Financial companies are hesitant to invest in decentralised finance because of uncertainties and operating risks posed by the unregulated DeFi market, a top official at Abu Dhabi Global Market has said.
While the traditional financial scene is witnessing the potential of DeFi, which introduces efficiency and enables service integration, regulators and DeFi advocates have to tackle its risks before mainstream adoption, Wai-Lum Kwok, senior executive director of authorisation and FinTech at ADGM’s Financial Services Regulatory Authority, told The National in an interview.
“Just like virtual assets in the past, we have the view that DeFi is at the cusp of becoming part of financial services. [But] the traditional financial sector currently faces a lot of constraints in terms of investing in DeFi,” Mr Kwok said.
“The challenge for traditional financial services firms is how to adopt and incorporate DeFi into their services in a way that still keeps their obligations with the customer to act with due care and diligence.”
For DeFi players who have never been regulated before, the challenge is understanding how to “transition to a regulated financial services mindset where they have an obligation to investors”, he added.
DeFi can potentially replace middlemen such as brokers and banks in the financial system and it is generally considered to be a safer way to conduct transactions based on blockchain technology.
The global DeFi platform market is expected to hit $507.92bn, a compound annual growth rate of about 44 per cent in 2028, Emergen Research reported.
But illicit activity is a huge problem, with money laundering, market manipulation and online theft among the biggest threats to DeFi, blockchain data platform Chainalysis said in a report last month.
While it cannot be totally eradicated, the reduced volume of illicit activity is a sign that market players are more engaged to combat these threats, which have the potential to cost users billions, it added.
Though DeFi is still in its infancy, discussions are increasingly taking place to study the pros and cons of the technology, Mr Kwok said.
In the international community, market bodies including the Bank for International Settlements and the International Organisation of Securities Commissions have done some foundational work, but there has not been much discussion on what a regulatory framework might look like, Mr Kwok said.
“We recognise that in order for us to develop the DeFi market, we need to appeal to a wider audience. To do so, we need to bring in regulations that will instil trust and confidence for traditional financial services firms to accept and embrace DeFi in a bigger way,” he said.
The current cryptocurrency crash is also playing a major role in financial companies’ perception of DeFi. The plunge in Bitcoin and other virtual assets, as well as the troubles that have beset crypto platforms, are being viewed as serious red flags for the industry.
Bitcoin, the world’s first and largest cryptocurrency, crashed below the key $20,000 psychological level on June 18 as investors continued to shy away from riskier assets amid concerns of rising interest rates as central banks try to rein in inflation.
The digital token has since pared back its losses and was trading at $20,732.66 as of 8.45pm UAE time on Tuesday, CoinMarketCap reported. Still, it is down more than two thirds from its peak of almost $68,000 last November.
This is holding back companies from investing in DeFi, although only on a short-term basis, said Mr Kwok, and regulators such as the FSRA and ADGM cannot offer any opinions on the merit of investing in any financial product.
However, the latest cryptocurrency spiral is a step in potentially rectifying issues within the industry, which would ultimately improve the market going forward.
“The correction that we are seeing in today’s crypto market could accelerate regulation of the market, providing more clarity and confidence to institutional investors to come in a bigger way,” he said.
ADGM, which recently issued a discussion paper on DeFi and opened its latest sandbox programme for FinTech firms to pitch their ideas on decentralised applications, is moving to start conversations within the industry to help realise its full potential.
Until the risks are properly addressed, DeFi’s growth will be stunted, Mr Kwok said.
“The end game is to work with industry participants to come up with an appropriate regulatory framework for DeFi that is robust and yet sensible and workable for the industry,” he said.
“We do not claim to have all the answers. We need to validate our opinions, views and policies with inputs from the industry.”
Updated: June 29, 2022, 4:00 AM