What we’ve noticed: The decentralized finance (DeFi) sector of the crypto ecosystem offers exciting opportunities for early adopters. But the newness of the space and relative inexperience of the investors has provided bad actors with a new playground for widespread scamming and theft, according to a report on 2021 crypto crime trends by Chainalysis. And regulators are taking notice of DeFi’s inherent problems.
What’s DeFi? A thriving segment of the crypto sector, DeFi seeks to revolutionize financial services using blockchain-based software instead of centralized intermediaries. This enables crypto-denominated lending outside of traditional banks.
Investors facing historically low or sub-zero interest rates have been drawn to DeFi by the promise of high returns on savings and the hype over successful decentralized tokens like Shiba Inu. Consequently, DeFi transaction volume grew 912% in 2021, per Chainalysis.
Data dive: As DeFi grows, so too does its issues with stolen funds, according to Chainalysis and the blockchain forensics company CipherTrace (now owned by Mastercard)—which both hold some of the largest datasets on crypto-crime and blockchain metadata in the world.
What are the risks? DeFi’s greatest strength is also its greatest weakness: The ethos of decentralization that makes it so dynamic also allows for scamming and theft. As David Carlisle, director of policy and regulatory affairs at Elliptic, told CNBC: “How do you apply regulatory standards designed for centralized intermediaries to marketplaces where there’s no clear centralization?”
Major DeFi platforms say they bolster security by doing things like hiring external firms to audit code for vulnerabilities and maintaining keys and passwords needed to access user wallets in secure environments. But critics’ main concern is that the DeFi market eliminates third-party control of users’ assets—the same third parties that, in traditional finance, help spot and stop scams.
What do regulators want to see fixed? According to the US Securities and Exchange Commission, the DeFi community needs to address two structural problems—indicating the direction its regulatory work will take:
Lack of transparency: DeFi investing is not transparent—creating “a two-tier market” in which professional investors and insiders have a huge advantage over retail investors.
Pseudonymity: DeFi markets are vulnerable to difficult-to-detect manipulation.
The SEC’s objections to opacity and pseudonymity suggest that in the future, it could require DeFi projects to provide information on originators and beneficiaries in the transfer of funds.
What’s the solution? DeFi’s adoption and growth face an uphill battle if potential users don’t feel they can trust new projects. They need to be educated on how to spot and avoid the dubious ones. But “buyer beware” and an ethos of personal responsibility won’t be enough to bring DeFi and crypto safely into the mainstream.
The industry needs to self-police until regulations arrive: