The Banking Executive Magazine - May 2022 Issue

Will DEFI Take Over Banks? ble to all parties, without any bar- rier or discrimination. Moreover, individuals who plan to build on top of a decentralized platform can do that freely. It provides a high de- gree of accessibility and supports collaboration within the commu- nity. Products developed within the DEFI ecosystem are designed to benefit from each other. That is why, DEFI products are also known as money Legos. • Trustless: The most significant ben- efit of using DEFI services is you do not need to trust that the service will perform as promoted. Users can authenticate that DEFI services perform as intended by auditing their code and using external tools such as Etherscan to identify if a transaction was correctly executed. • Quick Innovation: Another signifi- cant advantage of DEFI is its quick rate of innovation. The Decentral- ized Finance Ecosystem is con- stantly building current capabilities and experimenting with new capa- bilities. The build-centric nature of the DEFI space has transformed into a rich ecosystem embedded with ground-breaking financial services. • Efficiency: Removing intermedi- aries causes less friction and makes processing a financial transaction more fluid. • Costs: In traditional finance, the in- termediaries governing transac- tions are taking fees that are generally higher than the ones users currently pay on DEFI apps. • Open and democratic system: Ac- cording to the 2017 Global Findex report, worldwide, there are about 1.7 billion adults that are un- banked, meaning they are ex- cluded from the financial system. With DEFI, users do not necessarily need to have a bank account to ac- cess financial tools, they only need an internet connection. If users meet the conditions of smart con- tracts, they will have exactly the same access to various products (loans and insurance, derivatives, and crowdfund). DEFI RISKS DEFI entails various risks including: • Bugs in the smart contracts: Since smart contracts are immutable, if you have an error in the code, it will be repeated over and over again. • Cyberattacks: Hackers can find breaches in DEFI contract code and exploit it for their own bene- fits. • Volatility: DEFI is highly volatile like cryptocurrencies. • Complexity: It is difficult to under- stand DEFI projects and to pick which ones to invest in due to the complexity of the technology. DEFI REGULATION DEFI is a rapidly-growing part of the cryptocurrency market that promises to deliver traditional financial prod- ucts like loans and savings accounts without involvement from regulated middlemen as in the case of banks. But regulators are increasingly con- cerned about platforms offering DEFI services that may not be as “decen- tralized” as advertised. Decentralized finance could get split into regulated and unregulated seg- ments. DEFI has been loosely defined as a global ecosystem of web applica- tions and eWallets that leverage smart contracts stored on public blockchains, instead of relying on centralized intermediaries like banks, stock exchanges or brokers. China has essentially banned the use of DEFI and private digital assets, and Russia is debating whether to take a similar approach. The Bank for International Settle- ments is concerned that there is a “decentralization illusion” in DEFI. Until recently, regulators have largely ignored this emerging parallel finan- cial system. DEFI protocols might appear out of regulatory reach. Copies of blockchain transaction history are stored in nodes all over the world. Historically, regulators have only held purview over legal entities within their jurisdiction. This changed with the Foreign Account Tax Compliance Act (FATCA) of 2010, which saw United States au- thorities regulating beyond their cur- rency and coordinating with other jurisdictions by signing intergovern- mental agreements (IGAs) for en- forcement. The European Union EU followed a similar approach with the General Data Protection Regulation (GDPR) in 2018, to control the data of Euro- peans wherever they are in the world. Though it remains unclear how authorities can enforce against organizations outside the EU. There is opportunity for the appropri- ate level of regulation to give DEFI enough breathing space to make a difference, boosting transparency, in- creasing financial inclusion and en- abling credit to unbanked people. DEFI has the potential to create fairer, more transparent and more liquid markets through completely new mechanisms, helping everyone to re- duce fraud and front-running, resolv- ing fragmentation and creating markets that are efficient, resilient, fair and equally accessible to all. Defining the right regulation could make or break DEFI. Given such an opportunity to rebuild finance from the ground up, regulators should put clear objectives. DEFI presents several opportunities. However, it also poses important risks and challenges for regulators, ISSUE 161 MAY 2022 the BANKING EXECUTIVE 13