Top 8 DeFi Trends in 2022 (Part I)
Apr 14, 2022
Since 2019, decentralized finance (DeFi) has been one of the most rapidly expanding areas in the crypto space. During the Covid-19 pandemic, interest in crypto and DeFi skyrocketed, and investments increased. Although DeFi is still in its early stages, the total value managed (i.e. collateral pools, DeFi smart contracts/protocols) by top platforms like Maker, Compound, Uniswap, and Aave has risen from less than $1 billion in 2019 to over $90 billion in early June 2021. Currently, these four protocols host around $38 billion worth of crypto assets.
Investors seeking better transparency, control, and efficiency for their assets perceived the openness of the sector as an appealing alternative to traditional finance and banking services. The emergence of incentive structures, such as yield farming and governance tokens, together with the development of decentralized stablecoins and a rapid expansion of centralized ones, were important factors in the 2019-2022 DeFi boom.
The call for the elimination of traditional financial middlemen like banks, exchanges, and lending services by the use of decentralized technology helped for the exponential increase in DeFi’s userbase. The idea of vesting one’s trust in computer code and mathematics made more increasingly sense in a world rampaged by ever-increasing inflation and reduced belief in the democratic process.
The decentralization of finance was viewed as the logical next step by an international community of users who wanted to opt out of “the system”. Allowing users to deal directly with one another without the use of a central authority became increasingly appealing. DeFi accomplishes that by utilizing self-executing software protocols that aren’t completely controlled by a central authority. As a result, DeFi promised to return money and asset ownership to users by allowing them to trade, borrow, and lend money from anywhere on the globe as long as they have an internet connection.
“2021 saw a mix of Covid-19 still affecting our daily lives and ability to earn a living and the opening of the global trade/financial market after a very abnormal 2020. As a result, most people started looking at alternative options to going into a bank branch to get loans and at alternative assets to invest in, in order to diversify from traditional stocks/bonds types of investments. As more traditional banking and financial services institutions realize that they can grow faster and serve more clients more efficiently by adopting some DeFi principles, we expect to see wider adoption and continued growth in DeFi”, said Brad Yasar, the CEO of EQIFI.
2021 was highly successful for DeFi and led to the expansion of the mutually beneficial relationship between decentralized financial applications and the wider crypto market.
At the time of writing, according to DeFi Lama, the Total Value Locked (TVL) in DeFi is $161.69 billion.
That impressive number is the result of the efforts of both institutional and retail investors. While these two types of users have applied different strategies, they have both entered the market in large numbers, helping to propel a variety of crypto assets towards new all-time highs.
According to Cryptonews.com, industry insiders and experts predicted that the DeFi sector will continue to grow in 2022. In particular, they also expect that decentralized autonomous organizations (DAOs), decentralized exchanges (DEXes), non-fungible tokens (NFTs), and scalability solutions to increase significantly in the next few years.
Regulations in the sector are also expected to be a hot topic. DeFi is developing, parallel financial system that has so far not been regulated in most jurisdictions. As there is no central authority that provides guarantees or protection of users’ funds, DeFi participants must be extremely cautious. According to cryptosec.info, around $2.4 billion have been lost due to exploits in the space, with the most recent hack, that of the Ethereum/Ronin bridge amounting to $625 million.
Looking into more than 120 topics on DeFi covered by the BLOCKCHANCE conference, Europe’s leading congress on blockchain technology, it is easy to spot several trends that are emerging:
4. Cross-Chain Technology and Scalability Issues
5. DAOs and Governance Tokens
6. DEXes and AMMs
7. The DeFi derivatives market
8. Stablecoins and CBDC (Central Bank Digital Currencies)
In this part of the series, we will focus on regulation, since it is already an extensive topic to cover.
DeFi is currently governed by existing legislation usually in the banking, AML/KYC, and finance space. However, the regulatory rules that apply to cryptocurrencies do not necessarily apply to DeFi. The traditional regulatory approaches rely on the presence of centralized entities that operate a service and/or issue financial assets. However, these may be unsuitable for the highly technical DeFi space where automation, peer-to-peer, and peer-to-contract transacting are the norm, and where custodial services are usually managed by smart contracts. What’s more, in DeFi some services are provided by self-sovereign applications that will run for as long as they provide economically useful services and cannot be stopped.
