European Union: DeFi: Cryptoasset Buffet (re)opens For Business

If cryptocurrencies aimed to disrupt payments and initial coin offerings (ICOs) did the same for venture capital, the latest crypto-craze goes after the core banking business: lending and deposit taking.

What is DeFi?

Decentralised Finance - or DeFi for short - is the latest buzzword from the world of blockchain and cryptoassets. According to Binance Research, a research arm of the leading crypto exchange, DeFi stands for "[a]n ecosystem comprised of applications built on decentralised networks, permissionless blockchains, and peer-to-peer protocols for the facilitation of lending/borrowing or trading with financial instruments"¹.  DeFi projects and businesses aim to replicate existing financial services in a peer-to-peer, decentralised, accessible, interoperable and transparent way, while simultaneously eliminating the need for traditional financial intermediaries, such as banks, securities exchanges and other financial institutions.²  Enabling technology for DeFi is of course blockchain or, more generally, distributed ledger technology (DLT) with its promise of "decentralisation of trust" and (at least theoretically) open access to users and developers alike. While still small in comparison to the traditional financial sector, DeFi has already attracted non-trivial amounts of crypto-capital: USD 11.03bln worth of value has been locked in Defi as of mid-October 2020, according to DeFi Pulse, an industry monitor.³

The narrative behind DeFi is very similar to the one for cryptocurrencies generally: through disintermediation - eliminating various middlemen taking a piece of each transaction - DeFi decreases transaction costs and improves financial inclusion by giving access to financial services to previously "unbanked" segments of the global population. In addition, since DeFi runs on open (permissionless) protocols - typically Ethereum - which operate without formal institutional gatekeepers, anybody with the appropriate skills can build on the platform and experiment with new business models. This facilitates innovation and (arguably) enables more efficient capital allocation. 

What is really going on?

Reminiscent of the 2017 initial coin offering (ICO) boom, the world of 2020 DeFi features an incredible diversity of projects.⁴ Most fall into one of three broad categories: 

1.    Decentralised (collateralised) lending;
2.    Decentralised marketplaces, typically decentralised cryptoassets exchanges (DEXes); and
3.    Other decentralised financial services, such as asset management, derivatives issuance and insurance.   

With the possible exception of DEXes, decentralised (peer-to-peer) lending seems to be the killer app of DeFi, with USD 4.21bln worth of value (and growing) locked in as of mid-October 2020.⁵ While DeFi lending comes in many flavours (custodial and non-custodial, protocol- or platform-based, etc.⁶), its core use case is enabling holders of liquid cryptoassets (such as Ether and Bitcoin) to earn interest from their holdings. Borrowers, on the other hand, may wish to borrow cryptocurrency to take short positions in it (i.e. betting on the decline in their value) or to acquire token utility or governance rights.⁷ Platform providers often earn income from interest rate spreads (i.e. the difference between the received and paid interest) or from transaction fees. Lenders de facto deposit their excess liquidity, meaning that they lock in their assets for the term of the loan. The practice of staking one's assets in exchange for a return - which is at the core of many DeFi applications - is widely known as "yield farming". To balance out the risk, borrowers must typically provide collateral (in the form of a different cryptoasset) against their borrowings, sometimes as high as 150 % of the loan value (which somewhat reduces the appeal of DeFi for the truly unbanked, who may not have any excess capital to pledge).  

The rate of innovation as well as sheer variety in the DeFi space is extraordinary even by crypto standards. If you thought animal-themed projects such as Dogecoin and CryptoKitties were whacky back in 2017 during the ICO era, wait until you hear of SushiSwap (and its visionary-to-villain creator "Chef Nomi"),⁸  YAM Finance and its clone Spaghetti.Money (which attracted USD 200m in staked assets within 24 hours of launch⁹) and PieDAO. Tongue-in-cheek references to food and farming are a common theme in DeFi and these types of projects - fusing games and memes with finance - have already been nicknamed "Weird Defi".¹⁰  Nevertheless, the amounts involved are no laughing matter.  

