3 min read

The Future of DeFi – Its Impacts on Financial Service Providers and AML

In recent times the crypto currency industry went through a phase of rapid growth which spawned a vast spectrum of projects exploring various use cases for blockchain technology. One of the biggest growth sectors within crypto is DeFi (Decentralized Finance) which started becoming popular in mid-2020.  

DeFi is an umbrella term which encompasses financial protocols/applications/services that are built on smart contracts blockchains like Ethereum. 

They include lending protocols (see Terra, AAVE, Compound), trading platforms (see Mirror Protocol, DyDx), Automated market makers and decentralized exchanges (see UniSwap, THORchain). 

These applications aim to replace traditional financial institutions by cutting out the middleman to lower operation costs and providing fairer yields for their users. With the advent of smart contracts, this is now possible. Programmable money can reduce a financial institution like a bank, brokerage, exchange or even insurance company (see Nexus Mutual) to a few hundred lines of code. 

 A future without banks? 

The total amount of value locked into DeFi protocols rose from $4 billion (about $12 per person in the US) in August 2020 to $194 billion (about $600 per person in the US) as of March 2022. This is over a 4700% increase in usage over two years. A lot of this growth is attributed to the hype surrounding the crypto industry; however, do not mistake all of it for a bubble, genuine growth is also present as savvy crypto users opt to park their savings in DeFi protocols over a traditional savings account. This is due to the interest rates offered by banks being exceptionally low and not keeping up with the ever-rising rate of inflation. In early March 2022, a high interest savings account at a well-known American bank will net you 0.5% APY. On the other hand, if you were to stake your dollars in USDT (a stable coin which holds the value of the dollar regardless of market volatility) on AAVE you would get a flat 2.6% + 0.23% bonus in the form of a token. These returns on stable coins are much higher when the crypto market is doing well (risk-on environment) reaching as high as 17% APY in the past. When the crypto market crashes, these APYs decrease as more liquidity is rotated into stablecoin protocols from other volatile currencies. This is because they are safer since they don’t drastically fluctuate in value, this influx of liquidity increases the supply that lenders have available, and decreases yields as a result. 

In this time of extreme fear in global financial markets, growth stocks and speculative assets have an unclear future ahead; the upcoming Federal Reserve interest rate hikes to combat inflation will undoubtedly slow down economic growth. Yet DeFi users are not leaving. 

The S&P 500 is down -14.5% in the last 2 months. The total market capitalization of crypto is down -43% from its peak in November of 2021, with the AAVE token being down a staggering -82% from its all-time-high. Russian stocks collapse due to war, Chinese stocks crash with the looming Evergrande disaster, rapidly rising inflation, quickly aging workforce, global debt approaching $300 trillion (about $920,000 per person in the US). How will DeFi and crypto react to the global financial meltdown that is to come? Are crypto currencies far enough detached from the current financial system and could we see a mass migration to these protocols if banks get into financial trouble? Not anytime soon, mainly due to current smart-contracts platforms being extremely inefficient at handling substantial numbers of users; however, maybe in the future, once much needed upgrades to blockchains are developed. On this we can only speculate. 

What does this mean for AML? 

Keep in mind that DeFi is in the early stages of its infancy and many key concepts and mechanisms are still being developed; therefore, a lot of things are subject to change in the coming years, mainly about regulatory clarity. With continued growth, the amount of money flowing through DeFi will be too big to ignore. Eventually governments will be forced to pay attention to this growing industry. This means that there will be a market for suitable AML, taxation, and identity solutions to be built by private companies on these blockchains, especially as many world governments are looking at CBDCs (Central Bank Digital Currencies). Currently it is unclear how much of the money flowing through DeFi protocols is originating from criminal activity; a part undoubtedly is. However, with proper blockchain regulation and compliance, virtual currencies could be legitimized and integrated into the traditional financial systems. These systems, if implemented correctly, could prove much more efficient at detecting money laundering and fraudulent activity than traditional systems, since blockchain transactions are very transparent and easy to trace with the correct tools. At this point there are no complete solutions for tracking identities on blockchains, making KYC and CDD impossible. There are a few startups trying to tackle this issue (see Civic, Litentry). 

For this integration to become reality, added blockchain infrastructure must be developed to enable interoperability with co-operation between governments and public blockchain developers. These two groups have had a rocky relationship to this point. Crypto currencies sprung up to directly oppose centralized power structures like central banks and the government after the subprime mortgage crisis of 2008. Many banks that caused the crisis got bailed out by the IMF because they are “too big to fail”. This prevented an economic collapse; but left many affected by the crash with a distaste for centralized institutions.