By Jennifer Peve, DTCC Managing Director, Head of Strategy and Business Development
Decentralized Finance, more commonly known as DeFi, has been one of the finance industry’s hottest buzzwords this year.
At a high level, DeFi is defined as technology-enabled access to financial services such as the trading, lending and safekeeping of assets without the reliance on financial intermediaries. However, recent events have shown that this term is often overused and that, in many instances, DeFi activities are not as decentralized as some may think. The most recent crypto crash, and the resulting scrutiny, has shone a spotlight on intermediaries, raising questions about just how decentralized these DeFi models really are and what risks they may introduce to the ecosystem.
At the same time, the industry has begun to differentiate between specific areas of financial services, such as traditional finance (TradFi) and centralized finance (CeFi), as well as pure DeFi where there is truly no central control/operator. While aspirations to establish true DeFi models remain, the practical reality is that many institutional market participants are not yet ready to realize this vision and some functions will continue to be performed by central intermediaries.
When considering the move to DeFi, regulated financial market infrastructures (FMIs) have an important role to play. FMIs are the optimal providers to serve in an intermediary role, bringing the robust risk management and proven capabilities that come with such a responsibility. Additionally, FMIs are well placed to ensure the worlds of TradFi and DeFi do not develop in silos. The concept of on-ramps and off- ramps, where there is an exchange of DeFi assets with TradFi assets, clearly highlight where regulatory checkpoints are needed if TradFi assets are to interact with DeFi.
FMIs can also provide solutions around on-chain identities to address regulatory compliance concerns, as well as to satisfy KYC requirements. For example, consider the use case where an FMI plays a role in credentialing market participants with a verifiable ID. This could go a long way in building trust in DeFi by ensuring that even if a transaction occurs without any intermediary, the parties to that transaction can be confident in who they are transacting with.
IT IS IMPORTANT TO RECOGNISE THAT AS THE DEVELOPMENT AND USE OF DEFI TECHNOLOGIES EVOLVE, IT WILL CONTINUE TO PRESENT RISKS AS WELL AS OPPORTUNITIES TO THE INDUSTRY.
What is more, FMIs could potentially provide solutions that put TradFi assets to work in a DeFi ecosystem, leading to greater adoption by the institutional marketplace, and ultimately benefitting end investors. TradFi assets have significant potential to be leveraged in DeFi strategies, but only if the worlds of TradFi and DeFi can work together. Many opportunities could be unlocked, such as tokenising traditional assets to be leveraged as collateral in the DeFi lending ecosystem.
DTCC firmly believes in the potential of an increasingly digitized financial services ecosystem. However, any new technology initiatives in this space must provide equal or greater risk management and operational resilience capabilities than existing infrastructure and solutions, protecting and safeguarding the industry and individual investors.
Consider smart contracts that manage tokenized securities. While smart contracts could technically operate without any ‘owner’ and be truly decentralized, security and governance risks inherent to this model remain. There is also the possibility for FMIs to manage the smart contract, much like the approach DTCC is developing with its Digital Securities Management (DSM) service. Pending regulatory approval, DSM will employ technologies that allow for tokens to be held in a decentralized manner, with DTCC still providing governance and oversight, enabling more efficient processing and regulatory compliance.
As a final point, more concise regulation of DeFi in global jurisdictions can be expected to drive meaningful change in the marketplace by bringing clarity to existing participants and confidence to those adopting a wait and see approach. Asset definitions and regulatory agency oversight within the DeFi ecosystem could lead to more responsible growth and enable more institutions to participate in DeFi.
It is important to recognize that as the development and use of DeFi technologies evolve, it will continue to present risks as well as opportunities to the industry. Regulators worldwide are showing great interest in understanding the potential of DeFi and, as requisite legal parameters become more defined, it is crucial the industry can operate within an appropriate regulatory framework to capitalize on these opportunities, while mitigating risks to the financial system.
This article was originally published to The EUROFI Views Magazine in September 2022.