What is decentralised finance (DeFi)?

And how safe is DeFi?

Decentralised finance – DeFi – is a financial system based on blockchain technology and Ethereum. Before we go any further, let’s explain those terms. Blockchain is a decentralised digital ledger technology that records transactions across multiple computers or nodes. Each transaction, called a block, is linked to the previous one, creating a chain of blocks, hence the name. It is nearly impossible to delete or alter a transaction once recorded on the blockchain, which is what makes blockchain technology secure. Ethereum is a commercial blockchain platform. It has its own cryptocurrency, the Ether, but Ethereum is more than just a cryptocurrency. It is a programmable platform on which developers can build their own contracts. 

Now, on to DeFi. Decentralised finance aims to create a more open, transparent and accessible financial system without the need for traditional intermediaries such as banks (which are, by definition, centralised financial systems). DeFi has become increasingly popular in the cryptocurrency arena. It encompasses a wide range of financial tools and applications such as lending and borrowing platforms, decentralised exchanges, stablecoins, and prediction markets. A stablecoin is a cryptocurrency that is pegged to the US dollar (or other stable currency, or gold) to minimise the volatility usually associated with cryptocurrency, while maintaining the benefits. A prediction market is simply a betting platform. It allows participants to buy and sell contracts based on what they think the outcome of an event will be, such as a political election. 

Risks

DeFi is accessible to anyone with an internet connection and a compatible digital wallet. This means that users can access financial services and participate in the ecosystem without needing to rely on traditional banks or comply with conventional financial regulations. Unfortunately, this makes DeFi attractive to criminals. They can interact with a DeFi platform using a pseudonym and never reveal their actual identity. Without oversight or regulation from any authority, it is easier for criminals to engage in fraudulent activities, such as money laundering. At the same time, all DeFi transactions are recorded on the blockchain and are transparent. So the user may be anonymous, but the transaction can be traced. This will hopefully mitigate the risk of money laundering. Currently, DeFi is unregulated, but that is set to change.

Regulation 

International regulatory bodies are debating how to classify and regulate DeFi. While some countries view DeFi as an entity with its own set of rules and regulations, others view it as subject to existing financial regulations. As a result, users may experience inconsistencies due to the lack of clarity surrounding formalised legislation. Increasingly, traditional financial institutions are collaborating with DeFi platforms to integrate anti-money laundering and “know your customer” protocols, to reduce the risk of DeFi becoming a home for dirty money and unscrupulous financial activities.

Since DeFi is a relatively new and rapidly evolving area of finance, there is still some legal uncertainty when it comes to its regulation and protection of users. This presents challenges for consumer protection. For example, users of DeFi platforms have limited options available for recourse or legal action if they are subject to a security breach or fraud. Similarly, smart contracts pose legal challenges in respect of contractual enforcement and dispute resolution. A smart contract is a computer program that lives on a blockchain. It enforces the terms of an agreement (contract) between parties, removing the role of intermediaries, like brokers. Since there is no centralised authority or intermediary function, parties can engage in financial agreements without needing to comply with any proper agreement standards. 

What’s next for DeFi?

Decentralised finance is in its infancy. It is too soon to tell if it will replace traditional financial institutions or fade away. For every advantage (e.g., independence from a global financial system often viewed as greedy), there is a disadvantage (e.g., lack of consumer protection). The future may well depend on regulatory developments that make consumers/investors feel more secure and criminals more exposed. It is likely that the silos within which most DeFi platforms operate will fall away, and we will see more interoperability. This is necessary for assets to be able to move across blockchain networks, which consumers are likely to demand. It is no different from the ability to make an electronic payment to someone who banks with a different bank, or to call a friend on a different cell phone network.

Ironically, it is also likely that existing financial institutions will want to get involved. This sounds like a contradiction of terms, but experts believe that partnerships and collaborations – even acquisitions – between organised finance and DeFi platforms are probably inevitable. This could lend credibility to DeFi, and arguably make a regulatory framework easier to implement.

Stay safe

Until then, if you are attracted by the autonomy and security of DeFi, it’s a good idea to be aware of the risks, and be prudent in your adoption of DeFi. Carry out thorough research on any platform you are considering using. Maintain a diversified portfolio; in other words, don’t put all your eggs in one basket (or one platform – don’t abandon traditional financial institutions with rigorous consumer protection in place just yet). Use cold digital wallets (see Cryptocurrency theft) to store your private keys. Practise good security measures: use strong passwords, don’t re-use passwords, and don’t click on links in emails from senders you don’t know (phishing). Even if you know the sender, if anything about an email or text message is suspicious, delete it immediately and contact the sender by another means. They may have been impersonated. Malicious actors will go to great lengths to gain access to your crypto wallet and your DeFi platform. 

For more information

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 cryptocurrency?
• Cryptocurrency – the wild west or a carefully regulated environment?
• Cryptocurrency – myths and misconceptions
• Cryptocurrency theft

SD Law

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