Decentralized finance (DeFi) is becoming one of the most important areas in the blockchain industry. In the past two years alone, the total value of DeFi Locked (TVL) – the total value of assets locked on various DeFi platforms – has grown steadily from $ 21 billion at the beginning of the year to more than $ 100 billion today.

DeFi represents a wide range of financial products and services, including the all-too-popular decentralized exchanges (DEXs). However, despite the explosive growth of DeFi credit and credit products, insurance and even decentralized derivatives trading, regulation on a global scale still seems a long way off.

Through DeFi, blockchain technology is reshaping the world’s financial systems and building markets that are ideally safer, more transparent and more accessible.

Financial innovation is intuitively quite profitable, but the deepest pocket institutions are still reluctant to enter the field due to a lack of regulation, and this can play an important role in the introduction of financial innovation.

Some believe compliance is the only way forward, and while regulation can centralize certain aspects of DeFi, compliance projects will endure in the long run. Others argue that DeFi should self-regulate and the community needs to understand what is best for their future. Even so, there will always be unregulated platforms to evade regulatory scrutiny, but whether large-scale self-regulation is really healthy for the industry remains to be seen.

While there are a large number of mid-cap funds that are making great returns by investing in digital assets, the larger hedge funds are unwilling to take the risk. This is in part because of the scrutiny under which better-known players are monitored for regulatory compliance, and this could also explain why some of the largest companies haven’t touched the category yet.

Rule the stubborn

The main problem with applying traditional regulatory frameworks to decentralized financing is that they have been designed with different objectives. Traditional finance favors stability, investor protection, compliance enforcement and, above all, centralization. DeFi is working on a system that will incentivize collaboration between distributed participants by removing economic incentives and without centralized intermediaries being to blame, traditional frameworks are not translated into decentralized assets.

In recent years, the impact of regulation on the crypto sector has been evident, providing retail investors with a sense of security, driving capital into digital asset markets, while supporting innovation and curbing fraud and illegality. The same could be said for DeFi, and while not everyone is fully convinced, familiarity and education can be great motivators for adoption.

A former law enforcement officer with the Department of Crime and Illicit Funding for the U.S. Department of Homeland Security and chief executive officer of Huobi Nevada, Robert Whitaker, told Cointelegraph:

“There will always be illegal websites running in the background. DeFi platforms want to be regulated and believe that regulation is the way to a powerful alternative to traditional finance or banking that will survive – and work very well in my opinion. “

Once the necessary infrastructure is in place to meet the needs of larger institutions, investing in decentralized finance can become even more experimental to accelerate innovation. This year alone, several financial services giants have made significant strides in the blockchain space.

JPMorgan is reportedly developing a proprietary blockchain with its own token to enable instant money transfers to its customers. In addition, HSBC announced earlier this year that it would support the bank’s digital currency Central Government (CBDC) through regulation after it launched a plan to move more than a third of its eligible assets to a blockchain-based custody platform. Morgan Stanley also recently announced that it will bring digital assets to its customers.

From BNY Mellon confirming support for digital asset custody to BlackRock exposing sneaky interactions while researching the asset class, adoption is definitely on the rise. The question is: can regulation keep up?

Innovation regulations to regulate innovations

Recently, blockchain technology leader ConsenSys received more than $ 65 million in funding from global financial services leaders such as UBS, JPMorgan and Mastercard that could bring them something 3.0.

According to a report by PWC, nearly 50% of traditional hedge fund managers are considering investing in crypto. While these companies are likely to lead the way in adoption, that may not happen until the required regulatory infrastructure is built into the DeFi ecosystem.

Despite countless warnings from reserve banks around the world about the security, scalability, and money laundering risks posed by digital assets, most of them agree that their role in radically improving the financial system is possible. However, the US Securities and Exchange Commission considers DeFi to be a significant lack of investor protection and has ordered additional agencies to be set up to block DeFi products and platforms.

The past year has been filled with news about international companies and national regulators working towards a better understanding of blockchain technology. In September 2020, the European Commission proposed a framework to improve consumer protection and establish clearer behavior for players in the crypto industry, including the introduction of new licensing requirements.

In late March, the global anti-money laundering and terrorist financing regulator, the Financial Action Task Force (FATF), announced that it would update guidance on a risk-based approach to digital assets and virtual asset trading companies. In July, the Japanese Financial Services Agency (FSA) emphasized the importance of regulatory requirements for decentralized financing.

Back in February, SEC Commissioner Hester Pierce said regulators need to give DeFi both legal clarity and the freedom to experiment so that it can compete directly with options. However, the SEC has also taken action against a number of companies involved in decentralized financial applications.

For example, the regulator has reportedly launched an investigation into the lead developer behind the world’s largest decentralized exchange, Uniswap Labs, who is primarily focused on how investors use the platform and its marketing. Additionally, SEC chairman Gary Gensler recently made some harsh remarks about the DeFi industry, claiming that only a small number of DeFi tokens are non-securities.

While self-regulation may seem ideal to some, government and financial agency intervention can simply be a necessity.

Bending principle

The main challenge for regulators will be to insure private actors and minimize risk for investors. If legislation can somehow do this while ensuring that DeFi platforms are compliant with anti-money laundering protocols, regulation can encourage adoption and generate incredible growth for space in a risk-controlled manner.

However, brute force throttling may not be the best way to deal with it. Traditional rules apply to transactions between people, and applying these standards to human-written code, smart contracts, is a complex endeavor. However, standards can be created through codified principles.

This includes setting capital limits and creating risk control frameworks for private actors in the industry. However, since this goes against the fundamental ethos of decentralized finance – decentralization – it requires a proactive and collaborative approach from DeFi space and innovative thinking from DeFi managing authorities.