In summary, if the 2017 ICO boom was primarily a capital formation affair fuelled by regulatory arbitrage, the 2020 DeFi drive explores other, more sophisticated financial products and intrudes on banks' home turf with disintermediated peer-to-peer lending platforms. This is an attractive, albeit sometimes risky, proposition for holders of large cryptoassets war chests, as otherwise idle coins can be put to work earning a return. 

DeFi should not be confused with "Open Banking", despite their potentially convergent goals. Open Banking is a concept where banks - traditionally the exclusive custodians of customers' funds as well as, crucially, their financial data - are compelled to allow access to this data to third-party service providers.¹¹  This enables the latter to build innovative (fintech) applications, "democratising" access to the consenting customers' bank accounts and banking data, as if they were essential infrastructure. In the EU, this development is driven by the Payment Services Directive 2 (PSD2) and is, just like DeFi in the crypto space, expected to foster innovation in payment services.   

(Legal) issues and challenges

Despite occasional views to the contrary among tech enthusiasts, DeFi - just like the rest of the blockchain universe - does not operate in a legal vacuum. It is inevitable that technology aiming to disrupt one of the most heavily regulated sectors - finance - will collide with existing regulation. Here is a high-level overview of a few of the legal and conceptual issues facing DeFi: 

• Licensing issues and regulatory developments: Lending - not to mention accepting deposits from the public - are regulated and licensable activities across the EU, sometimes reserved to credit institutions. The licensing processes are administratively cumbersome and impose stringent requirements on the prospective applicant. Needless to say, the majority of DeFi projects do not bother. Should they? Economically, decentralised lending projects often look very similar to core banking business, except they primarily operate with cryptoassets instead of fiat currency and - arguably - merely facilitate peer-to-peer transactions instead of underwriting any risk themselves. The latter may not always be the case, however, as many DeFi lending operations also maintain liquidity pools. In addition, the argument "if it is done in crypto only, it should be okay" is a shaky one. A vivid illustration of this is the recent enforcement action by the United States' Commodity Futures Trading Commission (CFTC) targeting BitMEX, a leading crypto derivatives exchange, alleging that BitMEX has been operating an "unregistered trading platform".¹² In the EU, the landscape could change drastically for the DeFi sector with the eventual adoption of the Digital Finance Package.¹³ The regulation package - currently in the legislative proposal stage - introduces, among other things, investor protection measures in respect of cryptoassets (including a licence for "stablecoin" issuers).
• Evolution of anti-money laundering / know-your-customer rules: At least in the EU, AML rules (last amended by the 5th Anti-Money Laundering Directive) mostly target "fiat on-ramps" - i.e. exchanges enabling purchase and redemption of cryptoassets for "real" currencies, such as the euro and US dollar. This approach assumes that the proceeds of crime take the form of fiat currency, and that conversely cryptoassets only have value to malicious actors once converted into fiat. This assumption may no longer be true, as the cryptoassets and DeFi ecosystems develop. Regulators and legislators may therefore decide to follow the (crypto-)money and expand stringent KYC requirements to crypto-only operators, which may prove impossible to comply with for many DeFi teams and may put a quick end to the decentralisation utopia.  
• Jurisdictional challenges and supervisory gaps: The decentralised and global nature of DeFi (and cryptoassets generally) makes it difficult for an individual regulator to conduct effective and comprehensive supervision and take enforcement action when necessary.¹⁴ This may cause serious harm for investors or consumers. On the other hand, the opposite may occur, where multiple regulators will claim supervisory authority over a DeFi operator, resulting in a disproportionate regulatory burden or in regulatory paralysis as various bodies sort out which one should exercise supervision or take enforcement action.  
• Technological centralisation displacing counterparty centralisation: DeFi can enable decentralised execution of transactions and can bring together separate parties without nominally placing an intermediary between them. However, whereas counterparties get decentralised, the technology bringing them together does not. Reliance on a particular platform, protocol or provider creates a single point of failure in a very similar way as a bank can become a nexus of financial risk. DeFi thus replaces single counterparty risk with technological risk (i.e. a serious flaw in the protocol's code, a key developer abandoning the project, etc), which is much less regulated and more difficult to police.¹⁵ The story of SushiSwap is a cautionary reminder of the huge amount of de facto control that can vest with a single developer over a nominally "decentralised" platform.¹⁶  

