DeFi’s Amorphous Autonomy Proves A Policy Puzzle


Angie Lau: Is DeFi defying the rules or defining them? Does it react to macroeconomic developments, and will it continue its exponential growth in 2022?

Welcome to Word on the Block, the series that takes a deeper dive into blockchain and the emerging technologies that shape our world at the intersection of business, politics and economy. It’s what we cover right here on Forkast.News. I’m Editor-in-Chief Angie Lau.

In January of this year, the total value locked in DeFi was around US$22 billion. This value was locked in the Ethereum blockchain, where DeFi protocols were birthed. 

But as of today, near the end of the year, that number is now north of US$250 billion — that’s some exponential growth in less than a year. Now, this has led to generous profits for some investors while others have been scammed, rug-pulled and wrecked without any protection. 

Much like governments around the world, the Organisation for Economic Cooperation and Development has also taken notice ahead of its upcoming January report… ‘DeFi: Activities, Risks and Why it Matters.’ 

We’re joined by OECD Policy Analyst at the Directorate for Financial and Enterprise Affairs Iota Nassr.

Iota, really pleased to welcome you to the show.  

Iota Nassr: Thank you. Hi, Angie. [I’m] very pleased to be here, too. 

Lau: So today we are talking about decentralized finance. This is a topic that you and your team have been researching, investigating, analyzing for the past year. There are regulators around the world trying to figure out the appropriate regulatory framework to tackle this very much unregulated industry still. But as we think about all of that, let’s define this space right now. In a nutshell, how do you define — at the OECD and as an analyst — how do you define decentralized finance right now?

Nassr: It’s a very good start by trying to define this space. Just let me say the general, usual disclaimer — that the views I express here today are my own, unless otherwise stated.

So what DeFi claims to do is to replicate the traditional financial system in an open, decentralized and autonomous way through applications that are built initially mainly on Ethereum, but now increasingly on other blockchains, as well. Now, when discussing definitions, there are two possible misconceptions that we need to highlight. The first is that not all blockchain-based financial applications are DeFi. The fact that a financial product or service is built on a blockchain does not make it, by default, part of the DeFi market. The second misconception has to do with the fact that not all self-proclaimed DeFi applications are truly decentralized. Now, the degree of decentralization varies from one DeFi project to another, and it does depend a lot on the stage of development of the application, but also on the existence of other centralized features or other characteristics that we can discuss. 

In the OECD analysis, we have used some key defining characteristics for DeFi protocols. For example, these include the fact that a DeFi project needs to be built on a public, permissionless chain where nobody approves participation, anyone can send the transaction, and people act in a general manner anonymously or pseudonymously. Those protocols rely on smart contracts — which are self-executing, based on some triggers. And importantly, they are non-custodial in nature. This means that there is no central authority getting access or control over the digital assets of the participants, and the owners themselves hold their private keys, and with them the data, as well.

And, importantly, DeFi applications are community-driven, and the governance of those protocols is community-driven and relies on participants for decision-making through the use of governance tokens.

And, of course, one of the most important characteristics — which is being described as the Lego of the financial markets — is the fact that DeFi applications are composable. So, one DeFi project can be pieced together with another and create new products.

But what I want to highlight in terms of defining DeFi is that, given the recent hype that we’ve experienced around this market, a lot of startups and projects arbitrarily market themselves as DeFi without being truly decentralized. For example, there are projects which have admin keys, which means that they lack complete decentralization.

There are people who have actually some kind of power and control given by those admin keys. So, overall, although it’s important to know that decentralization is not binary, so we cannot just say ‘it is or it is not’ — it goes on a spectrum that we cannot measure. In fact, we have to remain cautious when defining DeFi projects. 

Lau: That’s a really good point of distinction — for the audience as well, because a lot of investors are taking a look at the space and figuring out how to participate. To your point, it’s not binary. There is a spectrum of governance, of centralization, of control, actually, that each product and each project pushes forth in DeFi. So it’s actually up to the investor — at the moment, at least. And it’s something that you observe as you research this space — it’s up to the participants to actually figure it out themselves, which speaks to the opacity of this space, which makes it difficult to navigate.

Nassr: Indeed. And it’s a bit of a paradox, because we’re talking about distributed ledger technology being one of the most transparent areas in terms of financial products and services, as everything is open and available on the ledger. And in DeFi protocols, we’re talking about open source, so anyone can actually see all the details of the source code underlying the protocol. At the same time, for the average user, it’s very difficult to actually read and audit this kind of code without having the necessary technical skills. So we have this paradox where we have absolute transparency, but at the same time, we have the need for some technical, engineering, software development or coding skills which the average user does not have. And this brings us — as an organization and as a community of policymakers — a lot of interest in this market, given that the whole system of DeFi at the moment lacks the usual investor protection and safeguards that any other regulated financial product or service has… actually to protect consumers and investors. 

