DeFi could go mainstream, with a little help from Gulf regulators

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• Supporters of decentralised finance say it empowers users
• But the FBI and other agencies have warned about security risks
• Tighter regulation of the industry could change that

For those who imagine a world without banks, decentralised finance – better known as DeFi – is an empowering development in the crypto universe. So, how does it put users in charge of their own finances? 

DeFi is the provision of financial products and services without the need for intermediaries such as banks, exchanges or brokerages. 

“This is done through a concept called smart contracts implemented on blockchain,” said Ahmed Ismail, president and CEO of FLUID, a Dubai-based AI-powered liquidity aggregator. 

“In layman’s terms, DeFi provides every individual access to financial services without having to fulfil any pre-set conditions.”

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Those services include everything from the borrowing and lending of cryptocurrencies to the trading of digital assets in decentralised exchanges. 

The latter include peer-to-peer marketplaces such as Uniswap and Sushiswap, both of which are built on the ethereum blockchain. 

Cryptocurrency exchanges like Bybit also offer products such as liquidity mining, which allow users to deposit liquidity and earn fees in return.

“At its heart, DeFi is the democratisation and disintermediation of finance,” said Bill Xing, head of financial products at Bybit. 

“In the past, only wealthy individuals and funds could access the best financial products and services. Furthermore, markets were – and still are – beholden to market makers and centralised entities. 

“DeFi has opened the door so that anyone can be a market maker, anyone can be a venture capitalist, and anyone can lend or borrow money, without the need for invasive background checks.”

Within the GCC, the UAE is the closest to providing a sustainable platform for DeFi products. Abu Dhabi’s Financial Services Regulatory Authority (FSRA) has had a comprehensive crypto regulatory regime in place since 2018.

It issued a discussion paper on DeFi in April, which sought to engage with the DeFi community regarding policy considerations and regulation.

In Dubai, the Dubai Multi Commodities Centre, the Securities and Commodities Authority and Dubai International Financial Centre have all set up similar regimes.

“They work closely with crypto firms to help create a safe, exacting and transparent ecosystem,” said Ismail. This favourable environment has led the UAE to become a magnet for crypto firms. 

In December last year, crypto exchange Binance signed a partnership agreement with Dubai World Trade Centre Authority to establish a hub for global virtual assets. It was also granted a virtual asset licence from Dubai’s Virtual Asset Regulatory Authority (VARA) in March. 

The same month, Bybit announced plans to move its global headquarters from Singapore to Dubai and is currently working on this with UAE regulators. 

The Bahamas-based cryptocurrency exchange FTX was handed a virtual asset licence by the VARA in July. 

About 2 billion people have no access to banking

“The fact that DeFi exists is, in itself, a paradigm shift compared to traditional banking – TradFi – that we’ve been accustomed to for centuries,” said Ismail. 

“The DeFi industry has the potential to disrupt the TradFi industry by using blockchain-based applications and services to replicate banking, investing and trading activities. 

“Many TradFi services already have a DeFi counterpart, and more are on the way. The single biggest advantage DeFi offers is access. 

“Currently, around 2 billion people don’t have access to banking, whereas DeFi has no barriers to entry.”

There are concerns, however, particularly around security. On August 29, the FBI issued a warning about the contract vulnerabilities on DeFi platforms, noting that cyber-criminals had stolen “$1.3 billion in cryptocurrencies” in just three months. Almost 97 percent of that had been stolen from DeFi platforms. 

“Since DeFi is by nature decentralised, it presents various risks and less control by exogenous parties such as regulators,” said Mads Eberhardt, a cryptocurrency analyst at Saxo Bank. 

“The risks are mainly around hacks, with the latter amounting to well north of $1 billion stolen from protocols in the last year.”

Hacks on the rise

DeFi hacks are increasing in both scope and scale, with the Lazarus Group, a North Korean state-sponsored hacker group, blamed for the $622 million Axie Infinity attack in March. 

As hackers take advantage of the vulnerabilities in smart contracts and protocols, there’s “an urgent need for all parties in DeFi to implement robust cyber-security frameworks to prevent hacks and breaches,” said Ismail.    

These security issues feed into another concern – the absence of regulation. The very nature of DeFi means it is anonymous. 

As the FSRA pointed out in its discussion paper earlier this year, this poses “potential risks in the areas of market conduct, anti-money laundering and countering the financing of terrorism.”

As such, regulation is viewed as a priority, with the FSRA believing regulatory intervention is likely within the medium term.  

“Governments are better off regulating digital assets than delaying action on formulating a unified regulatory framework,” said Ismail. 

“The past few months have witnessed numerous crypto debacles and users have no recourse to their investments. Broadly speaking, regulation brings caution, and caution begets trust. 

“There are many that would see regulation as stifling innovation, but it is essential to ensure that investments of all stakeholders are safeguarded.”

Eberhardt is the least convinced of DeFi’s short-term prospects. “I doubt DeFi will play a greater role than being a niche within crypto in the next few years,” he said. 

“It will take more time than that for DeFi to potentially mature into something that non-crypto advocates utilise daily. 

“When that has been said, I think particularly regulators around the globe will make substantial progress on a proper regulatory framework in the next couple of years.”

Nevertheless, Ismail believes DeFi will play a much wider role within conventional finance within the next two to three years, with banks and insurance companies adopting aspects of DeFi that enable them to be more efficient. 

“Despite the challenges, it is impossible to overlook DeFi’s advantages in boosting productivity, cutting expenses, providing privacy and transparency, promoting financial inclusion and adding more value to communities,” he said.

Xing agrees. “As time goes on, more institutions will require exposure to crypto assets, and the links between traditional finance and decentralised finance will become stronger and more effective.”