Footnotes

¹ Binance Research (Calvin & Etienne): Lending & Borrowing, Studying the landscape of the (Ethereum) decentralized cryptoasset lending industry, 6 June 2019, accessible at https://research.binance.com/en/analysis/decentralized-finance-lending-borrowing (13 October 2020).

² Yan Chen, Cristiano Bellavitis: Blockchain disruption and decentralized finance: The rise of decentralized business models (2020), Journal of Business Venturing Insights 13 (2020) e00151, accessible at https://www.sciencedirect.com/science/article/pii/S2352673419300824?via%3Dihub (12 October 2020).

³ DeFi Pulse, accessible at https://defipulse.com/ (12 October 2020).

⁴ See a list of selected DeFi projects sorted into high-level sectors at https://defipulse.com/ (accessed 12 October 2020). 

⁵ DeFi Pulse, accessible at https://defipulse.com/ (12 October 2020).

⁶ Binance Research (Calvin & Etienne): Lending & Borrowing, Studying the landscape of the (Ethereum) decentralized cryptoasset lending industry, 6 June 2019, accessible at https://research.binance.com/en/analysis/decentralized-finance-lending-borrowing (13 October 2020).

⁷  Ibid.

⁸   Adriana Hamacher: The Man Who Saved SushiSwap, Decrypt, 13 September 2020, https://decrypt.co/41606/the-man-who-saved-sushiswap (13 October 2020).

⁹ Ogwu Osaemezu Emmanuel: Spaghetti Money DeFi Protocol Attracts $200M in TVL Under 24-Hours, BTC Manager, 19 August 2020, https://btcmanager.com/spaghetti-money-defi-protocol-200m-tvl-24-hours/ (13 October 2020).

¹⁰ Brady Dale: Yearn, YAM and the Rise of Crypto's 'Weird DeFi' Moment, Coindesk, 31 August 2020, accessible at https://www.coindesk.com/yearn-yam-cryptos-weird-defi-moment (13 October 2020).

¹¹ Deloitte: How to flourish in an uncertain future, Open banking and PSD2, 2017, accessible at   https://www2.deloitte.com/content/dam/Deloitte/cz/Documents/financial-services/cz-open-banking-and-psd2.pdf (13 October 2020).

¹² JD Alois: BitMEX Hit by CFTC Enforcement Action for Illegal Crypto Derivatives Trading, AML Violations; Criminal Action Unsealed Simultaneously, Crowdfund Insider, 1 October 2020, accessible at https://www.crowdfundinsider.com/2020/10/167473-bitmex-hit-by-cftc-enforcement-action-for-illegal-crypto-derivatives-trading-aml-violations-criminal-action-unsealed-simultaneously/ (13 October 2020).

¹³ European Commission communication: Digital finance package, 24 September 2020, accessible at https://ec.europa.eu/info/publications/200924-digital-finance-proposals_en (13 October 2020).

¹⁴ Dirk A. Zetzsche, Douglas W. Arner, Ross P. Buckley: Decentralized Finance, accessible at: https://ssrn.com/abstract=3539194 (13 October 2020).

¹⁵ Dirk A. Zetzsche, Douglas W. Arner, Ross P. Buckley: Decentralized Finance, accessible at: https://ssrn.com/abstract=3539194 (13 October 2020).

¹⁶ Adriana Hamacher: The Man Who Saved SushiSwap, Decrypt, 13 September 2020, https://decrypt.co/41606/the-man-who-saved-sushiswap (13 October 2020).