Furthermore, DeFi transactions made between unhosted wallets are exempt from existing regulatory obligations like KYC and AML checks and it is unclear how these could be subject to any such monitoring regime that is usually operated by a centralized third party. Existing rules assume the presence of intermediaries and regulate them as a way of regulating financial markets. Such regulations usually cover a specific geographic area and vary based on the nationality of users they aim to protect. Due to the decentralized and global nature of blockchain networks, participation in DeFi activities does not currently necessitate interaction with the regulated banking system or other national legal regimes like taxation or national identity systems. Furthermore, as with any new market, the categorization of products is difficult.
Governance tokens issued by DeFi projects may not constitute investment contracts under securities laws. The lack of intermediaries and wide distribution of governance tokens may make it difficult for governance tokens to be regulated under existing securities laws. The regulatory system under which governance tokens will fall will be determined by how they are categorized.
Code is a key element from a regulatory point of view as well. Even if a corporation develops the open-source software for a DeFi service, the service is simply software code running on a blockchain that anybody with an internet connection may interact with. This makes it harder to enforce restrictions. In this respect, it is insufficient to regulate the code solely from the perspective of traditional financial services. DeFi software is not only about virtual assets on the blockchain, but also about automation and smart contracts in general. These are all intertwined, and regulators must take them all into account.
From Bitcoin to DeFi
In 2021, institutions’ interest focused mainly on Bitcoin (BTC) and to a certain extend on Ethereum (ETH), whereas retail users focused on whichever hyped altcoin or meme coin was currently surging in the market (e.g. Doge and Shiba Inu for example). However, industry leaders and analysts predict that by the end of 2022, we will observe convergence in preferences across the different types of investors participating in the market, with retail becoming more and more mature thanks to an increase in market research and analysis from established organizations and institutions.
We expect that this year institutions will play a more significant role in driving the market. Institutional actors (large brokerages, investment banks, exchanges, custodians, etc.) will further increase their engagement in the process of regulating the space. As the DeFi space matures, a segment of more risk-tolerant retail traders will seek out higher returns from more speculative crypto assets. DeFi offers multiple substantial and varied regulatory dangers and problems, which will only get better pronounced as the industry expands. In order not to frustrate the commercial adoption of DeFi, governments will need to be flexible. One should prevent too strict regulation as that could severely disincentivize people to enter the DeFi market. The approach should be based on disintermediation whereby regulatory bodies should look beyond centralized intermediaries.
To promote the development of a vibrant DeFi ecosystem, it is necessary to put in place a proportionate regulatory framework that supports innovation and fair competition. Regulators should thereby maintain an adequate balance between safeguarding positive blockchain-based financial innovation in terms of greater efficiency and broader inclusiveness in finance on one hand and limit the potential of these financial applications being misused for money laundering, scams, and terrorism financing.
Since DeFi does not fit well within the traditional financial regulatory architecture, experts believe that laws directly affecting DeFi should and will be introduced in 2022. These will have a positive effect on the industry. Policymakers and regulators are scrambling to come up with frameworks that will allow them to address these challenges appropriately.
The World Economic Forum
The World Economic Forum recently developed a policy toolbox for decentralized finance in an effort to assist governments in addressing this issue and defining the regulation of cross-border digital asset markets. The policy document was written with input from legislators involved in the creation of the new European Markets in Crypto Assets Regulation (MiCA). The toolkit lays a solid platform for policymakers to understand and research the key challenges driving DeFi legislation. As a result, the authors suggest technologically agnostic approaches that can integrate regulatory objectives, innovation, and market development with fair, efficient, and enforceable norms.
The European Commission
The European Commission announced the Markets in Crypto Assets Regulation (MiCA) in September 2021. The goal is to strengthen the consistency and legitimacy of token regulation in general, as well as the oversight of issuers and organizations that qualify as crypto asset service providers (CASPs). MiCA would create explicit crypto asset rules within the European Economic Area (EEA) by taking a technology, asset class, and jurisdiction-neutral strategy.
MiCA intends to give better legal certainty, foster innovation, ensure adequate levels of consumer and investor protection, promote market integrity, and financial stability, and therefore transform Europe’s present fragmented crypto asset legislative and regulatory framework into a single body of law.
It is expected that MiCA will come into force no later than 2024 with some experts expecting it to become part of EU’s legislature as early as this year. Persons involved in the issuance of crypto-assets will be subject to MiCA in EU countries. The new regime distinguishes between which tokens qualify as financial instruments and hence fall under the old financial services regulatory framework, as amended, and which tokens qualify as crypto assets and thus fall under MiCA’s specific crypto asset services regulatory regime (CAS). A “substance over form test” will be used to determine the above.
