autonomously without human intervention and generally never take custody of funds, leading some to argue that they are impossible to regulate . In fact, many DeFi platforms are so centralized that the teams behind them can block risky transactions and take other actions to combat potential criminal activity, suggesting that they could be regulated like other cryptocurrency platforms.

Below, we discuss the development of DeFi to date, as well as some questions about the regulatory obligations of decentralized platforms.

Breaking the explosive growth of DeFi

DeFi is the abbreviation of decentralized finance, and most DeFi platforms are decentralized applications (dApps) built on smart contract-rich blockchains, mainly the Ethereum network . dApps can implement specific financial functions under the control of underlying smart contracts, which means that they can automatically execute transactions, loans, etc. when specific conditions are met . Most dApps build liquidity by raising funds from users who believe in the project and use these funds for production purposes governed by the protocol. Without the need for centralized infrastructure or human governance, dApps allow users to perform financial transactions at lower fees than other fintech applications or financial institutions.

Decentralized exchanges (DEXs) are the most popular type of dApp, as we can see in the chart below showing the growth of DeFi by platform. DEXs allow users to buy, sell, and exchange different tokens built on a specific blockchain (again, mostly Ethereum) directly between each other’s wallets for greater privacy and security .

Most of the growth of DeFi this year can be attributed to four platforms, namely Uniswap (including V1 and V2), Kyber, Curve Finance, and 1inch Exchange. All five are DEXs, of which 1inch Exchange is an aggregator that allows users to obtain various assets on several different DEXs.

The above chart shows the total value of DeFi platforms broken down by average transfer size in 2020. The data shows that most individuals sending funds to DeFi platforms are retail users, as the vast majority of transfers are in cryptocurrencies below $10,000. However, it is actual professionals who really drive the market. Because most of the transactions sent to DeFi platforms come from transfers above $10,000, and 47% of the total comes from transfers above $100,000 .

Finally, in the chart below, we see that funds sent to DeFi platforms throughout 2020 came from illicit sources.

Data shows that DeFi platforms are less at risk for illegal activity than the entire cryptocurrency ecosystem . In the 2020 Crypto Crime Report, we found that 1.1% of all cryptocurrency transaction volume was sent to or received from addresses associated with illegal activity. Overall, in 2020, only 0.05% of all funds received by DeFi platforms came from addresses associated with criminal activity, while 0.07% of all funds sent by DeFi platforms went to such addresses.

What are the regulatory responsibilities of DeFi platforms?

Most cryptocurrency platforms keep users' funds safe and have teams internally managing deposited funds, maintaining orders, and resolving customer issues, much like traditional financial institutions. DeFi platforms, on the other hand, are managed by self-executing code, at least in theory, which means they can run on their own without the need for any team or company to maintain them. They generally do not keep users' funds throughout the process, but rather route them between wallets based on the platform's underlying protocol . Because DeFi platforms are not active intermediaries like other cryptocurrency platforms, they are not subject to regulation like traditional money service businesses, such as the Bank Secrecy Act, securities laws, and other compliance requirements .

Of course, even with this kind of decentralized operation on DeFi platforms, there may still be issues that regulators need to explain and clarify. So who will audit the code of DeFi platforms? Who will deal with vulnerabilities? Who will help victims of DeFi-related scams and other forms of financial crimes? This is why some people believe that regulators are likely to explore other means to enforce the law against DeFi platforms, whether or not they are affiliated with formal companies.

However, as cryptocurrency researcher Ryan Selkis pointed out in a recent newsletter, this debate is moot at this point. Because most DeFi platforms currently do have core teams that are constantly updating the protocol to freeze user funds or block transactions when necessary. This became most apparent after the KuCoin hack in September, when cybercriminals attempted to launder stolen funds by exchanging them on DEXs such as Uniswap and Kyber. The teams behind these projects froze some of the funds controlled by the hackers, suggesting that these platforms are not as decentralized as some narratives claim .

Ultimately, regulators will decide how to enforce existing regulations on DeFi platforms, or create new ones if necessary, to protect the integrity of the financial system . Given the low level of illegal activity in DeFi compared to other parts of the cryptocurrency ecosystem, DeFi law enforcement may not be a priority at this time. Nonetheless, given the ability of the largest DeFi platforms to freeze funds and take actions to prevent egregious cybercrimes such as the KuCoin hack, teams are able to proactively take preventive measures and cooperate with law enforcement. DeFi teams that implement some form of transaction monitoring, know your customer (KYC) protocols, and other elements of traditional compliance programs are likely to be in a better position when regulators come knocking.