Decentralized finance, DeFi, has quickly grown in popularity and is beginning to gain the attention of regulators attempting to stay ahead of one of the latest investor crazes. Blockchain-based financial technology such as DeFi largely operate outside of the traditional finance ecosystem occupied by governmental agencies, intermediaries, central banks, brokerages, exchanges, and banks by utilizing cryptocurrencies. DeFi providers are offering lending, banking, and investing options that are decentralized and not dependent on financial markets or regulations. As a result, DeFi providers often operate illegally or lack the protections that govern traditional financial service providers.
Similar to peer-to-peer systems that allow users to lend fiat money (e.g., U.S. dollars), DeFi platforms allow individual lenders to offer cryptocurrency loans in a permissionless manner, without an intermediary, such as a bank or broker. DeFi lending relies on smart contracts to pool investors’ money and the smart contract issues the tokens to the borrower. The collateral for these DeFi loans are the cryptocurrency itself, which is often worth more than the loan.
State bank regulators have begun to release guidance to consumers that addresses risks related to DeFi, including investments through exchanges in cryptocurrencies, noting that DeFi platform users typically have little recourse should a transaction go wrong, and the parties involved in the transaction could be located anywhere in the world .
Putting It Into Practice: While the advisory attempts to put a positive spin on DeFi, it cautions investors before they enter into relationships with potentially unlicensed people in an unregulated marketplace, who are operating illegally. While it is true that many well-known and not-so well-known companies are engaged in DeFi or running decentralized exchanges or marketplaces, some appear largely to be doing so without heeding any consumer protections laws or regulations, including licensing requirements where applicable. As a result, these DeFi platforms, at a minimum, likely are facilitating the violation of basic lending and investing laws, as the advisory notes.