What is the future of decentralized finance (DeFi) — the hottest blockchain trend of last year — and what does it mean for traditional banking and the world of centralized finance?

A panel of industry experts tried to answer that question this week at a global summit organized by the Bank for International Settlements. 

DeFi and its underlying blockchain technology are bringing a paradigm shift in how we structure our systems globally, said Joseph Lubin, chief executive officer and founder of ConsenSys, a New York-based blockchain software technology company.

“DeFi is building the early stages of a much more seamless global financial infrastructure,” said Lubin, who was part of a panel discussion on “CeFi to DeFi: can global finance be de/re-constructed?” at the BIS Innovation Summit 2021 held this week. 

“The current one is very siloed with nation states linked by essentially correspondent banking relationships,” said Lubin, who is also a co-founder of Ethereum. “Our planet is increasingly in need of systems shared across nation states on which companies in those nation states, and the nation states themselves can transact and trust that their rule systems that mediate those transactions will be honored, will be automatically applied.”

Society was evolving from being natively analog to natively digital, “where elements like money, financial instruments, identity, art and governance are realized entirely in software,” Lubin said, adding that digitization would lead to standardization and automated compliance and tokenization as well as remove the frictions of current processes.

DeFi applications offering financial services directly to individuals are on the rise. Unlike in traditional finance, which requires intermediaries like banks, DeFi transactions are governed by smart contracts without the need for intermediaries.

Decentralized finance protocols for a wide variety of financial services, such as lending, borrowing, yield on savings accounts, asset issuance, trading and insurance, are already being built. The applications also could be permissionlessly combined like “lego” blocks — or what is called composability — enabling more capable systems to be created rapidly.

Another panelist, David Puth, chief executive officer of Centre — the company behind USD Coin (USDC) — sees the convergence of decentralized and centralized finance as inevitable. 

“As DeFi continues to evolve from this very early stage, it will be impossible for the centralized finance world to ignore the incredible potential,” Puth said.

Centre’s USDC, a stablecoin pegged to the U.S. dollar, is the world’s second-largest stablecoin by market capitalization. The vast majority of DeFi protocols and stablecoins operate on Ethereum, and the total value locked in DeFi protocols has surpassed U$$39 billion as of publishing time.  

See related article: Will DeFi upend traditional finance and democratize capitalism?

Opportunities abound, but there are risks

The opportunities in DeFi are tremendous but they come with risks. “There’s risk of losing principal, technology breaking down, people unwittingly doing things in the DeFi space that can’t be undone and then no recourse for the party,” Puth said. “As an industry, we need to work together, and work together with regulatory bodies.” 

Another panelist, Hester Peirce, a commissioner on the U.S. Securities and Exchange Commission (SEC) said that DeFi “could help the resilience of the financial markets by moving away from centralized potential points of failure to a more distributed approach that means that no one particular point is particularly important.”

“A lot of what’s happening in DeFi is really outside of what the SEC’s purview is, because a lot of it has to do with more banking-like functions than I would say securities-like functions,” Peirce said. “At this point as regulators, we’re watching what’s going on, and I think any kind of wholesale shift in the financial system will take quite a long time.”

“To the extent that people are building things that are intended to mimic securities or doing things related to asset management, that would fall within our purview. And so I encourage people to be thinking about potential securities implications,” Peirce said. 

“If you set up some sort of decentralized exchange or automated market maker that is trading securities, among other things, then you’ve to think about what the implications are there. Now that poses all kinds of interesting challenges for us as a regulator because we’re used to dealing with a centralized counterparty,” Peirce added. 

See related article: SEC commissioner Hester Peirce says enforcement is never good way to provide clarity

Peirce has proposed a three-year “safe harbor” period for token sales to allow crypto entrepreneurs to build their networks without fear of running afoul of securities laws, Peirce said that she’s hoping to present her proposal to the new SEC chair and suggest that he pursue something like it. “If not, I’m not wedded to that, but I think we need to provide some clarity for people trying to develop these networks,” she said.

Peirce does not think that there will be uniformity in international regulations given that different countries have different philosophies towards regulation. “In general, where most of the international benefit is, is learning from one another, sharing ideas about how to approach some of these new regulatory challenges,” she said. 

“We can be conscious of the limitations of our jurisdiction, something that, frankly, the SEC hasn’t always done that well,” Peirce said. “We can also do something which the SEC has done in other areas, which is, allow for substituted compliance so that if actors are compliant with their home countries’ rules and those rules have sort of the same end objective as ours, we can give deference to those rules.”

Panelists also say that governments must be careful not to stifle innovation and point out the need for regulatory coordination. 

“International coordination and multi-stakeholder cooperation are critically important,” said Sheila Warren, head of blockchain and data policy and member of the executive committee at the World Economic Forum. “There is a danger of regulatory fragmentation, and we’ve already seen some of this in the more pure cryptocurrency space.”

Lubin added: “Regulators should look to regulate uses of the technologies, but not the technology itself. It is important to note that this disruptive technology is premised on designing protocols that are essentially self-policing or having protocols police other protocols.” 

Centre’s Puth commended the U.S. Office of the Comptroller of the Currency (OCC) for giving greater permission to financial institutions to work with cryptocurrencies. In January, the OCC issued guidance allowing federally chartered banks to participate in blockchains and use stablecoins for payment activities. 

“Opening up on public blockchains and using stablecoins is a great way to facilitate what I think will be an enormous opportunity for the traditional banking business to engage in the intersection of centralized finance and decentralized finance,” Puth said. 

“What is happening in blockchain, in decentralized finance, this is a global phenomenon,” Puth said. “It’s not going to slow, and we need the regulatory community to be working together to help enable safe applications of the practices that we’re all involved with today.”