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Future Leaders Webinar Series: Regulating decentralized finance

Hosted by the FT’s Trading Room editor, Philip Stafford, the webinar discusses the impact of cryptocurrencies, NFTs and various decentralized financial instruments on seeking to open new sources of wealth creation.

The panel of experts explored how decentralized finance could increase access and democratize investments — outside of central banks and entrenched players. However, a lack of oversight has the potential to create risks that the general public could easily miss.

Alongside Philip, the webinar included insights from experts such as Hilary Allen, American University, Washington College of Law, Timothy Spangler from Dechert LLP, and Ryan Clements, University of Calgary & Duke Law School.

Opportunities and obstacles in decentralized finance

Fundamentally DeFi (decentralized finance) doesn’t rely on centralized financial intermediaries and operates as a form of blockchain finance. For example, DeFi utilizes blockchain smart contracts, such as Ethereum, instead of former central financial intermediaries, like bank exchanges.

Despite being difficult to define, DeFi can be broken down into four components:

  • DeFi offers a level of transfer mediation of value between parties called ‘trust minimization’, which helps the ability to mitigate and minimise the impact of risks.
  • There is no involvement from centralized intermediaries, therefore no use for traditional banks, investment dealers or clearing houses.
  • DeFi involves programmable or composable architecture, such as software building upon blockchain.
  • Individual users have their own custody of crypto assets and they interface with that application, which runs on the base settlement layer.

The webinar explored DeFi from many perspectives and discussed the pros and cons of regulating decentralized finance. For example, detractors argue that DeFi is not as revolutionary as proponents advocating for DeFi believe. There are intermediaries and programmers involved, including those who maintain ledgers which manage the code — lots of interest in DeFi is, in fact, coming from established financial institutions.

Alternately, the experts argued that there is enthusiasm around technology that can execute transactions without an intermediary. The technology itself focuses on a coded computer program posted on a ledger, known as a smart contract. These smart contracts execute the transactions and collateralization — whatever the financial product is.

With automating all of this, what happens when something doesn't jive with what the code anticipates? This is outside of how the parties really wanted to operate. There is potential but also skepticism and a concern that we may be building a financial system that is more rigid and fragile than the one we already have.

Hilary AllenProfessor of Law America, Washington College of Law

However, the experts suggested that all contracts have limitations. To a certain level, these contracts are incomplete, and this raises a concern that if a smart contract encounters something new and unfamiliar, it might have unforeseeable results. This has the potential to create further concerns that what is being built is actually producing a more rigid, fragile financial system.

The panel also evaluated how finance plays too central a role in people’s lives to be the exclusive domain of financial institutions — especially as billions of people are already unbanked. Alternatively, they argued that there should be a way in which we can send value without intermediation.

We live in a world where 2.5 billion people are unbanked in America. There are 16 million human beings who are unbanked. Banks are getting further away from people, more people are becoming unbanked or underbanked.

Timothy SpanglerPartner, Dechert LLP

Where to start with regulating decentralized finance?

The regulation of DeFi poses many jurisdictional challenges — who would be in charge of regulation? What should be regulated first as a priority? With such questions, come challenges around anonymity and enforcement and cross-border functions. All of these factors could require legislative changes as a solution.

The webinar highlighted that in order for DeFi to achieve its mission, it needs systems that create fair, healthy and effective market conditions, with an aim to ensure investor protection. Rather than stifling DeFi’s innovation, the experts argued that with a regulatory framework, the market would become more transparent and bring its usage to a broader range of unbanked people.

It’s argued that there is an increasingly urgent need to regulate DeFi due to its popularity snowballing and more people than ever before are involved with it. They suggested that the longer it takes to implement regulations the more entrenched, political and technologically advanced DeFi becomes — making regulation extremely difficult in hindsight.

Further to this, there is an underlying concern that the technology can be used to harm people. The experts in the webinar argued that regulation should focus around what people are doing with lines of code and with blockchain technology. To avoid harm and exploitation, it's human interaction that must be regulated.

Several studies were highlighted in the webinar discussion that focus on code discrepancies. Significant inconsistencies have been found between what is said to be in the code and what is actually in the code, highlighting another reason for code regulation and auditing.

Regulating smart contracts

Another substantial factor surrounding decentralized finance is the need to regulate smart contracts. Smart contracts are not legal contracts but are purported to replace a regular paper contract that governs obligations between payments.

Smart contracts can be integrated into an actual legal contract with contractual obligations, but those lines of code are only meant to coordinate two different sets of updates on one or more different blockchains. The webinar experts suggest that we must look at what is being lost by going from paper contracts to a coded one.

The webinar experts also explored the fact that it’s difficult to hide criminal activity on smart contracts, allowing us to figure out who did what, when, and where with the blockchain.

Due to the nature of computer programming language, it can give access to granular details of every movement or action made. The experts argue that if incorporated into the public sphere and adopted widely, the transparency of an immutable ledger would help crack down on stock manipulation, insider trading, and other kinds of financial crimes.

Much can be said for where to begin and what needs prioritizing to regulate decentralized finance. The experts in the webinar suggest that the first place that we must look as we begin to regulate DeFi are the centralized crypto asset trading platforms as this is where the unregulated trading is taking place. However, there also needs to be parameters around mainstream technology in DeFi, such as stable coins, to address systemic risk to individuals.

Follow the button below to relive the discussion and watch the full webinar on demand.

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