Decentralised Finance and UNSDGs – How should regulators respond?

Decentralised Finance

By Dr Iwa Salami

This article looks at what Decentralised Finance (DeFi) is and its potential to facilitate the achievement of the UN Sustainable Development Goals (UNSDGs). It also considers some of the limitations of DeFi and the approaches to regulating this industry which was not set up for regulation but due to the impact of its growth, cannot be ignored
by regulators.

The total value currently locked into decentralised finance (DeFi) is $53.5 Billion. The total amount locked into it as at 12 May 2021, according to DeFi pulse, was $86B – significantly higher than it currently is and a figure recorded before the industry took a huge hit from the slump in the crypto-asset market which began on 17 May. This is a significant amount indeed, given that DeFi is just over two years of existence.

Despite the recent slowdown in the crypto-asset space, the potential of DeFi to attract an increasing number of users globally means this amount is likely to continue to rise. However, the characteristics of DeFi enabling it to facilitate global financial inclusion and, therefore, supporting the achievement of the UNSDGs, are also the characteristics making it a very challenging space to regulate.

What is decentralised finance?

Decentralised Finance can easily be defined as non-custodial finance which enables all types of financial transactions currently existing in traditional financial systems but which is done on a peer-to-peer basis, without the use of intermediaries but enabled instead by smart contracts. Transactions facilitated by decentralised finance include borrowing and lending, savings, investments, derivatives and insurance.

DeFi and UNSDGs

Of the numerous advantages of DeFi, the most compelling is its potential to facilitate global financial inclusion – which can play a critical role in helping to achieve a good number of the UNSDGs planned to be met by 2030. This is so as DeFi enables those excluded from traditional financial services due to high costs of those services since intermediaries offering them are profit driven and are hardly located within low-income communities and countries across the world. As DeFi services are: accessible globally; require only internet connectivity and are cheaper than traditional financial services, low-income individuals can access a broader range of financial services. These services have the potential to lift them out of poverty, offering them other opportunities like starting up small businesses and through that promoting the attainment of other UNSDGs including: 1) No Poverty,(2) Zero Hunger, (3) Good Health and Well-being, (4) Quality Education, (5) Gender Equality, (6) Clean Water and Sanitation, (7) Affordable and Clean Energy, (8) Decent Work and Economic Growth, (9) Industry, Innovation and Infrastructure and (10) Reducing Inequality. In any case, as all 17 SDGs are integrated – with action in one area affecting outcomes in others – financial inclusion through DeFi can play a critical role in the achievement of these goals. Also, as countries have committed to prioritize progress for those furthest behind (particularly as poorer economies contend with the economic fallouts from the ongoing global pandemic), promoting ideas that can speed up the attainment of these goals such as DeFi, are worth considering and given the necessary attention and support required for their continued growth.

Finance

Limitation of DeFi in facilitating UNSDGs inclusive growth agenda

However, for DeFi services to be able to foster the achievement of these UNSDGs which seek to leave no one behind, the current limitations of DeFi would need to be addressed and it is these that regulators globally would need to draw their attention to.

DeFi is difficult to understand: The use of these services require that users have some understanding of its uniqueness in comparison to traditional financial services. An example is the case of loan-taking in DeFi. In DeFi, loans are heavily collateralised due to the volatility of the crypto-assets in which they are taken out. The risk of a DeFi loan is inherently the risk to the collateral to liquidation in the event that the asset price of the crypto in which the collateral is held goes down. Also, in DeFi, investments such as contributions to a liquidity pool pair linked to a volatile asset means that investments in that pool can significantly depreciate relative to the downward trend of the asset. This was the recent experience of Mark Cuban, billionaire entrepreneur and a supposedly seasoned investor, who invested in a new crypto project by contributing to a liquidity pool of the project’s stablecoin and governance token and suffered significant losses when the price of the token plummeted. User must understand how to achieve what they want to achieve to minimise losses. This is very critical and would require time and effort dedicated by users to have a better understanding of how DeFi works.

