DeFi and decentralisation

The Bank for International Settlements publishes its Quarterly Review and calls for greater regulatory supervision of blockchain-based decentralised finance

The rapid uptake of decentralised finance applications, or DeFi as its commonly known in crypto spheres, has caught the attention of regulators as they continue to grapple with how to effectively supervise and manage the risks presented by this fast-growing technology. 

On 6 December the Bank for International Settlements (BIS), the umbrella body for central banks around the world, published its Quarterly Review highlighting the need for systematic regulation and the coordination of supervision of DeFi activities at an international level. The report also questioned the truly decentralised nature of DeFi platforms and the software protocols on which they operate.

What is DeFi?

DeFi refers to some form of finance activity based on self-executing smart contracts built on a blockchain network, often the Ethereum blockchain, involving mainly permissionless mechanisms and anonymous transactions. DeFi applications generally involve no centralised intermediary or custody of assets, relying on smart contracts to create liquidity in peer-to-peer digital asset markets.

It is designed to cut out central actors and intermediaries with the application or software layer of these applications often being run by a DAO, or decentralised autonomous organisation.

A previous briefing note from us covers a high-level overview of DeFi, covering what it is, an example use case, and potential issues.

Key points to note from the BIS Quarterly Review

In our opinion, some of the key takeaways from the BIS review are:

  • the ?decentralisation illusion?
    The report points to the fact that pivotal entities (typically, application developers) are ultimately in control. The BIS suggests that these entities, as well as DeFi's links with the traditional financial system, could become the natural entry points for financial services regulation that is needed to address issues related to financial stability, investor protection and illicit activities. The report notes that ?Defi platforms have groups of stakeholders that take and implement decisions, exercising managerial or ownership benefits. These groups, and the governance protocols on which their interactions are based, are the natural entry points for policymakers?.
  • the need for international coordination
    Given DeFi's characteristics, future regulatory policy will require international coordination.
  • the innovative potential of DeFi
    With improvements to blockchain scalability, large-scale tokenisation of traditional assets, and suitable regulation to ensure safeguards and enhance trust, the BIS notes that DeFi could yet play an important role in the financial system.

What's next?

Although DeFi applications have often sought to operate outside the regulatory perimeter, acting merely as a further infrastructure layer, the regulatory analysis of the precise activities can be extremely nuanced and multi-jurisdictional.

In addition to existing regulatory and anti-money laundering considerations, at a European level the Regulation on Markets in Crypto-assets (MiCA) - which is going through the EU's legislative procedure - is likely to have significant implications for the DeFi market. We?re also awaiting the outcome of HM Treasury's consultation and call for evidence on the UK regulatory approach to cryptoassets and stablecoins, which closed on 21 March 2021.   

What is for certain is that DeFi is still very much in its infancy. The potential for DeFi to democratise finance, lower cost and improve barriers to entry will become more apparent over time. 

In any event, the mass adoption of crypto and the developments in blockchain technology can be seen to be driving innovation in mainstream financial services and beyond.

For more information on smart contracts, see our previous briefing note here.