By Michał Andrzejewski for GovTech Europe.
Learn more about decentralised finance and what it means to governments in Europe, particularly as debate over the proposed ‘digital euro’ continued.
Michał is an economist and lawyer in the field of European Law, and a business consultant in the FinTech industry. He is also a graduate of the New York University Abu Dhabi and the Bocconi University in Milan, and a researcher at these universities, specialising in the fields of economic policy and competition law. He advises clients at Nextrope, a leading provider of Blockchain services in the CEE region.
DeFi: WHAT IT MEANS AND WHY IT’S IMPORTANT
DeFi is short for: Decentralised Finance. To understand what this term encompasses, we must go back to 2009, when Bitcoin was released as the world’s first cryptocurrency. In the beginning, its utility was rather limited; Bitcoin was treated as an interesting cryptographic, technical innovation. Soon it was embraced as a speculative, highly volatile digital asset. In the first days, Bitcoin and subsequent cryptocurrencies were not involved in any sophisticated financial and digital products.
However, it didn’t take the FinTech community long to realise the potential of cryptocurrencies, beyond their speculative value. Now, the DeFi space encompasses all types of financial instruments operating without the need to rely on intermediaries (brokerages, exchanges, or banks). Transactions are concluded using computer algorithms called smart contracts and powered by the Blockchain. Such a system redefines the paradigms of our present economic structures.
As of March 2022, there are approx. 82 million Blockchain wallets, conducting over 250,000 transactions daily. This is not much compared to traditional systems (e.g. card transactions); for instance, Visa operates 150 million transactions a day. What matters, however, are the trends. The adoption of DeFi shows the same patterns as the early stage of debit cards and online payments. Within the past three years, the number of DeFi wallets more than doubled. DeFi is already making an impact on the financial industry that regulators cannot neglect.
What can we see in terms of the developments in the DeFi space so far? After over 10 years that it’s been around, decentralised financial products are either being tested or have already been adopted by top financial institutions, investors, innovators. Now it seems inevitable that DeFi will stay with us. It streamlines transaction processes and offers financial efficiency, so much needed in the globalised, fast-paced world.
WHAT THE DeFi CONCEPT CAN BRING TO GOVERNMENTS AS THEY MODERNISE THEIR TECH CAPABILITIES
With the rise of e-commerce and digital payments, the need for easy mass-access transaction systems is ever-increasing. Private entities (banks, financial apps, social platforms, online stores) already offer cryptocurrencies, tokens, and decentralised payment methods. The demand from the public is enormous; in my view, for two fundamental reasons. Firstly, a significant portion of the traffic in DeFi is driven by speculative opportunities to investors. Secondly, in retail finance DeFi products are already used to circumvent some steep hurdles set by conventional entities, such as: high transaction fees or deposits’ interest rates way below the rate of inflation, causing people to lose money in real terms, as they try to make some savings. There is also a great potential of DeFi in disrupting cross-border payments – so crucial for migrant workers sending remittances to their families abroad.
Now, central banks and governments of major economies are either researching or testing digital currencies of their own. In China, the electronic yuan is already out. In the EU and US, there are talks and first experiments with the digital euro and dollar, respectively. Around the world, the leading central banks realised that DeFi is a space where public presence may be either advantageous for citizens, or necessary for the long-term stability of modern financial markets. Extensive theoretical research has presented arguments for and against it. I think that the key reason for governments to get seriously interested in the digitalisation of finance, is that it’s inevitably going to happen – either on the governments’ watch, or without it. Therefore, regulators can use their edge to bring to this space greater confidence and trust.
THE CURRENT REGULATORY CHALLENGES TO DeFi
The DeFi industry can bring about many advantages to businesses and citizens, yet there are some risks currently present. As the saying goes, the devil is in the detail. We observe that at Nextrope, as a developer of Blockchain-based products. We have a complete outlook on technology details, with very advanced protocols and solutions that we prepare for our clients, ranging from large Polish banks to international start-ups. I’m sure I’m not alone in saying that a similar understanding of DeFi on the part of public experts, would greatly benefit all stakeholders of this space: technology developers, investors, consumers, as well as the broader society.
