The rapidly growing decentralized finance (DeFi) system – the collection of financial applications based on blockchain technology – holds promise for a new financial architecture that can eliminate the need for traditional intermediaries (such as banks, brokers and stock exchanges) and reduce rents (excess profits) in the financial sector. But it also creates formidable challenges for regulators, according to a paper to be discussed at the Brookings Papers on Economic Activity (BPEA) conference on March 24.
“DeFi applications could have the potential to democratize finance by creating a level playing field between providers of financial products and services,” write the authors – Igor Makarov from the London School of Economics and Antoinette Schoar from the Massachusetts Institute of Technology.
But, they warn in Cryptocurrencies and Decentralized Finance (DeFi), the rent reduction may not materialize automatically. Rents are often the result of inherent competitive constraints that arise from network externalities (the phenomenon whereby the value of a financial service or DeFi application increases as its use becomes more common) and cost savings. ‘ladder. These constraints exist in both the traditional financial system and the new architecture, and therefore require careful regulation.
If regulators wait too long, cryptocurrencies and DeFi applications may become too big to regulate.
The permissionless and pseudonymous design of DeFi apps can significantly limit the ability of regulators to oversee the industry and restrict unscrupulous players. DeFi generates challenges in enforcing tax and money laundering laws and preventing financial malfeasance, and therefore can create negative spillovers to the rest of the economy.
The document explains how decentralized finance works and the mechanisms behind it, such as the security protocols of the various cryptocurrency blockchains and smart contracts (embedded computer code that automatically executes transactions when predetermined conditions are met). The authors outline the benefits and potential challenges of the new system, including the difficulty of providing effective financial protections to consumers.
The authors then highlight ways to regulate the DeFi system that would “preserve the majority of the functionality of the blockchain architecture but support accountability and regulatory compliance.” They offer regulatory oversight of validators – participants in the blockchain network who guarantee the integrity of the blockchain ledger (the decentralized record of transactions) and who are paid in cryptocurrency to verify transactions. Regulators could certify validators to ensure that they verify that addresses on cryptocurrency networks belong to certified entities and then only process transactions to and from certified addresses.
The evolution of technology and regulation of the DeFi system has important consequences for the global economy and, ultimately, for the position of the United States, write the authors. They note that the United States derives “significant economic and strategic advantages” from the central role of the dollar and the American financial system and conclude, “it is therefore in the interest of the United States to encourage innovation and modern financial technologies, but at the same time to set standards that protect consumers and maintain the transparency and accountability of the system.
However, the exponential growth of cryptocurrencies and the growing political clout of the crypto community means that time is short for finding regulatory solutions, the authors warn. “If regulators wait too long,” they write, “indeed, cryptocurrencies and DeFi applications may become too big to regulate.”
Makarov, Igor and Antoinette Schoar. 2022. “Cryptocurrencies and Decentralized Finance (DeFi)”. BPEA conference project, spring.