DeFi has gained the attention of the financial industry, especially after the boom of DeFi during the summer of 2020. Yet even at the peak of the hype, the total value locked in defi protocols is still relatively small compared to the traditional financial markets.

For customers and businesses, it is very appealing to supply liquidity to Defi protocols due to its high return for investors. The low barriers to participating in these new financial products and the promises of high returns have led to exponential growth in participants and market capitalization.

Regulators worldwide are looking at the introduction of these new concepts to the financial industry, trying to understand how to set up a regulatory framework that will allow the industry to benefit from the technical innovation while still complying with regulations and providing the required consumer protections.

In the article below, we aim to cover some of the risks associated with DeFi and explain how NEXUS, our SaaS solution creates a bridge between traditional finance and the DeFi ecosystem to mitigate some of those risks.

The risks of DeFi

With decentralized finance (DeFi), parties execute transactions directly between themselves without going through a third party. Instead of using a central authority, DeFi uses distributed ledger (DLT) technology to record transactions. Transactions are directly settled between two accounts, with no counterparty risk. Still, other risks are present and have affected the industry severely over the past years.

Liquidity Risk

If there is insufficient liquidity in the market, traders will not be able to buy or sell assets quickly enough. The lack of liquidity means that prices will fluctuate more than usual.

Operational Risk

With no intermediary or central party in charge, there is nowhere to turn to or no one to hold accountable should things go awry. You have little recourse should your funds be stolen from Defi projects or if something goes wrong.

Regulatory Risk

One of the most significant risks associated with DeFi, is regulatory risk. If regulators decide to crack down on specific aspects of the industry, then investors might lose confidence in DeFi. On the contrary, investors will be more willing to invest in DeFi projects that have the approval of the regulating authorities.

Impermanent loss

Impermanent loss occurs when liquidity providers trade their tokens on the DeFi. The shift in the token distribution will cause the price of the tokens to change (appreciate or depreciate).

It is important to understand the risks associated with Defi protocols before you start investing. However, this technology has a lot of benefits to offer to the financial markets, but regulation is needed to inform and protect investors.

Dutch National Bank on DeFi regulation

The central bank and supervisory authority also say that the rapid developments in crypto markets make it essential to continue evaluating, tightening, and expanding regulations. For instance, further regulation in financial services offered decentral through blockchain technology – also known as Decentralized Finance (DeFi) – is likely going forward.

Source: The Dutch National Bank

deFi regulation, Dutch National bank

What we learned from crypto regulation

Currently, DeFi is unregulated, but as we addressed before, the financial authorities are gearing up to regulate DeFi. Here is what we can learn from the crypto asset regulations.

Critical components of crypto-assets regulation:

KYC/AML – Know Your Customer/Anti Money Laundering

Know Your Customer (KYC) and Anti Money Laundering (AML) laws require financial institutions to verify the identity of customers before allowing them access to services. These laws were put into place to prevent money laundering and terrorist financing.

Anonymous Trading

Anonymous trading refers to the ability to trade without providing personal identification. This type of trading is common among peer-to-peer marketplaces. While peer-to-peer transactions most likely will not be regulated, the on and off-ramp from fiat currency to crypto and vice versa are already regulated. Regulated CASPs are not permitted to receive or send crypto to anonymous wallets.

The trend is clear. All national or regional financial regulators align with the FATF recommontation that specifically addresses DeFi.

Securities law (or Capital Markets law)

Securities are financial investment in which a corporation or organization offers security to raise capital for its business. The regulation on securities is an independent set of regulations implemented per country or region. Depending on the protocol (smart contract) the service could be considered a security and, therefore, should comply with capital markets laws.

In the European Union, the issuer must conduct a legal analysis of whether these tokens have the characteristics of financial instruments within the meaning of MiFID II In the US, a common way to determine if an asset would classify as a security is to conduct the Howey test.

Read more: The advantages of digital securities.

Future of DeFi

DeFi offers greater transparency, and efficiency than traditional banking systems because it allows investors to interact with financial protocol directly without going through intermediaries.

We expect that DeFi will become an integral part of our financial system. It will provide new ways to invest, borrow, and insure. We also expect that DeFi will continue to evolve as new technologies emerge.

Appropriate regulation and supervision ultimately increase trust in these solutions and support their distribution.

How NEXUS can help you comply with regulation

Regulated DeFi requires due diligence for issuers and investors. Our solution NEXUS can help issuers comply with the upcoming regulation. Furthermore, we are ISO 27001 certified and ISAE 3402 compliant, these certifications are internationally recognized as an essential standard for companies in the financial sector.

KYC/KYB and Onboarding

Integrate KYC/KYB and onboarding solutions for customer-friendly onboarding. Only onboarded customers and businesses are authorized to use the services offered by the user.

AML and Fraud Prevention

NEXUS offers comprehensive customer compliance and risk management tools. The system generates compliance reports accepted by an AA- (Fitch rating) bank. Additionally, all transactions are fully traceable and auditable.

Geographical access

It is possible to limit investors’ access depending on the token classification and regulation in specific countries or regions.

Trust levels

NEXUS also provides an additional compliance security measure called Trust levels. These limits the amounts investors can buy or sell per day, month, or year, allowing for specific constraints for each trust level.

Get in touch to discuss how we can help you

Henri de Jong

Chief Business Development Officer

Quantoz N.V.
Europalaan 100
3526 KS Utrecht
The Netherlands

Registration number: 86401386





    Published On: December 20th, 2022 / Categories: Publications / Tags: , , , , /
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