Lau: Yeah, and I guess it speaks to why you care about DeFi. Why is the OECD caring so deeply about the DeFi space?

Nassr: So, at the OECD, we have looked into blockchain-based finance since the initial coin offering boom in 2017, and we have done a lot of work at the Committee on Financial Markets around tokenization of assets and the implications that tokenization has for financial markets, and also the regulatory approaches that policymakers have taken around tokenized assets.

It was more natural for us to delve into this market, but particularly given the speed of its development — and you mentioned some striking figures in your introduction about the rapid growth of DeFi, within the wider crypto asset market, which is also expanding exponentially. And, as I mentioned, all the traditional regulatory safeguards that we have both for investor protection, but also for market integrity, and which exist across the board of financial services, do not exist in DeFi. And this means that participants are exposed to a number of risks that we can discuss later, and which make it relevant for a policymaker community to examine this market and to think about potential policy actions that may or may not be required. Of course, that said, we at the OECD also do not underestimate the benefits and the potential benefits of decentralization of finance for the financial markets and for market participants. And so we are also looking into understanding those potential benefits, and how these can actually be transposed in traditional financial markets, as well. 

Lau: It’s so important to understand both aspects of this technology, so let’s start there. What is the potential benefit that you see in DeFi space? The statistics actually show us — and your research obviously confirms this — that we often talk about banking the unbanked: 1.7 billion people who don’t have access to financial services at the moment. DeFi is a potential bridge to all of these people. But in reality, what’s actually happening in the DeFi space as you see it.

Nassr: It’s true that the financial inclusion argument is one of the main arguments that we hear a lot in the space of DeFi — all about democratization of financial services… offering financial products to those that don’t have access to them. But I would say that we need to be really cautious when arguing for DeFi for financial inclusion, at least at this stage of the development of this market. And I can give you a couple of reasons for that.

First of all, the statistics for participation in DeFi markets as of today show that more than 60% of transaction volumes on DeFi applications come from large, institutional investors. This is research by Chainalysis, which showed, for example, that in Q2, 2021, transactions above US$10 million accounted for 60% of DeFi volumes. So, if we add the smaller institutional and professional investors in this kind of calculation, we end up with something close to 95% of total transaction volume being done by non-retail investors.

So, for the moment, DeFi activity is concentrated on institutions, and we see a lot of family offices participating in this market to enjoy the leverage opportunities that are available there.

This is not to say that there’s no potential, but we don’t see this practically happening today. So, as of today, we see limits in this kind of argument for another reason, as well, which has to do with what I mentioned around the skills required for the average user to get into the DeFi space. Of course, this is increasingly being addressed by fintech companies that provide platforms and applications to ease access to DeFi protocols for uneducated users. 

But there’s also another important example that goes counter to this financial inclusion argument, and it has to do with transaction fees. We’re all familiar with network congestion and what happens when we have increased fees, depending on the timing of the transaction, or the price of Ether, or other possible parameters. These kinds of increased transaction fees are a big obstacle for small transactions, so retail users who wish to execute very small-value transactions may be faced with disproportionately high fees, and this is effectively pricing them out. This is contrary to what we are discussing when talking about financial inclusion. 

Lau: To your point, there are firms and protocols and companies that are working to make that easier. And then on the other side of that are the risks. 

As you investigate this space, what are the potential risks that you see — the red flags that regulators need to pay attention to, and so too does the industry?

Nassr: So, just before I go into the risks, just to mention that — as I said — we do not underestimate the potential benefits of these kinds of protocols and of technology — and not just in DeFi, but across the board of blockchain-based financing, be it potential efficiencies and (the) cost and speed (of) post-trade efficiencies. All that is very important, and we are also looking at and highlighting these potential benefits, as well.

But it’s true that when it comes to DeFi at the current stage and state of this market, we have a very long list of potential risks and challenges, starting with the most commonly referred to, which is anonymity or pseudonymity, which goes hand-in-hand with the lack of any know-your-customer or anti-money laundering and safety checks. And this is all what’s been happening with the Financial Action Task Force travel rule and all the guidance that has been updated recently. This kind of pseudonymity and the lack of any AML checks gives rise to risks of money laundering, of terrorism financing, and any kind of use of illicit funds, and it facilitates misconduct. So this is a huge red flag across the board.

