This article was originally published in Blockchain Industry Review - a Crypto Curry Club Magazine published monthly and available in soft copy and the printed version.
Written by Guest Contributor Timo Lehes,
Co-founder of DeFi platform, Swarm Markets
Options, fairness, and good returns create value. This is just as true for crypto markets as it is in traditional finance and DeFi has reshaped the landscape for crypto investors by improving all three points.
Now, the industry must build a new toolkit for the financial world, leveraging the aspects of TradFi most beneficial to investor interests, in order to take DeFi to the next level.
The core elements of DeFi, including self-custody, person-to-person transacting, 24-hour markets, and transparent operations result in the optionality and return potential that propelled DeFi into a global phenomenon. But there is still room for improvement.
Two key areas that need to evolve are adding compliance and accountability to DeFi. By having both, they will deter manipulation, bring new asset classes to DeFi, and increase the scope of participants to include institutions.
Compliance is another word for fairness
Smart contracts alone are not a guarantee of a fair market. In fact, relying on the transparency of the blockchain alone may increase information asymmetry to the benefit of insiders and market manipulators. This is because the majority of investors cannot be expected to have the level of technical expertise required to accurately assess the risk of transacting with a particular smart contract.
Regulators with expertise in evaluating the safety of fairness of financial instruments must act as gatekeepers to ensure that the processes and rules written into smart contracts maintain the highest standards of investor protection. Furthermore, regulated assets are subject to disclosure requirements that level the playing field for investors, ensuring that information is publicly available needed to make an informed investment decision.
In this environment investors without the technical expertise to audit smart contracts themselves, will be able to invest with confidence, knowing they won’t be taken advantage of by the smart contract authors or parties with superior technical knowledge.
Supercharging DeFi with regulated securities
Stablecoins serve as an anchor point in DeFi. They are essential to DeFi because they are connected to value outside of volatile crypto markets, allowing investors to exit crypto positions while sheltering their assets and creating a stable environment for lending and borrowing.
Onboarding asset-backed securities (ABSs) and commodities into DeFi will go beyond stablecoins and bolster market stability. The market cap of asset classes that could be consigned to DeFi dwarfs the size of the entire crypto market.
The industry must work with regulators to build the infrastructure between asset owners, custody providers and issuers. This will allow regulated asset classes with intrinsic value to be digitized and enter the world of DeFi, making markets more stable.
The last step to enable DeFi to reach its full potential is to deter bad actors from hijacking the value created by honest investors.
Accountability is more than just KYC
“I expect that projects that solve for pseudonymity are more likely to succeed, because investors can then be comfortable that asset prices reflect actual interest from real investors, not prices pumped by hidden manipulators.” – Securities and Exchange Commission commissioner Caroline A. Crenshaw
Investors, the world over, have long demonstrated a willingness to share their identity with the entity through which they trade in return for access to safe markets. Know your customer (KYC) and anti-money laundering (AML) checks restrict known bad actors from onboarding, but accountability is more than just connecting identity with crypto wallets.
Detecting manipulation and having a system to enforce accountability after onboarding are inherently deterrent to bad actors looking to exploit investors. While it’s impossible to promise absolute security, markets are more likely to be free of manipulation when participants know they will be held accountable.
It also gives confidence to investors. Investors are free to engage in peer-to-peer transactions with unknown counterparties without the risk that they may become a party to wrongdoing and face consequences, like wallet blacklisting and frozen assets.
Adding an identity layer to DeFi provides a substantial value to users and it appears that regulators across the globe agree.
Investors are attracted to DeFi because of the potential for profitable returns on their investment and are glad to trade a small bit of anonymity in return for protecting their investment.
Much more than more of the same
DeFi has been battle-tested from a technological standpoint. The time has come to broaden the focus beyond just technological innovation in order to attract more participants and build more efficient, fairer markets. Early DeFi projects succeeded in translating key functions of financial markets into code. Now the work to transform regulation into code must happen, in order to protect investors.
Executing on regulatory compliance ensures fairness for all market participants, expanding the set of options for investors by adding new asset classes to DeFi and leveraging accountability that deters bad actors. An ecosystem of accountability, fairness, and efficiency enables so many more investors the chance to access the full potential of DeFi.
Meet Timo Lehes
Timo Lehes is an entrepreneur and FinTech and Blockchain Investor. Selected exits include AdTech company, Admetam virtualisation management software business, Witsbits, and online surveillance tech solution, MindMancer. Lehes also has experience as a fund manager, running the US arm of Chalmers Innovation Capital, and worked as an M&A advisor at Logan-Orviss/Azure. He holds a Master's degree in computer science and data communication from Chalmers University of technology.
Contact Swarm Markets and Timo