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Decentralized finance (DeFi) — one of cryptocurrency's most booming frontiers — is "going to end poorly" unless protections are bolstered for those who invest, Securities and Exchange Commission Chair Gary Gensler told Yahoo Finance this week.
DeFi uses a model for providing innovation in financial services such as lending, borrowing, savings, credit and insurance without the need of a financial intermediary, such as a bank. Speaking at the All Markets Summit: The Path Forward, Gensler compared DeFi to early peer-to-peer lending services that sprang up around the world in the 2000s.
He also cited financial stability concerns that have prompted the Biden Administration to regulate stablecoins, with a government working group expected to release guidance soon. However, industry participants have questioned how much retail protection DeFi needs, given the prevalence of large investors in the sector.
"Hopefully we get to the other side, where whatever innovation that's there survives, but again, the public's protected and we protect against financial stability concerns as well," Gensler told Yahoo Finance.
Crypto investors are wary of the SEC's involvement in the booming sector, with regulators using enforcement action to bring market participants to heel.
The latest skirmish has seen DeFi protocol Terra Labs going on the offensive by suing the SEC. The dispute comes down to the project's mirror protocol that let users trade synthetic assets valued in lockstep with real world assets such as S&P 500 (^SPX) stocks.
The main conflict between DeFi and regulators hinges on whether a project is sufficiently decentralized.
While the SEC has warranted that the two largest cryptocurrencies - Bitcoin and Ethereum - are sufficiently decentralized to be regulated as commodities, Gensler has previously said many DeFi tokens are 'Decentralized In Name Only (DINO),' and so its creators bare the full brunt of responsibility.
Legos of finance
Still in its early stages, DeFi has been likened to the financial equivalent of Legos. Without needing permission, developers can connect a wide array of financial applications to build entirely new services.
Because DeFi is so new and generally unregulated, these services aren't subject to the same kind of risk, liquidity and capital restrictions as traditional banks.
However, the question of self-regulation is on the minds of regulators like Gensler, who are concerned that if left unchecked, DeFi's infrastructure could pose risks to both individual investors and the broader financial system.
High profile examples of costly DeFi mistakes include exchange DiversiFi — which accidentally paid out a $24 million fee though in goodwill the recipient returned all the money — and DeFi protocol company Compound mistakenly paying out $90 million worth of tokens to its users. And less than three months before, hackers stole a much greater $600 million from the DeFi platform Poly Network, resulting in what's now considered one of the largest crypto-related cyber crimes.
“Crypto is the greatest Fintech innovation of all time,” Victor Fang, a veteran of cyber security company FireEye and current founder and CEO of the blockchain analytics startup, Anchain.
He added one caveat specific to DeFi: “If you make a mistake in your [coding] script, then you’re screwed big time and that’s just human error, meaning that you’re going to see a lot more,” he told Yahoo Finance.
Do these investors need protection?
Gensler's remarks to Yahoo Finance speaks to the idea that more oversight might be needed as the DeFi sector matures. If decentralized applications — especially those involving lending — trigger unintended consequences, it raises the question of who might catch a potential blow up and spillover effects to markets and investors.
As of October 21, DeFi analytics platform, DappRadar, showed that a total $178 billion is currently locked in DeFi protocols. Separately, a geography report by blockchain analytics firm Chainalysis indicates that the majority of volume in DeFi activity occurs in transactions sizes of $10 million or more, underscoring how big money and transactions dominate the nascent sector.
Additionally, most DeFi activity still occurs on the Ethereum blockchain, where network congestion has created transactions costs (also called gas fees) so high that smaller investors — the ones arguably most in need of investor protections — are severely limited in their participation, some argue.
Who are these big money players who've taken market majority in DeFi over the past year?
Venture capitalist funds "dedicated to crypto, crypto native DeFi funds, individuals who have been in the space for a long time and are sophisticated and have accumulated large capital balances," according to Shiliang Tang, CIO at quantitative hedge fund LedgerPrime.
David Hollerith covers cryptocurrency for Yahoo Finance. Follow him @dshollers.