Decentralized Finance: Risk, Regulation, and the Rise of DeCrime

Decentralized Finance (DeFi) looks set to revolutionise financial services, by replacing centralised intermediaries with software running on blockchains.

Decentralized Finance (DeFI) refers to the use of platforms such as Ethereum to offer an alternative financial system that is open for anyone to use, and which allows centralized intermediaries to be replaced by decentralized applications (DApps).

Over the past two years the DeFi ecosystem has flourished, with DApps offering decentralized lending, exchange, asset management and derivatives gaining significant traction.

The “total value locked” (TVL), a measure of the liquidity of DeFi services, has increased from $500 million in November 2019 to just over $247 billion today – according to a very good report on the subject – DeFi: Risk, Regulation, and the Rise of DeCrime.

Because it is built on an open infrastructure, DeFi can be used by anyone with an internet connection, promising far broader access to the financial services that are currently enjoyed by a privileged few.

It also means that anyone is free to innovate and build their own financial services for a global market – greatly increasing choice and competition.

Growth in the use of DeFI over the past two years has been staggering:

• The total capital locked in DeFi services, a measure of liquidity, has grown by more than 1,700% over the past year to $247 billion
• Monthly trading volumes on decentralised exchanges (DEXs) have surged by more than 1,500% over the past year, to more than $300 billion each month
• Outstanding loans issued through DeFi lending protocols have increased at an annual rate of over 800% to $23 billion.

The same openness and innovation that makes DeFi so powerful also brings with it new risks.

The relative immaturity of the underlying technology has allowed hackers to steal users’ funds, while the deep pools of liquidity have allowed criminals to launder proceeds of crime such as ransomware and fraud.

This is part of a broader trend in the exploitation of decentralised technologies for illicit purposes, which we refer to as DeCrime.

• DeFi users and investors has suffered more than $12 billion in losses due to theft and fraud
• These losses are accelerating, with losses totalling $10.5 billion in 2021 to date, up from $1.5 billion in 2020
• DeFi is also being used to launder proceeds of crime – with DEXs, decentralised mixers and cross-chain bridges being exploited
• However the unprecedented transparency of DeFi provides law enforcement with new opportunities to follow the money and apprehend criminals.

In traditional finance stringent regulation aims to protect consumers and prevent money laundering – however these regulations were not designed for decentralised financial services.

The report notes that we are currently seeing regulators grapple with the consequences of DeFi as they attempt to apply traditional regulatory principles to the unique risks and challenges presented by decentralization.

As DeFi grows to become an increasingly significant part of our financial system the risks inherent in it will also impact traditional financial institutions.

These risks can not be mitigated through industry abstention alone. The interconnected nature of the global financial system, perpetuated through payment networks and correspondent banking relationships, ensures that the fiat financial sector is already systemically connected to decentralized finance.

Only through the implementation of DeFi-tailored KYC, AML and transaction monitoring policies and procedures can traditional financial institutions adequately assess and mitigate the new risks and exploit the exciting opportunities that decentralized finance presents.

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