On 16 February 2023, the Financial Stability Board (FSB) published a report on the financial stability risks of decentralised finance (DeFi). The report describes DeFi as an ‘umbrella term commonly used to describe a variety of services in crypto-asset markets that aim to replicate some functions of the traditional financial system while seemingly disintermediating their provision and decentralising their governance.’
CoinDCX welcomes the efforts of the FSB in preparing this document. While we recognise that the document is not consultative in nature, we wish, in the spirit of continual and constructive stakeholder consultation, to provide our comments and thoughts on some of the key findings of the FSB.
Our Comments on the document are as follows:
1. The scope and size of the DeFi ecosystem is still small and warrants keen monitoring:
DeFi is an emerging area of financial services, powered by technologies such as blockchain and crypto-assets. It offers non-custodial financial solutions that do not involve the use of intermediaries, built on a decentralised, highly composable, and interoperable infrastructure. These features, that are unique to DeFi, usher in an unprecedented level of efficiency in financial services and allow deeper financial inclusion. That said, DeFi is still at a nascent stage. Its total market cap is only USD 48 billion and its total value locked is at USD 54 Billion. The global cryptocurrency market cap on the other hand stands at USD 1.07 Trillion DeFi cannot even remotely compare to the size of TradFi, where the market cap of only the Indian equity market with the Bombay Stock Exchange stood at USD 3.36 Trillion.
The small size and mostly self-referential nature of this ecosystem has been categorically acknowledged in the document. In fact the document uses the absence of a contagion from the November 2022 FTX collapse and the modest impact of the May/June 2022 market turmoil on TradFi, as evidence to illustrate that the DeFi ecosystem is still at a nascent stage.
Based on these findings, the document concludes that this space needs to be monitored by the FSB; data gaps should be filled; interconnectedness with TradFi, the real economy, and crypto assets should be analysed; and the enhancement of policy recommendations for regulation of crypto-asset activities may be explored. At the same time, the document also identifies several risks and vulnerabilities associated with DeFi.
We believe that the approach of the document and some of its findings, do not align with the initial acknowledgment about the nascency of the DeFi ecosystem. First, most of the risks identified under the document are primarily associated with the functioning of the technology. Second, its discussion of enhancing crypto-assets regulation to potentially encompass DeFi is premature.
Most risks identified in the document relate to the development of the technology powering the ecosystem and include challenges with DeFi governance frameworks; dependence on often congested and unreliable blockchain networks; reliance on oracles and off-chain bridges. Web3 and more specifically DeFi is still developing and is yet to reach the inflection point on the technology development S curve. Tech-based solutions are being developed to many of the concerns highlighted in the document. For instance, several solutions such as side chains and layer 2 protocols have been created, to address concerns of blockchain congestion. In the same vein, issues that may arise from blockchains’ reliance on external data, are being addressed by decentralised, on-chain oracles. Like any other disruptive technology, ecosystem participants are working towards addressing many existing risks and challenges to ensure that the technology functions seamlessly. Given the nascency of this space (which is also explicitly acknowledged in the document) these technological critiques appear excessively harsh and disproportionate. The DeFi ecosystem is far from mainstream and the technology and use cases are still developing.
Second, this document discusses potentially regulating certain aspects of DeFi. By minimising intermediaries, DeFi holds the potential to level the playing field for financial actors who have traditionally been disadvantaged. In a recent paper, the BIS also acknowledges DeFi as a relevant development because it harnesses innovative technology that might shape the future financial ecosystem. To benefit from the potential of DeFi, a tailored and well thought-out regulatory framework introduced after extensive stakeholder consultation is necessary. Such a framework should involve the regulation of only the business-owned onboarding points to protocols, not the protocols or software themselves. Accordingly, the document’s suggestion regarding exploring regulatory approaches comes across as rushing the process without ample thought. A conversation around regulating the DeFi ecosystem first requires an extensive study of its features such as progressive decentralisation, varying governance and economic models. It is also important that its benefits are given a fair consideration. It is imperative that international standard setting bodies such as the FSB find a way to enable access to DeFi in a manner that is safe for users, conducive to business and provides a legal framework to encourage innovation.
2. The different risk profiles and offerings of DeFi and TradFi:
The document discusses in some detail the similarities and differences between DeFi and TradFi. It concludes that the underlying incentives and nature of activities in DeFi and TradFi do not differ materially. However, the means used by DeFi and TradFi to fulfil their functions are different and the processes employed by DeFi to provide services are novel in many cases. The document also explicitly acknowledges features that render DeFi unique and novel such as smart contracts, blockchain, blockchain native tokens, composability, self-custody etc.
We believe that drawing comparisons between the two ecosystems helps in articulating the nuances of DeFi in terms that are relatively more familiar. At the same time, such comparisons highlight aspects of the two systems that are dissimilar. In our view however, there are two such dissimilarities that are not adequately acknowledged in the document. First the risk profiles of TradFi and DeFi are vastly different, and second, DeFi is a novel product that promotes innovation to an unprecedented degree. While its offerings may have initially started with replicating TradFi activities, it has and will continue to far exceed the scope of TradFi activities.
