DeFi is being debunked as investor doubts and regulatory scrutiny grow

The year 2023 would be the year when decentralized finance platforms (DeFi) would prove their worth.

Cryptocurrency observers predicted a rise for the DeFi sector after the public fallout from the FTX collapse, along with other industry implosions, which undermined trust in centralized digital asset platforms.

Instead, the opposite happened. Decentralized cryptocurrency platforms have seen their spot trading volumes drop by nearly 76% since January last year.

DeFi fortunes are also being hammered in Washington with the introduction of the bipartisan Crypto-Asset National Security Enhancement and Enforcement (CANSEE) Act.

The law imposes new safeguards designed to eradicate the use of crypto in money laundering and specifically targets DeFi platforms and services, requiring them to meet the same anti-money laundering (AML) compliance obligations and economic sanctions as other financial firms, including centralized crypto trading platforms, casinos and pawnshops.

“This is a trend we’re seeing across multiple jurisdictions to hold DeFi companies and services to the same standards as traditional financial institutions, which will hopefully increase transparency in the industry and reduce illegal activity,” said Jill DeWitt, senior director of financial crime compliance at Moody’s Analytics, in a statement to PYMNTS.

“All companies involved in the US financial system need to know who they are doing business with, including ownership, traceability of transaction origins and sanctions screening,” she added.

By design, DeFi offers anonymity. Perhaps that is why the sector is not so well in the spotlight.

Also see: Is DeFi infrastructure ‘tailor-made’ for crypto risk management?

DeFi Under Siege as sentiment shifts

The real-world usefulness of the crypto sector, more than a decade after its commercialization, remains somewhat shrouded, while the appeal of digital assets is increasingly blunted by ongoing industry turmoil and regulatory scrutiny.

Decentralized crypto platforms facilitate digital asset trading by using smart contracts that allow users to hold their tokens in custody rather than transferring them to centralized custodians or intermediaries.

“This technology is actually better than the existing one [centralized] infrastructures from a security perspective,” said Dr. Yan Zhang, co-founder of Web3-native payment aggregator Pelago, told PYMNTS in April.

Connecting buyers and sellers directly without intermediaries, DeFi platforms aim to remove the risk of misappropriation of funds or platform mismanagement (a la FTX) by relying on algorithmic automation to anonymously match interested parties.

This fully technical approach also helps to obscure the various parties and is rife with money laundering and malicious abuse.

Criminals, drug traffickers and hostile state actors like North Korea have all shown a tendency to use DeFi as a preferred method of transferring and laundering ill-gotten gains.

According to an April U.S. Treasury Department report, “Illegal actors, including criminals, scammers, and North Korean cyber-actors, are using DeFi services in illicit money laundering.”

In general, DeFi services appeal to sophisticated crypto proponents who can deftly navigate complex and technical user interfaces. The lack of ease of use makes it challenging for institutions to act on, as do the inherent compliance issues.

Read also: Crypto continues to serve as a case study in behavioral economics

The Regulatory Prospects of Crypto

While trading volumes on DeFi platforms have dropped by more than three-quarters since January 2022, volumes on centralized exchanges aren’t faring much better, dropping nearly 69% over the same period.

That’s because the crypto sector has become increasingly contentious, as a historic lack of regulatory clarity enabled bad actors who then tarnished the industry’s reputation among private and institutional investors, as well as policymakers.

Despite a landmark precedent in the Securities and Exchange Commission’s (SEC) Ripple case, Capitol Hill’s prospects for crypto are shifting as lawmakers try to rein in what they see as a history of past abuse.

Congress has introduced 50 bills related to crypto and digital assets since the beginning of this year, two of which will be voted on by the committee on Wednesday (July 26) and Thursday (July 27).

“The digital asset space is confused with regulatory uncertainty, lack of authority and lack of framework for core principles,” said Rep. Dusty Johnson of South Dakota in a statement.

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