What Decentralized Finance Means for Community Banks

By Brian Laverdure

As discussed in ICBA’s first Crypto Chronicles blog post, cryptocurrency emerged from Satoshi Nakamoto’s desire to create a “purely peer-to-peer version of electronic cash.”

Many proponents within the crypto community are working towards that goal by developing new systems that provide completely open, permissionless financial services enabled by smart chains and digital assets. Those applications are collectively known as “decentralized finance,” or DeFi.

What is DeFi?

DeFi refers to blockchain-based applications that provide an array of financial services directly to consumers and businesses without intermediaries, such as banks or central banks.

Also known as DApps, these applications rely on smart contracts, or “computer code that automatically executes all or parts of an agreement.” Smart contracts fulfill the traditional roles of intermediaries, including custodians or payment system operators, by locking in cryptoassets and only initiating actions once certain conditions are met.

Measuring the true scale of DeFi is challenging, but one tracking website estimates nearly $60 billion worth of cryptoassets have been committed to smart contracts in DApps.

Consumer risk

Consumers that participate in DeFi do so at great risk and may suffer losses. Digital assets quickly rise and fall in value, and assets may be stolen by hackers or malicious developers.

According to research by blockchain analytics firm CipherTrace, DeFi hackers stole $156 million in cryptocurrency between January and April 2021, and another $83.4 million was lost to DeFi-related fraud.

Consumers are also falling victim to fraudsters and cryptocurrency investment scams. Between October 2020 and April 2021, nearly 7,000 consumers filed complaints with the Federal Trade Commission, reporting crypto scam losses exceeding $80 million.

Without intervention from policymakers and regulators, consumers may stand to lose even more as DeFi continues to grow at an extraordinary pace and bad actors increasingly target DeFi applications.

Regulatory scrutiny

While no single regulator is responsible for the range of financial activity spread across the DeFi universe, multiple policymakers are keeping a close eye on the growth of DeFi and its potential negative impacts for banks, consumers, investors, and more. Recently they have intensified their scrutiny of stablecoins, which are critical building blocks in DeFi applications.

On July 19, the President’s Working Group on Financial Markets met to discuss “the rapid growth of stablecoins, potential uses of stablecoins as a means of payment, and potential risks to end-users, the financial system, and national security.” Led by Treasury Secretary Janet Yellen, the group serves as a forum for the heads of the Federal Reserve, FDIC, OCC, Securities and Exchange Commission, and Commodity Futures Trading Commission to examine significant issues for the financial sector and U.S. economy.

The financial markets working group released a statement at the end of 2020 that called for stablecoin issuers to comply with U.S. laws and regulations, including anti-money laundering and counter-terrorist financing obligations. Secretary Yellen “underscored the need to act quickly to ensure there is an appropriate U.S. regulatory framework in place.”

Additionally, individual agency leaders have expressed concerns about DeFi, with the SEC and CFTC paying close attention to this space.

SEC Chairman Gary Gensler has issued warnings that many cryptoassets qualify as investment contracts and crypto exchanges may not follow federal securities laws. In testimony before the House Appropriations Committee in May, Gensler said “…crypto lending platforms and so-called decentralized (‘DeFi’) platforms raise a number of challenges for investors and the SEC staff are trying to protect them.”

In a speech before the American Bar Association on July 21, Gensler reinforced his concerns about the trading of synthetic assets, which are cryptocurrencies that can track the prices of other assets like stocks. Gensler said platforms engaged in the exchange of these assets, as well as stablecoins backed by securities, are “implicated by the securities laws and must work within our securities regime.” He also warned that the SEC may file more cases and use other enforcement tools to combat DeFi activity that violates U.S. laws and regulations.

Separately, the CFTC is taking a closer look at how DeFi may facilitate markets for unlicensed derivative instruments.

In June, CFTC Commissioner Dan Berkovitz criticized DeFi for lacking trusted intermediaries “to monitor markets for fraud and manipulation, prevent money laundering, safeguard deposited funds, ensure counterparty compliance, or make customers whole when processes fail.” He cautioned that regulators “should not permit DeFi to become an unregulated shadow financial market” that competes with regulated entities, and he acknowledged a need to work with other regulators to “focus more attention to this growing area of concern and address regulatory violations appropriately.”

Community bank implications

DeFi threatens to disintermediate banks with an alternative system that competes with products and services offered by regulated institutions.

ICBA is concerned about the increasing potential for negative effects of these unregulated financial products and services for American consumers.

Without trusted intermediaries performing necessary actions, such as monitoring for criminal activity, bad actors could use DeFi services to scam consumers, launder money, or fund criminal operations.

Looking ahead

ICBA will continue to monitor DeFi developments and keep members informed. From a regulatory standpoint, ICBA supports interagency efforts to harmonize the digital asset regulatory framework and address the use of cryptocurrencies by bad actors.

ICBA also urges policymakers to act decisively to ensure that community banks, their customers, and the American economy are not threatened by shadow banking services that exist outside the regulated financial system.

Brian Laverdure, AAP, is ICBA vice president of payments and technology policy.

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