This means that the intend of an instrument, not the technology behind it, will be used to determine whether it is a crypto-asset subject to MiCA.
The European Commission plans to also include stablecoins in the customized MiCA regime on crypto assets (to the extent they are not currently regulated) and change the e-money regime to include a new type of “e-money”: “electronic money token or e-money token means a type of crypto-assets whose main purpose is to be used as a means of exchange and that purports to maintain a stable value by being denominated in (units of) a fiat currency”.
Stablecoins are likely to be categorized as asset-referenced tokens, defined as “a type of crypto-assets whose main purpose is to be used as a means of exchange and that purports to maintain a stable value by referring to the value of several fiat currencies, one or several commodities or one or several crypto-assets, or a combination of such assets.”
For stablecoins that do not fall within the above definition, the issuers must still publish a white paper, notify the regulator, and may not refer to their coins as being stable.
Issuers of large-cap e-money tokens and significant asset-referenced tokens will be directly regulated by the European Banking Authority (EBA) and will have additional obligations in respect of capital, interoperability and liquidity management.
European Central Bank
In February 2021 the European Central Bank (ECB) published an opinion on the MiCA regulation. Their proposals aim at granting greater powers to the ECB, setting prudential requirements for certain stablecoin issuers, and generally improving anti-money laundering and financial crime prevention measures. The ECB however suggests several adjustments and clarifications, and specifically calls for improvements, including greater clarity about which tokens and what activity will fall under and be regulated by MiCA, by which regulatory authority under MiCA, and what activities will be subject to the MIFIR/MIFID II framework. This aims to support the provision of crypto asset services on a cross-border basis and to establish a truly harmonized set of rules for crypto assets.
The ECB has suggested a distinction between crypto assets that would be classified and thus treated as MIFID II financial instruments and those that would fall under the scope of MiCA’s regulatory regime.
Specifically, the ECB has requested a number of changes concerning the supervision of stable coins i.e. what MiCA defines as Asset-Referenced Tokens (ARTs). The ECB has asked for additional safeguards under MiCA, including prudential and liquidity requirements for such issuers. And there is the issue of what financial stability and prudential supervisory aspects will require greater regulatory and supervisory oversight by the ECB, and how will the EEA’s central bank interact with oversight executed by other European authorities.
The European Parliament
Two European Parliament committees – the economic and Monetary Affairs Committee (ECON) and the Committee of Civil Liberties, Justice, and Home Affairs (LIBE) – recently approved amendments to the Transfer of Funds Regulation (TFR) that could have negative consequences on the competitiveness of EU’s DeFi sector. The provisions could pave the way for a crackdown on so-called ‘unhosted wallets’, the term institutions use to refer to regular wallets. Art. 5 of the draft requires exchanges to report to the authorities every transfer from a non-customer wallet of at least EUR 1,000 (USD 1,1115).
The ECON committee also proposed amendments to the MiCA regulation. This text included three main elements to ensure uniformity in regulating crypto-assets across the EU:
- a uniform legal framework for crypto assets;
- protecting consumers and safeguarding against market manipulation and financial crime;
- including crypto-assets mining within the EU taxonomy for sustainable activities.
The first two amendments were approved and are now included in the most recent edition.
The third amendment, which dealt with mining sustainability, was voted out of the text. It sought to reduce the usage of Proof-of-Work (PoW) in cryptocurrency mining, but would also have affected the listing and trading of PoW-based crypto assets within the borders of the Union.
Conclusion to Part 1
Even at this early stage of the development of crypto assets and DeFi-related regulatory initiatives, we would need hundreds of pages to cover them all. With numerous governments looking to enhance their oversight close monitoring of the regulatory landscape is critical. Environmental and sustainability themes are undoubtfully on the rise and will continue to play a key role in crypto legislation in the future.
Regulations are a two-edged sword – they could help DeFi further penetrate the mainstream and bring financial inclusion, transparency, and efficiency to billions of users worldwide, but could also stifle innovation and push some of the world’s brightest minds to jurisdictions that are more open to financial and banking experimentation.
Expect the next part of the series next week.
This article is based on research conducted for Mettalex by Felix Bucsa.
The Mettalex Research blog post series dives deeper into the latest innovations in Decentralized Finance. Check out our analyses on DeFi 2.0 principles with focus on the MetaversePro implementation, on the different uses of NFTs as collateral in DeFi (Part I), (Part II), (Part III), and on the novel tokenomics model Ve(3, 3).
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