DeFi Policies and Guidelines

Decentralized Finance aka DeFi is a kind of digital financial service, which is independent and built upon blockchain technology.

Decentralized Finance aka DeFi, in simple terms, is a kind of digital financial service, which is decentralized, i.e., independent of intermediaries, and is based and built upon blockchain technology. Under DeFi, we’ve got three identities:

  1. DeFi Protocols – the type of software, interfaces, required to manage and convert digital assets assembling on the blockchain
  2. DeFi Services – the utilization of DeFi protocols to formula financial provision
  3. DeFi Users – the individuals who resort to DeFi services for the purpose of transaction

For availing DeFi services, one can seek smart contracts, programmable wallets, or other centralized web apps. Other form in which DeFi could be extended include:

  • A traditional directing unit
  • A community encompassing a non-profit body
  • Decentralized Autonomous Organization (DAO) wherein rights and commitments are quantified in the form of smart contracts

Quad Characteristics of DeFi

Any DeFi service would have a basic of IV characteristics, which may include:

  1. Financial Service – The custom wherein there is transfer of value amid groups directly.
  2. Trust-minimized operations – Since a DeFi protocol has calculated (pre-established) guidelines, thereby, the transactions, on an unconsented basis, are implemented and logged over the unambiguous logic of a DeFi.
  3. Non-custodial design – Irrespective of the account holder, the assets issued or administered by the DeFi services, cannot be “unilaterally expropriated” or modified; not even by other parties, or intermediaries or other services.
  4. Open and Composable architecture – By open architecture, third parties and mediators can recognize, encompass and authenticate the integrity and safety of the deal. When we merge programmatic constituents to generate any financial mechanism and utility, we can call it as a composable architecture.

DeFi Stacks

While understanding DeFi, we’ll come across its architecture wherein we’ve a stack of layers, functioning to form a smooth DeFi provision. There are, in general, five layers:

  1. Layer 0 or Settlement Layer – the base layer on which the entire DeFi transaction and services are built
  2. Asset Layer – all token transactions take place in this layer
  3. Protocol Layer – all the rules and standards for transactions are defined in this layer; this layer includes a series of smart contracts that inevitably manage the performance of the assets operated in the DeFi setting; in short, this layer handles rules and smart contracts
  4. Application Layer – herein, one can create user interfaces and apps through which vendors and other users can interact with the DeFi platform and services
  5. Aggregation Layer – this layer is an extension to application layer; third parties can select applications from the application layer and combine them to create the products they require; to be specific, the work is done by ‘aggregators’ which fetch several applications together to benefit the users, by providing them with a sole dashboard to implement different kinds of DeFi transactions.

Triform Governance Approaches of DeFi

In reference to DeFi, governance generally stands for conduct by which collective conclusions are made, disagreements are settled, and amendments to protocols are executed. Multiple DeFi schemes issue ‘governance token’, which in turn offer “voting rights” on specific governance decisions and inferences. The three forms are:

  • Centralized Governance – the changes and alterations are done by straight by the operator who has the authority to regulate and implement them
  • Partially Decentralized Governance – this type of governance provides limited voting rights to the “token holders”; With the use of “multisig keys”, a change can be executed through delegates signatures
  • Decentralized Governance – herein the decisions are taken by a group of “token holders” through the formation of a decentralized autonomous organization (DAO)

Senary Service Categories of DeFi

As of now, there are six DeFi services that are identified:

  1. Stablecoins – functions to preserve a “constant value for tokens” in relation to a certain or numerous stable asset(s)

    1. Non-custodial stablecoins – works as DeFi services themselves 1. Asset-backed stablecoins – employ the use of smart contracts to gather and liquidate collateral in the shape of cryptocurrencies or other digital assets
    2. Algorithmic stablecoins – try to keep the peg over dynamic extension and narrowing of token stockpile
    3. Custodial stablecoins – are centralized stablecoins that use “fiat currency or high-quality liquid assets” as a reserve or standby
  1. Exchanges – permits the trading of digital assets among the users and customers
  2. Credit – takes in the construction of “interest-bearing instruments” that should be repaid at the time of maturity
  3. Derivatives – constitute the “synthetic financial assets” whose rate is dependent on or resulting from a primary asset or cluster of assets
  4. Insurance – offers safety against any risk or variety of risks by “trading the payment of a guaranteed small premium” for gathering a huge payout in the occurrence of a covered situation
  5. Asset Management – efforts to maximize the value of an asset portfolio dependent on risk predilection, time limits, divergence etc

Quinary Risk Categories of DeFi

Risks involved in DeFi can be divided into five sections:

  1. Financial – Draining and depletion of funds because of the transaction characteristics of associated users regarding the digital assets in the DeFi service

    1. Market Risk – the likelihood of an asset value to decline or fall off over some time horizon as a result of market environment, new information, or traders’ behavior
    2. Counterparty Risk – the probability of a counterparty to default (or levant) on its commitments to a financial instrument
    3. Liquidity Risk – the possibility that there might be inadequate funds or assets accessible to apprehend the value of a financial asset
  2. Technical – Breakdowns or failures caused by software systems holding the transaction execution, rate evaluation and coherence

