Policymakers, regulators should design balanced regulatory framework for decentralised finance

Cryptocurrency is a digital form of money that can be used to shop, book flights, and send money to friends and family all over the world without the need for an intermediary. The total number of cryptocurrencies worldwide has increased significantly from 66 in 2013 to over 6,000 as of July 2021.

It is critical to understand that not all cryptocurrencies are created equal. Some have faster transaction speeds (such as Ripple), while others are more private and secure (such as Monero and Zcash), and still others are more programmable (such as Ethereum). Only the top 20 cryptocurrencies, however, account for 90 per cent of the total market. Blockchain is the technology that underpins the vast majority of cryptocurrencies, and it functions as a database that stores every bitcoin transaction ever made.

Decentralised Finance (DeFi) is a vision of a new financial system built on the Ethereum blockchain that is growing at an astonishing rate. It operates without the use of any intermediaries and aims to provide the same services as traditional centralised finance (CeFi) – but in a completely permission-free, global, and transparent manner. It eliminates the distinction between the ‘haves’ and ‘have nots’ as anyone can borrow and lend money to others.

DeFi protocols, like traditional commercial banks, enable large-scale lending and borrowing (such as ‘Compound'), as well as providing uncollateralised loans (such as ‘Aave'). DeFi protocols, like traditional investment banks, enable the decentralized creation and trading of derivatives on assets such as stocks, currencies, and commodities (such as Synthetix), as well as searches for the best yields and investing automatically for its users (like Yearn Finance).

The emergence of decentralised exchanges such as Uniswap allows users to swap one cryptocurrency for another, similar to the activity of the CeFi exchange. Decentralised insurance (such as Nexus Mutual) offers insurance that covers bugs in smart contracts, which is a fundamental risk for DeFi users, similar to the function of traditional insurance, which tries to remove risk and brings security for market participants. Stable coins like reserve currency in central banks, are based on blockchain protocols that allow participants to interact with one another without the underlying risk of price volatility.

Overall, the rising use of DeFi protocols proves that the system is scalable and working. The total value locked (TVL) in DeFi applications skyrocketed from $0.7 billion as of January 1, 2020, to $80.57 billion as of August 10, 2021, according to the DeFi Pulse monitor. However, the influx of capital also makes it a popular target for hackers and scammers.

According to CipherTrace , DeFi rug pulls and exit scams will account for 99 per cent of all crypto fraud in 2020. DeFi-related hacks now account for more than 60 per cent of the total hack and theft volume in 2021, up from only 25 per cent in 2020. Hackers allegedly breached the blockchain-based platform Poly Network and stole more than $600 million in cryptocurrencies, according to the company's announcement on August 10, 2021, making it the largest hack in the decentralised finance space, which is gaining popularity among investors.

Huge prospects, significant risks

According to Fabian Schar, a professor at the University of Basel, DeFi presents huge prospects, but it also carries significant risks. Smart contracts can have security risks, which could lead to unintentional use, and scalability restrictions limit the number of users. Furthermore, the term "decentralised" might be deceiving at times. Numerous protocols and applications utilise external information sources and unique administrator keys to deal with the framework, conduct smart contract upgrades, or even perform emergency shutdowns. Nonetheless, if these issues can be addressed, DeFi might prompt a change in outlook in the financial industry and conceivably contribute toward a more strong, open, and transparent financial infrastructure.

In India, the legal status of the cryptocurrency market has progressed from being banned and illegal to being legal but unregulated so far. Government must intervene to capitalise on the opportunity presented by DeFi systems. However, policymakers and regulators are perplexed as to how traditional CeFi rules can be applied to DeFi systems.

The World Economic Forum recently published a policy toolkit for decentralised finance in an effort to assist governments around the world in suitably addressing this phenomenon and helping shape regulation of digital asset marketplaces between different countries. To encourage the development of the various DeFi markets, a safe and proportionate regulatory framework that supports innovation and fair competition must be put in place.

Policymakers and regulators must strike an appropriate balance between safeguarding positive blockchain-based financial innovation in terms of greater efficiency and broader inclusiveness in finance on the one hand, and limiting the potential for these financial applications to be misused for money laundering and terrorism financing on the other.

As on August 10, 2021, the total global cryptocurrency market capitalisation is $1.82 trillion, whereas the total value locked (TVL) in DeFi is $80.57 billion, which is a negligible value compared to the $20 trillion global financial sectors, implying that there is plenty of room for growth in this area. If India aims to become a $5-trillion economy, it cannot afford to ignore the $1.82-trillion market for cryptocurrencies and the huge potential gains of DeFi systems based on Ethereum blockchain.

Dr. Muneer Shaik is an Assistant Professor at Mahindra University, School of Management, Hyderabad.

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