FTX contagion has raised concerns globally about the risk involved in DeFi versus the opportunities they represent. Authorities in England are particularly sceptic calling for wider consultations.
The origins of cryptocurrency, particularly Bitcoin rooted in a financial system free from regulation and centralised control. The platforms that came after advocated for the same principles and have since attracted a huge following. The risks associated however cannot be understated. The past year has taught us otherwise, both centralized and decentralized platforms have crumbled under their own hands.
DeFi safety and regulatory concerns
As stated earlier, ‘Crypto’ was born in an unregulated space, and proponents intend it to remain so, however, authorities suggest that the crypto ecosystem has grown rapidly and broadened to encompass a range of mainstream financial sectors.
On 21 November, Jon Cullife, deputy governor at the Bank of England shared some intriguing concerns about DeFi with the Warwick Business Schools.
Some, of course, would argue that the answer is not proper regulation of the risks in centralised crypto platforms, like FTX, but rather the development of decentralised finance in which functions like lending, trading, clearing etc. take place through software protocols built on the permission-less blockchain.Jon Cullife, Deputy governor Bank of England.
In other words, Jon was reiterating the effectiveness of code, in this case, smart contracts in DeFi managing risks rather than intermediaries. Using DeFi by combining the functions of trading, clearing and settlement of tokenised financial assets into a single, instantaneous smart contract, rather than being carried out by separate institutions as was the case with FTX.
In the FTX debacle, balance sheets revealed that funds from the FTX exchange were lent out to Alameda research without prior permission from users. Unwise decisions from the entity led to the firm filing for bankruptcy in the United States.
The UK Financial Conduct Authority (FCA) had long provided warnings about FTX providing financial services without proper regulatory authorisation with the warning “you are unlikely to get your money back if things go wrong.”
While the exchange is not decentralized. Jon pointed out that behind decentralised protocols were “stakeholders who derive revenue from their operations.” The opaque nature of governance of DeFi protocols raised safety concerns.
Jon compared the whole scenario to a driverless car, “DeFi is as good as the rules, programmes and sensors which organise their operations.” Authorities in England would need a great deal of assurance for such systems to be deployed at a large scale in finance.
Plan of action
The Bank of England (BOE) is working with the FCA and the Treasury to set up a regulatory sandbox for developers to explore whether and how those risks can be managed at a high level of assurance.
The ‘new’ regulations will foster innovation which according to Jon sounded counter-intuitive to crypto enthusiasts. But he reiterated that these platforms should be developed and adopted at scale within a framework that managed risks.
Jon in his presentation called for stringent regulatory measures on financial institutions since they carried a certain level of risk to the public and more broadly the financial system.
The Financial Services and Markets Bill UK, being addressed in Parliament addresses the regulatory framework of digital assets. The bill will extend the regulatory regime of FCA and BOE to cover cryptocurrencies and stablecoins.
Following the signing of the bill, it is anticipated that cryptocurrency firms will have to abide by BOE and FCA terms or ship out.
The UK treasury is also working on a CBDC issued by the central bank, a native pound sterling. Jon revealed that BOE should issue a report before the end of the year detailing their next steps.