Decentralised Finance: Growth, Risks and Regulation of a Shadow Financial System with Crypto-assets

Abstract

Decentralised Finance applications aim to replicate existing financial products and services from the highly regulated Traditional Finance (TradFi) system using the distributed ledger technology and smart contracts. An open, multi-layered and composable architecture has facilitated the deployment of many DeFi projects leading to a growing complex network of interacting DeFi protocols. The size of the DeFi market has grown to several hundred billion USD in Total Value Locked by users in DeFi protocols. Important use cases include decentralised lending and borrowing, decentralised exchanges and crypto staking. The DeFi sector is effectively becoming a shadow financial system with cryptoassets. DeFi innovators praise decentralisation and disintermediation of financial products and services as beneficial. On the contrary, regulators and policymakers issue warnings on consumer risks and financial stability risks. Awareness has increased following a string of crypto-related collapses and failures during the Crypto Winter 2022-2023. The emerging consensus is that the DeFi market needs to be supervised, but how? The traditional approach to regulate a few centralised entities and financial intermediaries does not work. Thus, a range of regulatory responses and approaches is being discussed. In the European Union the path has been partly laid by the Markets in Crypto-assets Regulation (MiCA) as the text itself contains mandatory steps to address developments of the DeFi market.