Closely linked to the above is the ease with which error can occur in transactions by users. As DeFi applications transfer the responsibility from the intermediaries to the user, users are exposed to high risk of errors which can be very costly particularly if some retail, low-income earners channel all their savings to DeFi platforms and activities. As such, users would need to weigh up the benefits as against the risks of their individual DeFi activities as the risk of error and, as such losses, can be high. This is particularly crucial as transactions occurring on blockchains cannot be reversed.

The need for KYC Requirements: DeFi has been linked with huge cases of money laundering and this is largely due to the absence of the requirement that users fulfil KYC requirement. Owning crypto-assets in private wallets and having a Metamask wallet pretty much gives access to anyone to transact anonymously in the DeFi space. It is as such possible for users to transact anonymously and engage in all sorts of illicit activities – although, as activities on blockchains are publicly stored authorities are now able through blockchain tools, to track the activities of those transacting on them.

For DeFi to be a credible system to be able to facilitate the UNSDGs, global regulators would need to arrive at a consensus on how they would want identities verified for parties transacting in the DeFi space.

Nonetheless, the absence of KYC in DeFi which is driven by blockchains, is a big issue and for DeFi to be a credible system to be able to facilitate the UNSDGs, global regulators would need to arrive at a consensus on how they would want identities verified for parties transacting in the DeFi space. They would also need to agree who should be responsible for confirming these identities – would this be the responsibilities of the users themselves or platform providers?

Despite the fact that DeFi applications boast of no single point of failure – as exists in tradition finance where activities can concentrate around single financial institutions and pose financial stability risks – DeFi, however, itself is not without risks. As DeFi is enabled by decentralised applications (Dapps) which are powered by smart contracts and which facilitate peer-to-peer financial transactions, this can sometimes be problematic as smart contracts have been known to have bugs. This has previously resulted in huge losses to investors. This clearly presents a risk that developers would need to continuously work on to ensure that the security of the operation of smart contracts are strengthened. Finally, as these platforms operate globally and users are able to transact without centralised institutions no mechanisms to achieve accountability exists although most DeFi platforms providers still maintain a degree of governance control of their operations resulting in the argument that as they maintain some control of the operation of the services, they should be liable to some responsibilities when things go wrong. Regulators would need to delineate which aspects of responsibilities should fall on providers and which should fall on users. Nonetheless, this would depend on the degree of decentralisation of the operations of the DeFi services.

Considerations for Regulation

As DeFi activities operate on a global scale, a global approach to regulation would be useful. But achieving global coordination in this space continues to be a challenge and would need to be carefully thought out, particularly as decentralised applications are borderless. Nonetheless, the planning for global regulatory standards for DeFi should not be deterred.

Regulatory Sandboxes

One key approach from a global perspective is the institution among regulators of regulatory sandboxes for the operation of decentralised financial systems. More ambitious activities such as trialling out a global regulatory sandbox for these DeFi services, given their cross-border remit would be tremendously useful. This can be achieved within the context of the Global Financial Innovations Network (GFIN). The GFIN is a network of over 60 organisations committed to supporting financial innovation in the interests of consumers. It seeks to provide a more efficient way for innovative firms to interact with regulators, helping them navigate between countries as they look to scale new ideas. This includes the ability to apply to join a pilot for firms wishing to test innovative products, services or business models across more than one jurisdiction. The UK FCA currently chairs the GFIN’s Coordination Group, which sets the overall direction, strategy and annual work programme of the GFIN. GFIN may be used as a useful forum to provide potential DeFi businesses and developers the opportunity to work closely with regulators to trial out new projects and seek solutions to the current AML/KYC regulatory concerns of regulators.

However, all of this needs to be placed in the context of developing regulatory activity for the DeFi industry. At the global level, the Financial Action Task Force (FATF) – the global anti-money laundering watchdog – announced in its 2020, 12 months review on the status of implementing crypto-assets regulation, that jurisdictions can ban exchanges accepting non-custodial wallets in peer-to-peer transactions. This would have significant implications for DeFi as connections to DeFi services are done mostly through unhosted wallets such as metamask. On 25 June, the FATF released a statement about its 2021, 12-month review to be released in July 2021, indicating that it would postpone finalizing its guidance on this issue to October 2021.

