Is DeFi the future of crypto exchanges?

DeFi PERFORMANCE IN 2022-2023

DeFi has performed better than bitcoin in the past 12 months. The trading volume in DEX fell from $133.54bn in May 2022 to $57.16bn in May 2023, a 5.7% decline. The trading volume of bitcoin fell from $18.09bn to $8.65, a 52% fall. This has led some in the crypto community to believe that DeFi is the future of the crypto ecosystem, after the demise of FTX.

DeFi claims to have better governance than traditional crypto exchanges

Most crypto platforms play multiple roles that are required by regulation to be independent in traditional finance (TradFi), broker, exchange, market maker and custodian. The failure of FTX also exposed loose governance systems, allegedly allowing FTX to use customer assets to make illiquid investments in its affiliated companies. DeFi differs from crypto exchanges in that customers maintain custody of their own crypto assets and transact using protocols without centralised intermediaries.

Regulators are not convinced

In the wake of FTX’s fraudulent bankruptcy, US regulators have started to seriously analyse the potential risks posed by DeFi. SEC chair Gary Gensler has made clear that regulators will not be asleep on the wheel in the case of DeFi and that trading platforms should be regulated as securities exchanges: Calling yourself a DeFi platform is no excuse to defy the securities law

DeFi vs CRYPTO EXCHANGE

Both DeFi platforms and crypto exchanges are based on blockchain, but there are major differences. Crypto exchanges provide a platform for the trade of various cryptocurrencies against each other or against fiat. Crypto exchanges may also trade NFTs.
DeFis are essentially a smart contract protocols, associated with an internet website, where anyone can create an application that allows users to interact with smart contracts. These decentralised applications (DApps) facilitate the provision of financial intermediation in DeFi. However, DeFi products and services mainly interact with other DeFi products and services, such as cryptos and NFTs. DeFi platforms do not interact with traditional finance (TradFi) or the real economy. In that sense, there is very little difference between a DeFi platform and a crypto exchange. However, unlike pure crypto exchanges, DeFi platforms appears to provide services that are more akin to those of TradFi:

  1. pool resources in support of large projects from decentralised sources
  2. provide price information for various assets
  3. provide liquidity and liquidity pools on their platforms

The main difference with TradFi is that DeFi is based on systems in which computer code and decentralised validators verify the legitimacy of transactions and the availability of funds to execute them.

ARE US REGULATORS TAKING STEPS TO PREEMPT A NEW FTX-STYLE DEBACLE?

On 14th April 2023, the SEC officially opened a comment period on proposed amendments to the definition of “exchange” under Exchange Act Rule 3b-16. The objective is clear: to extend the applicability of existing rules to platforms that trade crypto asset securities, including DeFi systems. SEC Chair Gary Gensler made it clear that “[…]many crypto trading platforms already come under the current definition of an exchange and thus have an existing duty to comply with the securities laws.”

WHY NOW?

If crypto trading platforms and DeFi interfaces already come under the current definition of an exchange, and thus should have been regulated as such, it is surprising that this announcement is made more than a decade after these exchanges started to operate. A possible explanation is that bitcoin, NFT, and pure crypto exchanges did not actually assume the economic role of traditional financial intermediaries -let alone replace fiat- despite claims to the contrary by crypto enthusiasts. Early on, most regulators treated cryptos are a new asset class, and concluded that their low capitalisation -relative to the global financial market- did not pose dangers to international financial stability. This evaluation has proved correct in the light of FTX’s bankruptcy and the crash of Terra’s stablecoin Luna.

Recent investigation by the FSB is unearthing many similarities between the traditional financial system and the activities of DeFi platforms. Although DeFi is still “talking to itself”, when it starts acting like a financial intermediary in the real economy its regulatory flaws may cause instability in the financial system.

DeFi systems run exclusively on smart contracts, without any recourse from regulators, the courts, or even the DeFi platform itself. “Code is law” is the underlying principle of smart contracts that make up DeFi protocols. But there are documented cases of massive smart contract failures which have led to significant financial losses for investors.