DeFi has not gone away, but is it gaining traction?
In 2023 we wrote several articles about decentralised finance – “DeFi” for short. Its regulation and legal status lacked certainty at that time since the concept was new and the technology rapidly evolving. We revisit DeFi to see what has changed in two years.
The rise of DeFi has marked a shift in the world of financial services. DeFi is an emerging set of blockchain-powered financial services that is gaining popularity and acceptance. DeFi offers benefits such as greater accessibility, transparency and lower costs. However, as DeFi is relatively new, it carries risks. The technology behind DeFi allows users to conduct financial transactions, traditionally overseen by different regulators, without banks or other traditional market participants. Current financial regulations govern centralised institutions, whereas DeFi by definition decentralises finance.
What is DeFI?
DeFi is an umbrella term for peer-to-peer financial services on public blockchains, primarily the well-established cryptocurrency Etherium. The core principle of DeFi is the elimination of intermediaries such as banks from the financial system, which helps lower costs and speed up transaction times. In the absence of centralised control, traditional finance regulators are replaced by code, often through decentralised autonomous organisations (DAOs) and smart contracts. Although DeFi presents considerable opportunities to broaden access to financial services, it also introduces legal challenges for users and developers alike.
DeFi represents a disruptive force in the financial industry, challenging the traditional, centralised banking system. However, DeFi, much like the blockchain technology and cryptocurrencies it supports, is still in the early stages of development. Many issues must be resolved before it can rival the current financial infrastructure. Furthermore, traditional financial institutions and banks are unlikely to give up their dominant position so easily. If there’s an opportunity to profit from the shift toward a blockchain-based financial system, these institutions will be inclined to seize it, ensuring they remain relevant in the evolving landscape.
Key DeFi legal issues
Budding DeFi businesses must stay abreast of constantly evolving regulations to avoid any potential legal issues. Areas of concern include anti-money laundering and countering the financing of terrorism (AML-CFT) compliance, securities and liability risks, and the lack of clear regulatory framework, which makes enforcing regulations more complex. For companies to thrive in the DeFi space, they must recognise these challenges and take proactive steps to ensure they remain compliant with legal requirements.
Anti-Money Laundering and Countering the Financing of Terrorism (AML-CFT) compliance
Money laundering is a risk with crypto and digital currencies due to the anonymity it affords its users. Since many DeFi platforms allow pseudonyms and operate with decentralised authorities, they pose a challenge for regulators tasked with ensuring compliance with AML-CFT legislation.
This includes the Financial Action Task Force’s (FATF) “travel rule,” which requires the identification of both the sender and receiver in digital asset transactions.
Securities and liabilities risks
Another significant legal issue for DeFi is liability in the event of a security breach, hack, or failure of a smart contract. Although DeFi platforms are designed to eliminate the need for intermediaries and reduce the risk of human error, they are not immune to security vulnerabilities.
Smart contracts, which power DeFi applications, are essentially pieces of code that automatically execute transactions based on predetermined conditions. While they offer efficiency and automation, they are also prone to bugs and vulnerabilities that can be exploited by bad actors. Several high-profile incidents have demonstrated the risks associated with DeFi, such as flash loan attacks, Oracle manipulation and coding errors.
Another concern is the classification of DeFi tokens as securities. Digital assets cause headaches for regulatory bodies worldwide. By classifying DeFi tokens as securities, securities laws apply which will result in strict registration and disclosure requirements, exactly the conditions DeFi is trying to avoid.
Lack of clear regulatory framework
DeFi functions without borders, making it hard to identify which regulations apply. This uncertainty creates compliance difficulties as DeFi inhabits a complicated regulatory environment without clear direction. For example, determining whether a DeFi token qualifies as a security under current laws can be problematic, as traditional regulatory frameworks may not fully encompass the unique nature of decentralised tokens. This lack of clarity can hinder innovation and deter investment in the DeFi sector, with developers hesitant to introduce new products and services without solid regulatory guidance.
A further complication is fragmentation across jurisdictions, as different countries have differing and even conflicting laws regarding DeFi, making compliance even more difficult for global initiatives. To foster growth and ensure consumer protection, a clear, adaptable and balanced regulatory framework is essential. Such a framework would provide legal certainty, allowing DeFi to thrive while mitigating risks and ensuring market integrity, ultimately contributing to the sector’s global adoption.
DeFi has potential…but only if the risks and issues are addressed
While DeFi holds immense potential to reshape the financial industry, the lack of a clear regulatory framework, concerns over compliance with AML-CFT laws, and security and liabilities risks must be addressed before the concept can mature. As governments and regulatory bodies continue to refine their approaches to DeFi, developers, users and legal professionals must work together to create a safe, compliant and sustainable DeFi ecosystem that fosters innovation while minimising legal risks. In short, not much has changed in two years.
Let SD Law help
If you want to know more about decentralised finance and cryptocurrency, contact SD Law. We are a firm of experienced attorneys based in Cape Town, with offices in Johannesburg and Durban. Call Simon on 086 099 5146 or email sdippenaar@sdlaw.co.za.
Further reading:
- What is decentralised finance (DeFi)?
- Decentralised finance – regulatory developments
- DAOs – decentralised autonomous organisations
SD Law
The information on this website is provided to assist the reader with a general understanding of the law. While we believe the information to be factually accurate, and have taken care in our preparation of these pages, these articles cannot and do not take individual circumstances into account and are not a substitute for personal legal advice. If you have a legal matter that concerns you, please consult a qualified attorney. Simon Dippenaar & Associates takes no responsibility for any action you may take as a result of reading the information contained herein (or the consequences thereof), in the absence of professional legal advice.