DeFi Experienced Explosive Growth in 2020, but Sector Needs More Regulatory Clarity and Better Compliance Programs: Chainalysis

Blockchain analysis firm Chainalysis confirms that decentralized finance (DeFi) is growing at “warp speed,” however, regulatory guidelines and compliance requirements still remain unclear.

The Chainalysis team states in a blog post that DeFi’s explosive growth has been one of cryptocurrency’s “biggest stories” of 2020. The total value locked into DeFi protocols and contracts has surged dramatically this year, with September’s total having tripled month-over-month to over $26 billion, Chainalysis noted. Although there was a slight dip in DeFi token prices this month, the weekly figures suggest that overall activity is picking up again, the blockchain analysis firm revealed.

Despite the seemingly strong growth of the DeFi ecosystem, there are many unanswered questions such as how DeFi solutions may be treated or regulated under the existing Bank Secrecy Act. It’s also unclear how securities laws and several other standard regulations (for consumer protection and compliance) may apply to DeFi, Chainalysis notes.

DeFi platforms and services may “theoretically run autonomously without human intervention” and “generally never take custody of funds,” Chainalysis explains. However, this leads to questions such as can they be regulated or should DeFi services fall under the existing regularly framework.

Chainalysis argues:

“Many DeFi platforms are … centralized enough that the teams behind them can block risky transactions and take other actions against potential criminal activity, suggesting that they can be regulated like other cryptocurrency platforms.”

Chainalysis further notes that most DeFi apps aim to build liquidity by crowdsourcing funds from users who “believe in the project’s mission, and from there can put those funds to productive use as governed by the protocol.” Chainalysis adds that decentralized applications (dApps) may not require centralized infrastructure or “human governance.” dApps may allow users to conduct financial transactions at lower costs than many Fintech apps and traditional financial service providers.

Chainalysis also mentions that decentralized exchanges (DEXs) are the most widely-used type of dApp. DEXs allow traders to purchase, sell, and “swap” different cryptocurrency tokens developed on a specific blockchain (usually Ethereum) directly between one another’s digital asset wallets for “greater privacy and security.”

Chainalysis reveals:

“The data shows that DeFi platforms have less exposure to illicit activity than the cryptocurrency ecosystem as a whole. [According to Chainalysis’ 2020 Crypto Crime Report,] … 1.1% of all cryptocurrency transaction volume was received or sent by an address associated with illicit activity. Overall in 2020, just 0.05% of all funds received by DeFi platforms came from addresses associated with criminal activity, and 0.07% of all funds sent by DeFi platforms went to such addresses.”

Chainalysis concludes:

“Ultimately, regulators will determine how to enforce existing regulations on DeFi platforms, or if necessary, will create new ones to protect the integrity of the financial system. With illicit activity in DeFi low compared to the rest of the cryptocurrency ecosystem, DeFi enforcement may not be a priority at the moment.” 

It’s worth noting, however, that the largest DeFi platforms can freeze funds, and have shown their willingness to do so in serious cases of cybercrime (for example, the KuCoin hack). Chainalysis believes that DeFi teams can be proactive in “taking preventative action and cooperating with law enforcement in situations that call for it.”

Chanalysis further notes that DeFi teams that implement transaction monitoring services, appropriate KYC checks, and various other elements of a compliance program will “likely be in a much better position the day that regulators do come knocking.”

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