Then, the other potential risks have to do — as I mentioned before — first of all, with the lack of any kind of traditional regulatory safeguards for institutions for investment protection and market integrity. We can have market manipulation, we can have people losing their money, as you mentioned, but we can also have large-scale issues, such as ones having to do with the almost unlimited potential for leveraged trading that happens beyond the regulatory framework, and which can lead to greater cyclicality. We have new forms of concentration risks, which in turn can lead to financial stability vulnerabilities when it comes to overall collateralization. It’s true that today, we have in lending protocols over-collateralization, but if this level of collateralization is lower in the future to allow for better capital efficiency by (DeFi) protocols, this would mean that automatic liquidations could become even more frequent, given also the high volatility of the crypto assets that are being pledged as collateral. And given that all that happens automatically, many … retail users do not even understand this kind of technique, and get all their money lost without any disclosure or any kind of flagging to them beforehand. The volatility of the crypto asset market is something that does come back to us in many instances, particularly while we see a lot of institutional investor interest in the crypto asset space, and in the DeFi space, as well. This could lead to increased interconnectedness between the traditional markets and the decentralized finance markets, with other implications, such as creation of new channels for transmission of risk between the two universes.

Lau: I think that’s a great point, especially since you’ve noted that a significant percentage of participants in the DeFi space right now are institutional, family office types, high-net-worth investors — but they’re the centralized point of weakness, if you will. They’re the ones who are participating in both systems right now and the DeFi space, whatever leverage, margins, etc etc… the volatility and the risks that exist in this world could potentially bleed into the traditional finance world through this one person. So, if there’s a stress event, a financial stress event that happens in the DeFi space, for whatever reason, this person might have to liquidate, change market positions, etc etc… in the traditional space, and then that also create a series of events that nobody anticipated because it was happening in the DeFi space.

Nassr: I totally agree with your analysis, and this is actually what we’re actually arguing, as well — that there’s the creation of channels for transmission of risks that — for the time being, this market is very small — but is not insignificant. And if it keeps this exponential growth rate, it could become even more important to actually observe and analyze this kind of interconnectedness between the two markets. Because, as you said — and increasingly so through more traditional financial instruments that are referencing crypto assets, and through the participation of institutional investors directly into the markets for decentralized finance — it becomes increasingly possible that given the large volatility of those crypto assets, we could have spillover effects in the traditional markets, as well. 

Lau: What do you think — from your perspective — (OECD) member country regulators are concerned about? And I’ll note a recent (blockchain tracing and security company) CipherTrace report finding that while overall fraudulent activity in crypto is decreasing, rug-pulls and scams in DeFi have been on the rise in 2021. And, of course, everybody’s still talking about the ‘Squid Game’ token rug-pull, where bad actors were creating worthless tokens, listing them on decentralized exchanges, taking in investors, and then running away with all of those assets. What are regulators out there concerned about, from what you’re hearing, and obviously as you’re assessing this space ahead of your January report?

Nassr: So, as I mentioned, the list of potential risks is very long. There’s a focus on AML and safety from illicit activity, from the money laundering part of it. This is, as I said, addressed at the FATF.

There’s a lot of attention on consumer protection. You mentioned the high volatility of crypto assets. There’s a huge risk of loss of capital, particularly for the uneducated investor knowing that there is limited — if any — disclosure of the risks. Many … users have gone into this place for speculative reasons, for fear of missing out, without understanding the risks. There has been no disclosure around potential risks, so they find themselves losing all their capital without knowing how this happened. The automated liquidation of lending protocols is one very good example of this kind of mechanism.

Now, there is also insufficient audit or due diligence for those projects. There could be many instances of market manipulation. We have potential concentration risks.

We also touch upon some of the issues that are little discussed, having to do concentrations in token holdings. A lot of times, the people who build the project or the venture capital behind the project hold a majority stake of the governance tokens, which is in many instances not disclosed to the users and the participants. And this has risks of market manipulation, as well. We have discussed, we have touched upon, the systemic risk potential. There are operational risks.

But if I can highlight the main puzzle for the regulatory and policymaking community at the moment: when it comes to DeFi, it has to do with the absence of a single regulatory access point. So, who do we call when something goes wrong? Who does the supervisor communicate with on an ongoing basis? This is one of the of the major issues that has to be resolved when it comes to fully decentralized spaces, and which will be difficult to tackle because our current frameworks for financial services are built in the construct of having a financial intermediary in every single financial service provision, and that’s been the access point for the regulators and supervisors. In DeFi, of course, this is non-existent, and this is becoming a big puzzle for us. 

Lau: Unless regulators want to participate in the governance of tokens by owning tokens, it’s at that scale. It’s almost impossible to regulate, especially as we have thousands and thousands of altcoins now that are flooding into this space. How does one make sure that this is behaving as it should, and this one is a complete red flag and it’s a scam?

What role does the industry play here? What role do protocols play here… do the token teams themselves play here, do the decentralized exchanges? What role does the industry play?

