Jonas and Nicolas talk about Defi and regulation, an Xmas special

The main challenges for regulators in dealing with decentralized finance (DeFi) solutions and cryptocurrencies.

Photo by Kanchanara / Unsplash

This is the first in a series of interviews between Jonas (COO of Grand) and Nicolas (CEO of Grand) where the two deep dive into a bunch of different topics, taking turns asking one another about their respective areas of expertise. First off Jonas will ask Nick about decentralized finance (DeFi) regulation.

Jonas: Can you start off by explaining the role that financial intermediaries, such as banks, brokers, and exchanges, play in the financial system?

Nicolas: Sure, financial intermediaries are like middlemen in the financial system. They help with a bunch of important stuff, like keeping track of transactions, making sure everything is legitimate, and ensuring everything runs smoothly. They also help make sure that the financial system follows all the rules and regulations, like reporting taxes and protecting consumers. However, if they're not regulated properly, they can sometimes charge too much for their services and make the financial system less efficient. And if people lose trust in them or they get into trouble, it can create bigger problems for the whole financial system.

Jonas: Ok, so how does blockchain technology and decentralized finance (DeFi) differ from traditional financial intermediaries?

Nicolas: In essence, blockchain technology and DeFi are offering a new way to build the financial system. With these technologies, record-keeping is decentralized, which means it's not controlled by any one central authority. Access to the system is anonymous and open to anyone, and any intermediaries (like middlemen) are built on top of the system rather than being necessary for it to function. This could allow for reducing reliance on centralized intermediaries and possibly even getting rid of some intermediaries altogether. Traditional financial intermediaries act as gatekeepers, but DeFi solutions use decentralized platforms that try to shift some of the power and control to different parts of the new financial infrastructure.

Jonas: Ok, I think I'm with you so far.  So what are some of the potential benefits and challenges of DeFi solutions?

Nicolas: This is something people are still fighting about, so I'll mention just a few of the most obvious things. DeFi has of course a few potential benefits. One, as already mentioned, is the possibility of reducing reliance on centralized intermediaries and possibly getting rid of some intermediaries altogether, which could make the financial system more efficient and increase competition. Another potential benefit is the ability to provide financial services to a wider group of people, especially those who may not be able to use traditional financial systems due to lack of access or difficulty with identity verification.

But, and i guess you saw this coming, DeFi also has some potential challenges to consider. These solutions may be more vulnerable to security risks because they're decentralized and don't have the same protections as traditional intermediaries. They may also face regulatory challenges because they operate outside of traditional regulatory frameworks and may not be subject to the same level of oversight. Additionally, DeFi solutions may not have the same level of liquidity and credit as traditional financial intermediaries because they don't have the same access to funding sources, at least not yet anyway.

Jonas: Can you explain what a distributed ledger technology (DLT) is and how it differs from traditional financial systems?

Nicolas: A distributed ledger technology (DLT) is an alternative architecture for storing and managing information where no single entity has full control over all the states and transactions. Instead, multiple parties, known as validators, hold their own copies of the states and jointly decide which transactions are admissible. This differs from traditional financial systems, where a central entity, such as a bank, controls and maintains the accuracy of customer accounts and ensures that unauthorized persons do not have access to an account. DLT eliminates the central point of failure that exists in traditional financial systems and allows validators to be parties that do not trust one another or are even adversaries.

Jonas: How are blockchains categorized and what are the main approaches for permissionless protocols to be resilient to a Sybil attack?

Nicolas: Blockchains are typically divided into permissioned and permissionless ledgers depending on the set of entities that are allowed to be validators. In a permissioned blockchain, a set of validators is approved by a coordinating body, while in a permissionless blockchain, anyone can become a validator. Blockchains are also sometimes categorized as private or public ledgers. In a public blockchain, everyone has full access to the information stored on the blockchain, while in a private blockchain, only authorized parties can observe transactions.

There are two main approaches for permissionless protocols to be resilient to a Sybil attack, which is a situation where an adversary creates a large number of pseudonymous validators and uses them to gain disproportionately large influence over the consensus protocol. These approaches are Proof-of-Work (PoW) and Proof-of-Stake (PoS). In a PoW system, validators compete to solve a computationally difficult problem, and the first one to solve it is rewarded with a block reward and transaction fees. In a PoS system, validators are chosen to validate transactions based on the proportion of the native currency that they hold. Both approaches provide validators with financial incentives to work honestly and make it costly for an adversary to attain a majority stake and subvert the system.

Jonas: How does the decentralization of the ledger affect the scalability of a blockchain network?

Nicolas: The decentralization of the ledger can affect the scalability of a blockchain network in several ways. First, since multiple copies of the ledger are maintained by different validators, the network requires more resources to reach consensus on transactions. This can lead to slower transaction times and higher fees compared to centralized systems. Second, the decentralized nature of the network can make it more difficult to upgrade or change the underlying protocol, as all validators must agree on any changes. Finally, the decentralized nature of the network may also make it more difficult for new users to join the network, as they may need to go through a process of identity verification or be approved by existing validators. These factors can limit the scalability of a blockchain network and may impact its ability to handle a large volume of transactions.

Jonas: What are the main challenges for regulators in dealing with decentralized finance (DeFi) solutions and cryptocurrencies?

Nicolas: There are several challenges for regulators in dealing with DeFi solutions and cryptocurrencies. One challenge is that these technologies do not currently comply with traditional regulatory goals such as preventing the use of funds for illicit activities, protecting participants in financial markets, and ensuring the integrity of markets and payment systems. This makes it difficult for regulators to safeguard the financial system while also allowing for the growth and innovation of these technologies. Another challenge is the pseudonymous and jurisdiction-free nature of these technologies, which makes it difficult for regulators to determine who is participating in the system and how to enforce regulations. This is a consequence of the use of permissionless blockchain protocols and smart contracts, which can operate outside of traditional regulatory frameworks.

Another challenge is the rapid growth of cryptocurrencies and DeFi solutions, which can make it difficult for regulators to provide a clear regulatory framework. If regulators wait too long to provide a framework, it may become too difficult to regulate these technologies effectively, as they become too big to regulate. In addition, there may be resistance from the crypto community to regulatory measures, as they may result in losses for some investors. This puts regulators in a difficult position of trying to balance the need to safeguard the financial system with the desire to allow for innovation and growth. Finally, the global nature of these technologies presents additional challenges for regulators, as they may need to coordinate with regulators in other countries to effectively regulate them.

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