Rise of decentralised finance
EXPONENTIAL growth of decentralized finance in recent years is causing disconcert in traditional financial sector. For those who may not be aware of growing developments let me begin with basics.
Traditional financial sector comprises of capital markets, banks, equity and bond markets. Typically, entire financial sector is regulated by government through regulators and a maze of financial laws.
For example, in Pakistan, Securities and Exchange Commission (SECP) is the corporate regulator while banks are regulated by State Bank of Pakistan. Government’s oversight of financial sector does accrue a certain benefit. It is not possible to get up one morning and start an investment scheme soliciting money from people.
Aim of regulation of financial sector is to protect common investor from Ponzi schemes. As the financial sector is highly interdependent, governments are also wary of systemic failure in case of bank going into default causing a run on other banks.
Decentralized finance allows users to engage in activities of financial nature without meeting regulatory framework of the country. Let’s assume I want to raise capital for a business venture from general public.
For this purpose, I would need to float and sell shares to the public at large for which I would need to arrange for an initial public offering (IPO). This IPO would need to follow the requirements of Companies Act 2017 and meet certain standards. Invariably, in any country, offering a security for sale would have met stringent requirements of securities laws.
Defi on the other hand revolves around decentralized applications that perform financial functions on distributed ledgers called block chains, a technology that was first made popular by Bitcoin.
This concept of block chain has been replicated by numerous other entrepreneurs jumping in the arena and has since been adapted more broadly. Ethereum, Solana and Stellar lumens are some of other known and rapidly growing block chains.
Although cryptocurrency exchanges are playing a central role in trading and growth of cryptocurrency let’s be absolutely clear that transactions can be made directly between participants mediated by smart contract programs without any intermediary.
These smart contract programs, or DeFi protocols, typically run using open-source software that is built and maintained by a select team of developers or by interested community at large.
As increasing number of computer programmers use their skills trying to bring traditional financial products such as loans to the blockchain, several questions are arising. The idea sounds ravishing. Investors are enticed by the dream of turning billionaires overnight with some tokens showing historic growth.
Also, the idea that anyone could lend and borrow digital money at competitive interest rates, with no middle men involved is promising. There have also been claims that very soon these tokens would have real world usage replacing traditional financial products.
For example, proponents of XRP token (commonly known as Ripple) are of the view that the token at some stage may be useful to traditional banks for implementing international transactions.
Still there are detractors who chide cryptocurrency for having no real-world usage. They term it as a pyramid or Ponzi scheme cautioning investors of potential losses.
Criticism of such financial analysts is not completely out of place. There have been such bubbles in the past in which people have lost their fortunes. A small parable here might serve as guide for people who are too enthusiastic about cryptocurrency.
The Dutch tulip bulb market bubble, also known as ‘tulipmania’ was one of the most famous market bubbles and crashes of all time. Speculation in Holland during the early to mid-1600s caused a crazy increase in price of Tulips to the extent that the rarest tulip bulbs traded for as much as six times the average person’s annual salary at the peak of bubble. Today, the tulipmania serves as a red flag for the pitfalls that excessive greed and speculation can lead to.
Hence, various countries have cracked down on Binance, the world’s largest digital currency exchange, for operating without their authorization. Binance has no official headquarters which has helped it in remaining elusive. Binance has also publicly stated it considers regulators as a friend not as a foe.
Coinbase another, cryptocurrency exchange and most popular in the United States if facing similar heat. In September, representatives of the exchange got into a tug of war with the US Securities and Exchange Commission over a planned interest-earning savings product which was deemed a ‘security product’ by regulators.
Pakistan took a cautious route by banning cryptocurrency. However, with increasing investment in this sector it may not be possible to stick to a complete ban on cryptocurrency for long.
We would still need to protect our investors at two fronts at least. First would be to form a stringent and foolproof system to regulate any cryptocurrency exchange that begins to function in Pakistan.
This system would lay down basis for functioning of exchange, currencies to be traded, security systems to be installed to preempt hackers and several other features. Second would be to develop a legal framework for selling a cryptocurrency which has been locally developed. Treating it as an initial public offering and applying the same conditions mutatis mutandis would go a long way in avoiding any unforeseen issues.
—The author is a civil servant having an LLM from Harvard Law School, MSC from University of Oxford and an LLM from University of Turin/WIPO Academy.
