ANALYZING THE REGULATORY ASPECTS OF DEFI

INTRODUCTION

Decentralized Finance, the DeFi buzzword, is a model that utilizes distributed ledgers to provide a secure network of financial services with no centralized system.[1] Cryptocurrency and blockchain technology are used to manage decentralized finance transactions. DeFi seeks to democratize Finance by dislodging established, centralized institutions and favouring peer-to-peer connections that can provide complete financial services. The applications built on the DeFi platform have mainly been used for trading cryptocurrency or making loans with collateral.[2] Despite this, their complexity and size are proliferating. Moreover, they profited from investor confidence, lacked consumer protections, and ignored many issues and inefficiencies. However, DeFi is still a relatively new and unregulated space, and several regulatory aspects need to be considered.

THE PHENOMENON OF DECENTRALIZED FINANCE

The concept of decentralized Finance (DeFi) involves financial systems without a centralized authority operating without a safety net.[3] The system is competitive, contestable, composite system, and non-custodial. A network of computers is used to automate financial transactions by implementing financial protocols such as smart contracts.[4]Known as DeFi, this newest trend in crypto assets mimics various functions of the conventional financial system openly, decentrally, freely, and autonomously.[5] Decentralized blockchain apps are capable of offering financial services, products and goods. Using DeFi, peer-to-peer transactions can be conducted both remotely and in an inconsistent manner using Ethereum protocols.[6] With this invention, parallel Finance and an economic renaissance are emerging that goes beyond eliminating intermediaries. In June 2021, approximately 3 million unique addresses were using DeFi protocols, an increase that had been steady over the years.[7] As a result of supply and demand dynamics for each crypto asset, DeFi lending protocols have significantly higher borrowing and lending rates than conventional financial products.

NEED TO REGULATE DEFI

The decentralized nature of DeFi means no central authority oversees its operations, which can lead to market volatility and systemic risk. Regulations can help mitigate these risks by establishing rules for market participants, such as capital requirements, reporting obligations, and risk management practices. Finally, the law can help foster innovation and growth in the DeFi ecosystem by providing certainty and clarity for market participants. India’s financial regulatory framework was designed for centralized financial systems and did not account for the unique risks and challenges posed by DeFi. Without appropriate regulation, DeFi platforms in India could be vulnerable to fraud, money laundering, and other financial crimes.

REGULATORY ASPECTS OF DEFI

Investor protection comes as the priority to regulate DeFi. DeFi platforms must comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements per the Prevention of Money Laundering Act, 2002. There can also be regulations introduced through Foreign Contribution Regulation Act norms instilled to regulate the inflow and outflow of money through DeFi. This includes collecting and verifying customer information, monitoring transactions for suspicious activity, and reporting suspicious activity to regulators.[8] This can be challenging for decentralized platforms, as no central authority oversees compliance. Based on the risk assessments, DeFi platforms can implement AML controls, such as transaction monitoring, suspicious activity reporting, and customer due diligence.

Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. As smart contracts are at the heart of many DeFi applications, their proper functioning and security are critical. DeFi platforms must undergo code audits to mitigate risks to ensure that smart contracts are appropriately designed, implemented, and audited by third-party security auditors. With smart contracts being recognized by the Information Technology Act of 2000, the statute would apply through the domain of E-commerce and E-Governance aspects of regulation. Due to their global nature, DeFi platforms are often subject to multiple jurisdictions. Contracts and digital assets may be governed differently in different jurisdictions, which can complicate the enforcement of smart contracts. Although the Indian Contract Act of 1872 recognizes electronic contracts, there is no specific legal framework for smart contracts and their enforceability. Also, the existing financial regulations like the Securities Contract Regulation Act of 1956 and Securities Contract Regulation Rules 1957 can apply to the transactions if made through securitization mode and in dematerialized format.

DeFi platforms are often built on different blockchains, and interoperability between them is crucial for the growth of the DeFi ecosystem. This can pose challenges for regulators, as they need to ensure that cross-chain transactions are compliant with regulations and that regulators can access necessary data. Smart contracts do not sufficiently protect customers who are less financially savvy or vulnerable. Since smart contracts often lack the tools to measure a person’s financial sophistication or mental competency, they can have unfavourable consequences if they cannot be reversed as in traditional contract law.[9]

Smart contracts with off-chain data can be integrated into on-chain ones using Oracles.[10] By integrating data from multiple sources into smart contracts, decentralized oracles facilitate interoperability, even when those data sources are not accessible on the same blockchain network. DeFi platforms must have uniform data and asset transfer standards to ensure interoperability.[11] It can include data structures, messaging protocols, and asset tokenization guidelines. By standardizing communications across platforms, DeFi platforms can communicate with one another and reduce cross-chain complexity. Interoperability can help to increase liquidity, reduce transaction costs, and improve user experience.

CONCLUSION

There is currently no global or uniform regulatory framework for DeFi. Each country has its legal framework through some issued guidelines, notices, circulars, directives or taken enforcement actions against DeFi platforms. Blockchains cannot track the most significant financial transactions due to the lack of resources, efforts, or data. The flexibility of smart contracts may also make them less dependent on legal systems and contractual parties’ confidence. It is often time-consuming and uncertain to enforce agreements legally. It is imperative for DeFi platforms to work with legal and regulatory experts to ensure compliance with local laws and regulations and to implement best practices for security and risk management.

Author(s) Name: Aathira Pillai (Maharashtra National Law University, Mumbai)

References:

[1] “What Is DeFi? How It Works and Its Future – ET BFSI”  <https://bfsi.economictimes.indiatimes.com/news/fintech/what-is-defi-how-it-works-and-its-future/92771401>  accessed March 24, 2023

[2]Napoletano E, “What Is DeFi? Understanding Decentralized Finance” Forbes  <https://www.forbes.com/advisor/investing/cryptocurrency/defi-decentralized-finance/> accessed March 24, 2023

[3] Auer R and others, “The Technology of Decentralized Finance (DEFI)” (The Bank for International SettlementsJanuary 19, 2023) <https://www.bis.org/publ/work1066.htm> accessed March 24, 2023

[4]ibid

[5] “Why Decentralised Finance (DEFI) Matters and the Policy Implications?” <https://search.oecd.org/daf/fin/financial-markets/Why-Decentralised-Finance-DeFi-Matters-and-the-Policy-Implications.pdf>  accessed March 24, 2023

[6]ibid

[7] Craig T, “EthereumDefi Ecosystem Has Hit 3 Million Users” Crypto BriefingJuly 13, 2021 <https://cryptobriefing.com/ethereum-defi-ecosystem-has-hit-3m-users/> accessed March 24, 2023

[8]Defi, “Decentralized KYC Protocol a Gamechanger for DEFI Institutional Market” (Financial and Business News | Finance MagnatesJanuary 18, 2022) <https://www.financemagnates.com/thought-leadership/decentralized-kyc-protocol-a-gamechanger-for-defi-institutional-market/> accessed March 24, 2023

[9] Makarov I and Schoar A, “Cryptocurrencies and Decentralised Finance” EconPapersDecember 17, 2022<https://econpapers.repec.org/RePEc:bis:biswps:1061> accessed March 24, 2023

[10]ibid

[11]Supranote 7

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