This FATF position is, however, closely linked to the position taken on 18 December 2020 by the U.S. Financial Crimes Enforcement Network (FinCEN) which released a proposed rule to stop regulated exchanges from transacting with unhosted wallets. Thus U.S. crypto-assets users wishing to transfer their holdings from an exchange to any personal wallets may need to comply with new KYC requirements if this proposed rule should it be implemented. This is also likely to affect the US citizens wishing to engage with DeFi platforms as it may mean the prohibition of certain transactions from centralized exchanges to unhosted wallet addresses such as Metamask, which are critical for transactions on DeFI platforms.

For DeFi to operate safely and to be able to facilitate noble goals like the UNSDGs, there would need to be a public and private partnerships between DeFi platform providers, developers and regulators.

At the regional level, the EU Commission, in September 2020, proposed the Markets in Crypto-Assets (MiCA), Regulation which, if passed, will prohibit crypto-assets businesses (including decentralised finance platforms) from trading within any EU Member State without being legally incorporated in an EU Member State. Going by the proposals, the operations of crypto-asset issuers could be required to comply with licensing requirements and capital requirements and, more so, if the crypto-asset they issue are deemed as systemically important or significant, and have a significant cross-border element. There would also be the requirement to fulfil AML/KYC requirements for the transfer of these crypto-assets issued under the EU AML directive. These rules would most certainly cover DeFi platforms issuing stablecoins that fits within any of the six categories outlined in the proposed regulation. This proposed regulation, which is planned to come into force by 2024, is likely to have had a persuasive effect on the global approaches taken by FATF. Despite this, regulatory approaches for the crypto-asset industry across the world remains quite divergent and a lot still needs to be done to achieve convergence. This would be critical for achieving a robust global framework for crypto-asset regulation.

Summary

That DeFi is indicative of the future of finance and holds huge potential to facilitate financial inclusion is indisputable. As such, despite the huge need for regulation of the space, regulators, globally, would benefit from close collaboration among themselves and the DeFi industry. This can be conceived in the context of the GFIN or GFIN-like arrangements which aims to create a framework for co-operation between financial services regulators on innovation related topics, sharing different experiences and approaches. Given the developments in the DeFI space, this framework could be used as a platform to facilitate regulatory cooperation to achieve aligned approaches for regulating DeFi. For DeFi to operate safely and to be able to facilitate noble goals like the UNSDGs, there would need to be a public and private partnerships between DeFi platform providers, developers and regulators. Regulators should be able to balance the risks relative to the rewards of DeFi in devising a regulatory framework – an outright ban of DeFi activities is unlikely to be the ideal solution moving forward.

About the Author

Author

Dr Iwa Salami is Reader (Associate Professor) in Law, University of East London. Prior to joining UEL, she was a research fellow at the Centre for Commercial Law Studies at Queen Mary, University of London. She has previously worked in the UK and abroad including the Government Legal Service and the African Development Bank.

References

  1. Iwa Salami ‘Decentralised finance calls into question whether the crypto industry can ever be regulated’ The Conversation (11 December 2020) available at https://theconversation.com/decentralised-finance-calls-into-question-whether-the-crypto-industry-can-ever-be-regulated-151222.
  2. https://www.coindesk.com/understanding-dao-hack-journalists (last accessed 28 June 2021).
  3. Global Financial Innovations Network (GFIN), available at https://www.thegfin.com/ (last accessed 28 June 2021).
  4. FATF, 12 Month Review of Revised FATF Standards – Virtual Assets and VASPs (July 2020) available at http://www.fatf-gafi.org/publications/fatfrecommendations/documents/12-month-review-virtual-assets-vasps.html (last accessed 29 June 2021). FATF, Outcomes FATF Plenary, 20-25 June 2021, available at https://www.fatf-gafi.org/publications/fatfgeneral/documents/outcomes-fatf-plenary-june-2021.html (last accessed 29 June 2021). The Plenary agreed to finalise the FATF’s revised Guidance on virtual assets and VASPs in October 2021.
  5. Financial Crimes Enforcement Network, Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets available at https://public-inspection.federalregister.gov/2020-28437.pdf (last accessed 29 June 2021).
The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The Political Anthropologist.