2021 has been seen as the year of the DeFi boom. Currently, the TVL (total value locked) into DeFi has surged to $60 billion, up from $1.2 billion from a year ago, attracting the attention of financial institutions (FIs) and enticing them to begin experimenting in the field.
As fiat interest rates have hit rock bottom – in many cases turning negative – banks have had little choice but to pass on the costs to savers. In this low-rate environment, it is natural that traditional lenders have sought yield in other places, the burgeoning DeFi scene being one.
DeFi has opened up a true cross sectionality between crypto native banks and traditional banks. MakerDAO is one crypto institution that moved into the mortgage market in April of this year, after breaking from its typical business practice of providing banking services to speculators in the cryptocurrency space. A growing number of FIs are moving into the crypto space, whether for custody of assets, operating order book exchanges or moving into DeFi lending and borrowing markets. However, it is liquidity pools (LPs) especially that are allowing for an even field of yield for both FIs and crypto-native companies to compete in the same markets.
Decentralized finance (DeFi) has changed how capital is deployed with liquidity pools streamlining lending and borrowing markets. This includes ‘stakers’ – where capital is deployed en masse into a smart contract to be lent out, lent capital generating yield.
However, in all market operations, FIs have stringent compliance procedures in place to safeguard margins from regulatory action against money laundering and terrorism financing failures. FIs need assurance that they are not interacting with money launderers, terrorist financiers and Specially Designated Nationals.
LPs are an interesting phenomena from a compliance standpoint, as not only are the liquidity providers interested in the Anti-Money Laundering and Countering Financing Terrorism compliance checks on the pools but also the market makers or smart contract providers are also incentivized to keep their LPs clean from illicit funds to attract institutional investment.
Because anyone can create a smart contract; whether that be for a token or liquidity pool, the number of protocols is difficult to quantify and the threats ever-evolving. The pitfalls of DeFi – besides AML/CFT failings – include rug pulls, exit scams, flash loan attacks, general smart contract vulnerabilities as well as unique cases such as a stablecoin peg tied to the strength of a token (algorithmic stablecoins). Iron Finance’s TITAN token and its intrinsically-linked stablecoin IRON DeFi crash – both of which failed on 17th June, the former falling from $65 to $0.000000035, the latter breaking its peg – as well as Pancake Bunny’s flash loan attack on the 20th May, exemplify how far (and fast) billion-dollar protocols can fall. But mature protocols looking to go mainstream with institutional uptake are beginning to understand that compliance with AML regulations are a necessary barrier to overcome.
Stakers, borrowers and smart contract providers are right to be AML-mindful as there is more regulatory action in the space. The Financial Action Task Force – the global AML/CFT watchdog – updated its draft regulatory guidance in March this year for virtual assets to encompass DeFi (as well as NFTs), noting that founders and developers of DApps are encompassed into the definition of a Virtual Asset Service Provider (VASP) and thus beholden to the same level of regulatory scrutiny as more centralized entities.
Only a few nations have regulations applicable to DeFi, such as Singapore and Switzerland, but these ‘crypto havens’ are the exception.
In a bid to guide regulators around the world, the World Economic Forum published a policymaker toolkit for DeFi last week which recommends a number of policies, including; new licence types, warnings, prohibitive measures, opt-ins, pruning regulations, specialized regulatory units, incentivizing information flow, regulatory sandboxes, clarifying easy cases and coordinating government action.
The trouble for compliance departments of financial institutions staking in LPs is knowing what other entities a FI is pooling capital with. Coinfirm’s AML Risk Solution for Defi Liquidity Pools fixes this issue. This service is able to give FATF-grade AML compliance to DeFi with proprietary risk check data points and algorithms that can check against;
The AML Risk Solution for DeFi Liquidity Pools gives users an understanding of the level of exposure to these risks broken down between; direct, indirect and tainted funds. The solution analyzes the largest contributors to the pool with more clarity, as these major counterparties can significantly affect the compliance score of a liquidity pool.
As regulatory compliance failures are a top 5 loss event for financial institutions and can cause the price of blockchain protocols to crater, it is imperative that stakeholders in liquidity pools follow regulatory law.