Regulators in the US and France have published reports on the risks of DeFi, with suggestions on preventing them. But would they actually work?

The crypto industry as a whole is already under strict scrutiny from regulators worldwide, but the decentralised finance (DeFi) sector is just getting its spotlight.

While authorities aren’t intent on taking the whole sector down, both authorities from the US and France have published separate reports which assess the risks DeFi may pose to its users, and the broader financial world. 

But one element of these reports is worth keeping an eye on: both analyses provide suggestions on how to prevent such risks from DeFi, while still having DeFi run its course.

What’s DeFi, to the eye of the regulator?

Decentralised finance (DeFi) has been gaining reputation as a topic amongst regulators to be concerned about. To the US and France, they’ve decided to publish reports that analyse potential risks that DeFi may bring to their respective governments.

In broader scope, DeFi is already known to regulators as being a crucial, and emerging part of the crypto industry. But with recent (and multiple) exchange collapses, bank failures, and bankruptcy, DeFi is getting much more attention than ever – with the spotlight on decentralised (or marketed as decentralised) projects in crypto.

And now, regulators are assessing where they can step in to oversee DeFi firms, projects, and services.

What in DeFi are regulators focused on?

At the moment, both the US Treasury Department and French central bank are looking at how  DeFi businesses meet regulatory requirements for anti-money laundering, and the ways in which DeFi and its technology can be potentially used in malicious activities and illicit finance.

In the US’s risk assessment, DeFi has been painted as a common denominator in major hacks, and money laundering – both major issues prevalent in the industry. 

Putting particular focus on North Korea’s use of DeFi for laundering stolen funds, and how DeFi may not meet know-your-customer/anti-money laundering (KYC/AML) requirements. Not to mention, hacking in general.

It’s a well-known fact that US regulators aren’t so friendly towards crypto. While they acknowledge that many DeFi projects stay open source to let community members spot vulnerabilities in the system, US regulators also see that this very factor of crypto is enticing for attackers to exploit.

“This vulnerability can be compounded if the smart contracts are not written carefully or if they lack a mechanism for quick deactivation or alterations if a critical exploit is identified,” the US report said. “As such, it is critical that the DeFi service identify and address vulnerabilities and potential exploits in open-source code.”

As for recommendations, the US made a range of suggestions, including “strengthening existing supervisory and enforcement actions” to meet appropriate legal requirements, and methods in which DeFi can better engage itself with the private sector.

France’s version also shares the same sentiments as the US: that the government can create a set of “minimum standards”, or criteria in which it would use to define how it assess risks, and decentralisation.

The French report also suggests that financial transactions should be moved to private blockchains, even creating a method for developer certification.

France also notices the same vulnerabilities that DeFi infrastructures have, from blockchain corruption, issues with scalability, and the potential lack of interoperability and security between blockchains if things in DeFi were to develop even further.

Requests for comment

The US Treasury department published a set of questions for public feedback, including ways in which it would define whether any given DeFi project may be a financial institution, and thus subject to Bank Secrecy Act regulations. The US is also seeking recommendations where more clarity can be given towards compliance.

Meanwhile, the French report contains a set of questions for public input, ranging on topics including what DeFi can be defined and used for, what risks the public sees, avenues for security and access, and how blockchain technology – particularly smart contracts – are used.

While both reports do not point signs to an outright ban of DeFi, both regulatory forces seem to be open to learning from the crypto community on what DeFi can do for the future of finance.