Is decentralized finance (DeFi) a revolutionary reinvention of modern finance that should remain outside the bounds of regulation? Or is it jargon – algorithmic authority window-dressed as liberty and accompanied by the same problems as traditional finance – that should be hemmed in by rules?

A new paper by Hilary J. Allen, Professor at the American University Washington College of Law, argues for the latter case, stating that the DeFi ecosystem, which aspires to provide financial services using technology and without middlemen, is actually full of centralized intermediaries. “…if DeFi cannot deliver on decentralization, regulators should feel emboldened to clamp down on DeFi in order to protect the stability of our financial system and broader economy,” she writes.

A New Version of Shadow Banking?    

Allen likens DeFi to Shadow Banking 2.0. The first iteration of shadow banking occurred during the 2008 financial crisis, when the collapse of heavily leveraged and complex finance products like credit default swaps (CDS) and mortgage-backed securities (MBS) brought down the financial system. The conceit of disintermediation is that a system free of institutions that sold such products to investors could potentially prevent and eliminate another crisis.

But the building blocks of that crisis – excessive leverage, improper regulatory oversight, absence of accountability – are also present in the existing DeFi ecosystem, according to Allen. She uses three characteristics of the 2008 financial crisis – leverage, rigidity, and runs – to make her case that the current DeFi system exacerbates the potential for another financial crisis.

The cryptocurrency ecosystem is already infamous for being a wild west of leverage. DeFi offers an even easier opportunity for risky betting because it is easier to multiply the number of tokens (and associated products) using programming skills. A scam (and there are plenty of those in the crypto ecosystem) or a crypto bubble correction could induce a deleveraging. But that will bring down the entire house of cards.

The rigidity of algorithms makes it difficult to stop the process when DeFi does crash. It is difficult to stop self-executing smart contracts. Real world contracts can be controlled with manual intervention. Algorithms are peculiar in that the rules and conditions for execution of their processes are already baked into their code. Changing them is a time-consuming process that requires trawling through thousands of lines of code. The timeframe for algorithmic execution is also miniscule. Modifying them through governance procedures requires agreement between stakeholders and speed is not exactly a selling point for such processes.

“Locating the creators (of the smart contract), let alone coordinating a dispersed group of governance-token holders, would take time, and it seems highly unlikely that this could be achieved before the smart contract executes its programming,” writes Allen. The other option is to roll back the smart contract and ledger to their previous state. But even that is a perilous and time-consuming exercise because it involves locating and updating all distributed ledgers in a blockchain.

Finally, a run on stablecoins that are widely used as currency backstops for DeFi contracts could also magnify a possible crash. They connect different products and services within the DeFi ecosystem. Technically speaking, stablecoins should be a safe haven in the tumultuous crypto ecosystem because they are backstopped by a basket of reserves, mostly in the form of fiat currencies. But those reserves have been called into question time and again. For example, Tether paid a fine to the New York Attorney General (NYAG) for commingling its reserve funds. The regulatory gray area inhabited by such coins has also come under SEC scrutiny: SEC chair Gary Gensler referred to them as “poker chips” that are a price of admission to the cryptocurrency casino. A rumor or an adverse news report about stablecoins could very easily bring the entire DeFi structure tumbling down as fearful investors liquidate their holdings and bring down the value of their coins.

A Regulatory Solution

In many past instances, DeFi products have come close to crashing or malfunctioned. There was the DAO hack of 2016 that resulted in an Ethereum fork. A collapse in the value of DAI, a widely-used stablecoin in DeFi transactions, in March 2020 was another example.

But context is necessary to delineate these cases. DeFi is a nascent ecosystem that is still being tested. For the most part, it has functioned separately and away from mainstream finance. And, for this reason, it is still not time to become bearish about the technology. DeFi displays promise and has the potential to throw the door open to a new world of finance, one in which expensive cross-border transfers might become a thing of the past. It could also bring innovative products and new investors into financial markets.

For that future to come to a pass, however, Allen recommends a “precautionary approach” by regulators. She cites the CFTC Modernization Act of 2000, that cleared the decks for a rampant speculation and a subsequent financial crisis, as argument that the innovation shtick peddled by DeFi enthusiasts is insufficient to justify a hands-off attitude to the technology.

Her approach is prescriptive. She says regulated banks should be insulated from DeFi. Possible taxes on stablecoins or a licensing regime for stablecoins and decentralized applications that requires them to adhere to certain safeguards are also possible solutions. The latter strategy would require the aid of centralized crypto intermediaries, such as exchanges or wallets, because they could prohibit such tokens from being listed on their platforms.

But it might be a bit premature to justify such regulations. Stablecoins do not have any mainstream use cases. While there is much talk about the exponential growth in the amount of Total Value Locked (TVL) in DeFi, not all that amount represents real dollars. Security vulnerabilities in DeFi also make it prone to hacks and lapses in trading. So far, the harm caused by DeFi products and services is restricted to a bunch of rich crypto enthusiasts and the general public has been insulated from its effects.  

A better idea is to monitor its rollout to the common investor. Regulatory agencies already monitor the large institutions who might play a role in releasing DeFi products and services to average investors. Banks and financial institutions are already reportedly developing DeFi products and services. Monitoring their advances before coming up with a framework might be a more prudent approach.