13 December 2023

Bankenverband: Discussion paper Decentralised Finance – an evolution of the financial services sector?

The DeFi platforms are usually characterised by low barriers to entry, a lack of geographical restrictions and a high degree of autonomy from the traditional financial system, known as centralised finance (CeFi).

Decentralised Finance, abbreviated to DeFi, is the collective term for financial services that are automatically offered via decentralised protocols on public blockchains.[1] The main feature of DeFi is that transactions are conducted via a protocol consisting of smart contracts, which automatically link the two parties with one another. There is no other centralised authority. The DeFi platforms are usually characterised by low barriers to entry, a lack of geographical restrictions and a high degree of autonomy from the traditional financial system, known as centralised finance (CeFi). 

The range of possible services and transactions is diverse: from interest and yield strategies to lending of crypto-assets and derivative products. However, the DeFi market is currently highly volatile and complex. Investors and clients themselves are responsible for ensuring that offers are above board and, in the worst case, run the risk of losing some or all of their invested capital. Compared to the traditional financial system, DeFi still has somewhat of an experimental character.

There is no doubt that DeFi will be able to usefully complement existing financial services offers, as long as the DeFi market further develops and matures. Banks will also play a key role here: As highly regulated, trusted intermediaries and infrastructure providers in the financial market, they can offer capital efficiently and help DeFi providers meet regulatory requirements. In order for DeFi to serve the real economy to a greater degree and be safer for consumers, there must be more trust, transparency and reliability in the DeFi market.

Banks have already been engaged and supported projects in the DeFi environment with their expertise, but so far these have been isolated instances. One of the main reasons for the low level of engagement so far has been the lack of clarity on the regulatory treatment of DeFi protocols. This makes it difficult for regulated institutions to work with DeFi providers or enter the market. In principle, supervisory legislation is designed to be technology-neutral, so the decentralised nature of financial applications should not really play a role. However, at the heart of these regulatory uncertainties is the question of which party requires a licence to provide regulated financial services and how regulatory measures can be enforced, as these applications have highly decentralised organisations behind. 

According to DeFi principles, there are no central providers, instead, digital protocols are kept between all participants in coordination procedures. There are a number of solutions to the problem of the lack of a regulatory addressee on the market, e.g. automatic reading and monitoring of DLT registers by the supervisory authority and regulatory requirements being met voluntarily through the certification of protocols. The supervisory authorities are called upon to identify best-practice approaches through cooperation at a global level that can subject DeFi protocols to holistic regulation in the interests of protecting investors. 

With this paper, the Association of German Banks aims to hone a common understanding of DeFi, explain basic functionalities and highlight regulatory hurdles and initial potential solutions. We are convinced that DeFi will continue to expand and grow in market acceptance, and that banks will keep playing a strong role in a market featuring DeFi.

BDB

© BDB - Bundesverband Deutscher Banken