Nassr: At least at this stage of development of this market, there’s a big cultural difference between the industry and the policymaking community. I think the industry has this culture of anarchists, in some way, or cryptopunks, where they believe they don’t need to be within any kind of rules framework, and that they can exist outside any kind of rules. But we have seen in the past that no serious and responsible financial service or product has actually managed to develop and exist outside, or on the fringes of, regulation.

So, there’s a cultural gap that needs to be bridged, and this does happen through communication. At the OECD, we have tried to provide the platform for this kind of exchange to happen on a cross-border level. I think that this is increasingly happening throughout the globe and it will happen even more so as the market grows and develops even further.

Of course, we’re still at a very early stage in the DeFi market, so we have a lot of time until the industry matures. And again, the optimistic view I have is that there will be a lot more interaction between the two sides, so that both can educate each other and get to a golden middle, where they can actually find the solution to the issues. 

Lau: I think you’re absolutely right. As the industry matures, you’re also going to have more people who are experienced in the traditional space and bringing the discipline, and the responsibility, and the accountability, also, and changing probably from within, kind of, to temper and balance. If more people participate, it makes that system more functional and better in many ways. 

Twenty-twenty-two is just around the corner. We have the Biden administration, with the President’s Working Group advising that stablecoins be regulated like banks, people are looking into the DeFi space as OECD and others are. 

As you see this space evolving into 2022,what do you think the big developments are next year? What should we all be paying attention to?

Nassr: I think that the developments around stablecoins are very important, because stablecoins are actually the glue that links the DeFi space with centralized finance space, so, this is a very important part of the DeFi market, and developments there are very important.

I do think that there will be other, parallel developments in the growth of tokenization, in the growth of markets for tokenized assets, in the financial regulated kind of products, and not in a non-compliant way as currently (is the case) in DeFi, because one of the main issues that I have not mentioned is that many of the products or services that are within the DeFi system are actually products and services that are regulated and that have comprehensive frameworks built around them, but are provided in a non-compliant way by DeFi. So this is one of the potential areas where some work will be done to clarify the situation, perhaps. 

We expect that the growth of the tokenization market in regulated financial products will be instrumental. And we have actually seen a first example of that in France, with Société Générale and its subsidiary FORGE, trying to refinance tokenized security through the MakerDAO DeFi protocol. So, we see this link between the CeFi and DeFi world actually materializing, and we think this is groundbreaking and shows a lot of the potential of the DeFi markets. Overall, we are hoping to see more successful interoperability, or even integration, of DeFi protocols in mainstream finance, as I mentioned with this example. And this is very much linked to the growing institutional investor interest in this space. So, in other words, this kind of connection between the two, and the use of DeFi — perhaps not in its current form, but in terms of concept and mechanism — in mainstream finance is something that I would look to see more in the future. 

Lau: And just to wrap it up … the Bitcoin & Beyond Summit — our first global virtual summit — was just completed. We had one of your colleagues — Caroline Malcolm from the Global Blockchain Policy Center at OECD — join us. She said something really interesting about the role of regulators needing to explore non-traditional methods of meeting the objectives of things like anti-money laundering and tax compliance

As we look into the future, what is the mood of regulators to think in non-traditional ways about DeFi and blockchain? Is the appetite there to explore? I’m just curious.

Nassr: I personally tend to defer a bit. Again, going back to the fact that, as I mentioned, many of the parts of the DeFi market are actually the provision of services or products that are regulated and have frameworks around them… in that sense, we don’t need to do much other than clarifying what’s what and what needs to be done. But at the same time, I do agree that there is a very large element of novelty and innovation in these markets, which may require additional thinking and alternative methods, and we have heard scenarios of machine-readable law in code for reporting, and regulatory technology is something that regulators and supervisors around the world are getting into increasingly. So, there’s a bit of that, as well. At the same time, we need to keep in mind that most jurisdictions around the world have a technology-neutral principle in policy-making. It doesn’t matter what kind of technological means we are using, if the activity is the same, then the framework applying to it is the same. So there is a mix of both, I would say. 

Lau: It’s a fascinating space, and I’m so excited that you gave us a little taste, a little preview of what we can expect from the OECD in January, when the report is actually officially published. Thanks for giving us behind-the-scenes thinking perspectives and important insights from OECD, and from your own personal, professional perspective, as well. Iota, it was a pleasure having you on the show.

Nassr: Thank you, Angie. It’s been a pleasure. 

Lau: That was Iota Nassr, economist and policy analyst at the OECD. 
And I want to thank you, everyone, for joining us on this latest episode of Word on the Block. I’m Angie Lau, Editor-in-Chief of Forkast.News. Until the next time.

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