It is imperative to note that most existing financial regulations primarily aim to address concerns around malfeasance committed by trusted intermediaries, as they wield considerable power in TradFi. Given that key features of DeFi include self-custody and decentralisation, it considerably shifts the paradigm from TradFi and offers a tech-based solution to these issues associated with trusting centralised third-parties. Therefore, the risk profile of DeFi and TradFi is vastly different. Notably, we are not arguing that DeFi doesn’t pose any risks. As noted in the previous section, many of the existing risks are technological in nature and can be attributed to the nascency of the space. The profile of these risks therefore are substantially different from those under TradFi.
Second, the document states that functions of DeFi and TradFi are similar (while processes are different), but fails to sufficiently acknowledge the transformative potential that the former offers. We believe that offering financial services in a non-custodial manner is a key feature and function of DeFi, which substantially differentiates it from TradFi. Admittedly, DeFi began with mirroring activities offered under TradFi, but owing to its unique features, its scope has considerably widened. For instance, the novel concept of Know Your Transaction (‘KYT’) has been enabled through DeFi applications such as Codefi compliance and KYC chain. It takes the TradFi compliance of Know Your Customers to new heights. By focusing on the transaction, as opposed to the customer’s identity, KYT helps prevent risk of money laundering and terror financing in real-time.
One of the most important innovations of DeFi, as noted by the OECD report titled “Why Decentralised Finance (DeFi) Matters and the Policy Implications” is compossibility, which means that components of DeFi networks (i.e. digital assets, smart contracts, protocols and applications built on top of the protocol layer) can be combined to create new applications. Composability gives room for the creation of innovative products and structures, and has the potential to further amplify network effects, increasing the value of DeFi products and services as participation in the network grows. The open source nature of DeFi applications is a critical enabler of this attribute, as it allows everyone to look at the code and use it to create new applications. DeFi thus may have certain functions that are similar to TradFi, but it is a fundamentally different ecosystem, built on foundational pillars of self-custody, community driven governance, openness, and innovation. While the document studies these distinguishing features of DeFi, it does not appreciate their potential to expand the scope of this ecosystem far beyond TradFi.
3. Addressing concerns around data collection and monitoring the ecosystem
The document also identifies challenges in collecting data pertaining to the DeFi ecosystem. These challenges include difficulty in aggregating and analysing data on distributed ledgers; features such as pseudonymity, the cross-border nature, and the development of privacy-enhancing technologies; large number of off-chain transactions; lack of reporting etc.
As noted previously, this technology is still at a nascent stage. Despite that, since transparency and auditability constitute its core ethos, DeFi is much easier to monitor than other traditional systems including TradFi. This space, by design, offers publicly available and verifiable data. In parallel advanced tools are being developed to increase efficiency in this process of analysing such data and monitoring the space. There are now a wide variety of private platforms offering publicly available aggregated data on DeFi. An illustrative list of these platforms include coinmarketcap, DeFillama, Dune, DeFiprime, Chainalysis, Coinfirm, Elliptic blockchain analytics etc.
We acknowledge that the pseudonymous nature of this space presents unique challenges to traceability, which may potentially be augmented by the development of privacy enhancing technologies. However, at the outset, it is important to recognize that the overwhelming majority of flows on VDA platforms is for legitimate purposes. Further, as the ecosystem continues to develop, effective tools to capture bad faith actors have also emerged and successful enforcement action has been undertaken as in the case of Hydra. A key tool will be leveraging centralised crypto-asset service providers and other access points into the ecosystem. This issue, along with issues relating to the lack of consistent reporting is surmountable with clear, effective policies and industry cooperation.
Lastly, we appreciate the FSB’s efforts in presenting a non-exhaustive list of metrics that may be utilised to track and monitor the DeFi ecosystem. We wish to add other metrics like volume and flow of funds; concentration of funds on platforms; development activity, such as history and momentum of commits on github, active developers, etc. While many traditional metrics can be applied to DeFi, it is important to recognise that there are metrics that are arguably unique to the ecosystem. For example, UTXO age bands have emerged as a key metric for gouging activity on the Bitcoin blockchain.
We at CoinDCX, have always endeavoured to go above and beyond the minimum standard to run a safe and wholly compliant crypto-assets enterprise. We conduct ourselves so as to provide a positive example, both to other players in the ecosystem, and the government, with the overarching objective of developing trust between key stakeholders. Aside from domestic regulations, we follow global best practices in transaction monitoring and KYC/AML, and deploy significant resources to work with global leaders to ensure that our processes are of the highest standard. At the same time, we are, and always have been willing to update our processes based on any new information or mandate received from the relevant authorities, and are always more than happy to engage in transparent conversation.
We strongly believe that constructive dialogue and outreach will play a pivotal role in addressing the policy challenges in this complex and dynamic space. We appreciate the opportunity to provide comments on the document and will be happy to shed further light on any of the views expressed in this letter.
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