    1. Transaction Risk – consists of the drawbacks or failures of the primary blockchain network
    2. Smart Contract Risk – looks after code that does not execute as planned Miner Risk – deals with the leeway that transaction handling elements behave maliciously towards certain transactions
    3. Oracle Risk – contains the potential that data external to the blockchain on which a DeFi contract depends on is inexact or has been manipulated
    4. Operational – Let-downs of the human associated systems for key management, protocol development or governance
  3. Operational – Let-downs of the human associated systems for key management, protocol development or governance

    1. Routine Maintenance and Upgrades – a bit difficult to implement for decentralized services, or may produce vulnerabilities
    2. Forks (Code Forks) – opportunities for groups seeking to modify DeFi service entities
    3. Key Management – a latent hitch for all blockchain-based systems
    4. Governance Mechanism – takes in complex potential risks like “One-token, one-vote”, could be demoralized in cases where the participants are less, and can bribe each other to vote in their favour
    5. Redress of Disputes – after a smart contract gets executed, the output cannot be altered or reversed based on the orders of an individual, or a governmental authority
  4. Legal Compliance – Usage of DeFi to involve into illicit or illegal activities or to deceive supervisory compulsions

    1. Financial Crime – takes into account the breach of anti-money laundering/countering the financing of terrorism (AML/ CFT) restrictions, financial sanctions, and similar legal regimes
    2. Fraud and Market Manipulation – comprises of deliberate scams, misuse, and other actions to take advantage of investors
    3. Regulatory Arbitrage – failing to meet supervisory commitments by carrying out alike functions in an unalike technical manner
  5. Emergent – Large-level crashes or deflation of the financial system due to the interplay, evaluation and combination of DeFi components

    1. Dynamic Interactions – interactions between a possibly interminable number of interconnected DeFi components may generate risks that are not existing in any individual service
    2. Flash Crashes or Price Cascades – are likely to arise in tremendously volatile or rough market situations
  6. DeFi Financial Modulation General goals for financial regulation include, safety of investors, market productivity, prevention of illicit motion, safety, financial firmness etc. Few policy actions that could be taken in terms of DeFi could be –

    1. Forbearance – decision that no new regulations are required
    2. Warnings – issuance of cautionary notice to users
    3. Prohibitive Measures – forbid certain actions in DeFi division
    4. Pruning Regulations – disregard or eliminate regulatory requirements that are no longer vital in a DeFi setting

Policy Aids and Tools

To approach and tackle financial services, let’s look into a few steps regarding the same.

  1. Transitional Mechanism

    1. Specialized Regulatory Units – A desk designed with qualified crew can function as preliminary support to gain experience in new technology, understand the industry, and be mentored
    2. Incentivizing Information Flow – While the pertinency of prevailing disclosure necessities on DeFi platforms is indefinite, for effective regulatory analysis, efforts must be put to vitalize broad and reliable data disclosure
    3. Regulatory Sandboxes –Sandboxes could be set-up by policy-makers, where corporations may test, trial, examine, and operate their technology (or product) in a finite space accompanied with limited regulatory risks
    4. Clarifying Easy Cases – In certain scenarios, by looking after the easier or simpler cases initially, specifically the ones where intervention is not warranted, regulators can trim the sections of ambiguity and drive-in compliance actions
    5. Coordination Government Action – Sometimes, it may be suitable to take together different government units for a synchronized response; one such example for the same being the “Volcker Rule”
  2. Regulation throughout the life-cycle When it comes to DeFi services, they’ve a tendency to develop as more decentralized; wherein for policy-makers, it is important to acknowledge the degree of decentralization. In order to tackle latent dangers of DeFi services, regulatory measures can be acquired at four stages viz… development, publication, deployment, and operation. There would be a class of protocol developers. After a protocol is issued, it can be drawn into a service and then be distributed to the users, by the teams; also, the teams can fork those services. The service’s operation would be mediated by a decentralized governance procedure. A point to be kept as a tip, would be, it’s relatively easier to implement and execute regulatory obligations at an early stage in the life-cycle, as it would prevent long-term hinderance.

References:*

  • Decentralized Finance (DeFi) Policy-Maker Toolkit, June 2021 – World Economic Forum [White Paper]
  • DeFi Beyond the Hype – The Emerging World of Decentralized Finance, May 2021, Wharton University of Pennsylvania
  • The Fundamentals of DeFi. Retrieved February 2022, from https://applicature.com/blog/blockchain-technology/the-fundamentals-of-defi
  • Defi: A Rainbow 5-Layers Cake. (2022). Retrieved February 2022, from https://www.loop.markets/defi-a-rainbow-5-layers-cake/ Izraylevych, I. (2021). What is DeFi: Understanding Decentralized Finance. Retrieved February 2022, from https://s-pro.io/blog/what-is-defi