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Gemini cryptocurrency exchange logo seen on a Samsung Galaxy S9 Plus. Gemini said traditional financial regulations are not equipped to protect investors in decentralised finance, so new rules are needed. Photo: Shutterstock

Is the world ready for the lending risks from the rise of decentralised finance? Gemini says new rules are needed to ringfence DeFi risks

  • The cryptocurrency exchange said traditional rules are not equipped to protect investors in the fast-growing, US$247 billion decentralised finance industry
  • Blockchain-based DeFi is difficult to regulate because it is constantly transforming to stay ahead of regulators, says head of Hong Kong’s securities watchdog

Regulators should reach an agreement on how to define activities in the US$247 billion industry of decentralised finance, or DeFi, as existing rules are ill-suited for safeguarding against risks stemming from such crypto-lending services, says New York-based crypto exchange Gemini.

The comment followed the exchange’s launch of a lending programme in Hong Kong last month, which allows users to store and earn interest on 60 cryptocurrencies and stable coins. Gemini’s platform promises an annualised return of up to 8.05 per cent in exchange for lending these tokens out to various borrowers, who back up the loans with collateral.

As blockchain enables its users to borrow and lend funds with each other without the need for traditional players such as banks or brokers, existing rules governing these parties will not work for DeFi, according to Andy Meehan, chief compliance officer for Asia-Pacific at Gemini. There are currently no specific rules governing DeFi in Hong Kong.

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“There needs to be a general global agreement on what DeFi is and what mechanisms make the most sense for regulating the industry,” said Meehan. “But the answer is certainly not to apply existing frameworks designed to regulate the traditional financial industry to DeFi.”

The stance from the start-up valued at more than US$7 billion, and which runs a team of 50 in Singapore, underscores the increasing global popularity of DeFi, as regulators try to grapple with the risks from what some have coined the “shadow financial market”.

Between 2020 and 2021, DeFi users and investors have suffered from over US$12 billion in losses due to theft and fraud, according to crypto analytics provider Elliptic. The amount of money handled by related services, which include managing stable coins and other crypto assets, has grown 18-fold over the past year to US$247 billion.

Mehan’s comment echoes views from others in the industry that overregulation could hurt innovation. Last week, several US crypto exchanges, including CoinBase and FTX, urged Congress to take a light approach in regulating digital assets.

Meehan – who previously worked in a division of the US Air Force countering espionage, terrorism and cybercrime – said thoughtful regulations are needed to balance supporting innovation against protecting investors.

“There are many different facets to DeFi, so regulators need to be able to adapt to this new technology in order to establish the frameworks needed” to regulate it, he said.

Ashley Alder, chief executive officer of the Securities and Futures Commission in Hong Kong, delivers a keynote speech during HK FinTech Week at the Hong Kong Convention and Exhibition Centre in Wan Chai on November 1, 2018. Photo: SCMP / Nora Tam

However, regulating DeFi is challenging, according to chief executive of the Securities and Futures Commission Ashley Alder.

While digital finance provides many benefits such as financial inclusion, innovations like blockchain smart contracts, which automate crypto-lending activities, present risks that existing systems cannot deal with, Alder said at a seminar gathering central bankers and regulators in Hong Kong last week.

“Traditional regulation assumes that there is a legal entity, with an individual in charge with whom you could interact and be accountable. With smart contracts, there are none,” he said. “These organisations shape-shift within and across jurisdictions deliberately to keep ahead of ways that regulations could catch up. That’s the challenge.”

Hongkongers are among the world’s biggest investors in cryptocurrencies

In a recent report, Elliptic said DeFi is also being used to launder criminal proceeds, particularly tokens gained from hacks of crypto exchanges.

Hackers and scammers turn to decentralised exchanges to convert stolen tokens to ether, the native token of the Ethereum blockchain and second biggest cryptocurrency after bitcoin, because most decentralised exchanges do not impose identity and anti-money-laundering checks today, according to the report.

“We are seeing regulators grapple with the consequences of DeFi as they attempt to apply traditional regulatory principles to the unique risks and challenges presented by decentralisation,”, wrote Elliptic chief scientist and founder Tom Robinson and Chris DePow, senior adviser for financial institution regulation and compliance.