All those entities face risks that cannot be neglected. Disintermediation, with the help of digital technologies, brings efficiencies but requires very high levels of awareness from users and consumers. Firstly, the Blockchain protocol is built in a way that transactions cannot be reversed. Unlike in a bank, there is no physical branch where account holders may seek help. Secondly, there is the question of cybersecurity. Although DeFi products are secured by the nature of Blockchain technology, their usage may be subject to abuse by some parties with the wrong intentions.
Therefore, a fundamental challenge lies in awareness and know-how by individual users. Governments may play a crucial role in raising that citizens’ awareness – yet without scaring them away from Blockchain; experience has shown that such activities were rather futile. It would be most valuable, if the government action addressed vulnerable citizens with limited technical and financial literacy. That is to be done on all levels: from high-level, regulatory oversight, to spreading knowledge via public communication.
THE SOLUTIONS TO THOSE CHALLENGES
Expertise coming from established bodies would help to mitigate the unfit regulatory structures that the DeFi industry is facing: either a harmful legal vacuum or an inefficient public oversight. As cryptocurrencies were first launched, many governments seem to have either neglected their importance or actively pursued to disincentivise investors away from them. Such a strategy proved very ineffective. Blockchain-based products were adopted regardless – not only by individual speculators, but also large institutional investors. If DeFi is to prevail (and most likely it will), we’d better adopt appropriate rules.
Now, many regulations apply to FinTech entities, directly or indirectly. PSD2, MIFiD II, you name it. However, the extent and detail to which particular DeFi solutions fall under their control, is often unknown. I believe that public offices should collaborate with industry experts, to produce an efficient and fit-for-purpose legal framework and supervise the DeFi space appropriately. Consequently, we would realise the full potential of DeFi, to the benefit of markets and consumers.
DeFi’s FUTURE IN EUROPE
In the European Union, we are blessed to operate in the world’s largest integrated trade bloc with 447 million consumers. Innovative businesses await tremendous possibilities out there. As a single market, also the FinTech and DeFi space in the EU is looking mainly to the regulatory developments happening in Brussels, and Frankfurt – respectively by the European Commission, the Parliament, and the Central Bank (ECB). I am convinced that the European innovators and regulators have all the tools to make Europe into the global leader of this industry.
The EU is still investigating the worthiness of a publicly-backed virtual currency to rival private equivalents like bitcoin. This ‘digital euro’ would follow other examples like China’s ‘digital yuan’ which has already been tested extensively among the general public.
Currently, all the relevant developments for DeFi entities are in progress, or on hold. In September 2020, the European Commission released a Proposal for a Regulation on Markets in Crypto-assets. In July 2021, the ECB launched a pilot project on digital euro. However, we can read in the official communication that “this doesn’t mean that [the ECB] will necessarily issue a digital euro, but rather (…) will get ready to possibly issue it.” I believe that the DeFi space is awaiting further clarification and certainty on this matter.
I am personally optimistic. In February 2022, the EU Commissioner for Home Affairs Ylva Johansson said that “the EU is open to cryptocurrencies including Bitcoin or a digital euro, but regulations must first be strengthened to prevent fraud”.
Observing the Blockchain and DeFi space for years, I reckon the value and opportunity at stake is great. With appropriate regulation and incentives, more present projects can be either attracted to the EU market. In turn, that would make the benefits of the DeFi industry widely accessible to the European public. With time, new projects would emerge, as they are currently seeing steep competition from expanding Blockchain hubs, such as Dubai and Switzerland.
Europe could therefore leverage its expertise in technology, high capital of advanced economies, and law-making tradition. As European investors, developers, and societies, we should get many pieces of the puzzle in the right order, to ensure that our financial and technological tools are fit for the economic exchange of the upcoming decades in the digital age.
