Against the backdrop of the decentralized finance (DeFi) hype that took the world by storm over the past year, the World Economic Forum (WEF) on Tuesday released a toolkit for policymakers to examine the opportunities and risks the new technology could bring.
While DeFi can offer significant benefits such as greater financial inclusion for the estimated 1.7 billion people in the world who do not have access to traditional banking, it can also carry risks, such as the potential for scams and smart contract issues. The WEF, in collaboration with the Wharton School of the University of Pennsylvania, is now publishing a framework to help policymakers evaluate DeFi and map out possible regulatory responses.
“Potentially we can have this open-source technology that’s building on top of each other, but at the same time, we might be compounding risks and creating risks that may not be present in individual services,” said Sumedha Deshmukh, WEF’s platform curator of blockchain and digital assets, in an interview with Forkast.News.
“The leverage in the system that we see today, for example, could create volatile conditions where we have intermediaries that may intervene in the traditional financial system. That’s not the case in DeFi,” Deshmukh added. “It (DeFi) is all going to self-execute and happen autonomously without that kind of red emergency button, if you will, if something goes wrong. These are tradeoffs that we need to consider carefully and weigh if we want to value some of the things that DeFi offers.”
The WEF report — which includes case studies as well as flowcharts and worksheets — identifies a few risks that it says policymakers should bear in mind when it comes to DeFi. For example, policymakers should be aware of the “market risk,” when asset value could decline over some time horizon due to market conditions, new information or traders’ idiosyncratic behavior, and “liquidity risk” — a possibility that there could be insufficient funds available to cover asset withdrawals.
The WEF also warned that regulators should pay attention to risks that involve the interaction of multiple events, which could create failures that are not reflected in a risk assessment of each service independently. Recent real-world examples include banks that were thought to be “too big to fail” — but still did after collapsing from the weight of multiple factors — as well as scenarios in which ostensibly unrelated events, such as individual mortgage defaults, become highly correlated and produce cascading effects through chains of securitization, according to the report.
In the past year, the value of digital assets locked in DeFi smart contracts surged to US$13 billion from US$670 million, according to the WEF report. The number of DeFi-related applications grew from eight to more than 200, while the total number of associated user wallets increased to 1.2 million from 100,000.
Before blockchain technology-enabled DeFi, financial services like borrowing and lending were largely available only through intermediary institutions like banks. But DeFi platforms like MakerDAO and others are now enabling, for anyone, easy and more direct access to financial services via smart contracts.
“Fundamentally, DeFi is about providing universal access to financial services and tools,” Rune Christensen, co-founder and CEO of MakerDAO, said in April at a WEF panel moderated by Forkast.News founder Angie Lau. “It’s a set of financial systems and protocols that you can access on the internet, and the crucial thing is that everyone gets to access it on the same terms.”
At the same panel, Aušrinė Armonaitė, minister of the economy and innovation of Lithuania, said that the Lithuanian government hopes to facilitate better public and private cooperation and information sharing, as well as coordinate technology adoption and implementation.
“Hopefully that kind of framework where governmental and private institutions come together and work together towards a better regulation [that] would enhance change and appreciate the creative destruction we are facing, rather than defending ourselves from it,” Armonaitė said.
Deshmukh from the WEF shares a similar view. “It’s just about policymakers taking that understanding of what’s new and unique about DeFi and thinking through how to weigh some of those trade-offs and not necessarily shut it down just because it’s something they’re not familiar with.”
A significant benefit of DeFi, its proponents say, is its potential to increase financial inclusion — especially among the world’s poor. “The possibilities for financial inclusion alongside the accretive upside that these types of businesses generate mean that throughout the ASEAN and Indian region entrepreneurs, technologists, investors and innovators are working side-by-side to create open markets that can truly help everybody,” Michael Conn, CEO and chairman of Zilliqa Capital Singapore, wrote in a recent Forkast.News commentary.
Among the governments that the WEF worked with to create the DeFi toolkit is Colombia — which has also expressed interest in using it for DeFi policymaking.
Deshmukh said that the WEF hopes to work hand in hand with more governments over the course of next six months to a year “to see what they need to really move the needle on some of these policymaking and regulatory questions.”