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Forbes
Forbes
Business
Lawrence Wintermeyer, Contributor

DeFi Innovates At A Blistering Pace As Regulators Take Action

'Speed Camera Ahead' getty

In August SEC Chair Gary Gensler called on Congress to give the agency more authority to better police cryptocurrency trading, lending and platforms - a "wild west" he said is riddled with fraud and investor risk. This week's bitcoin flash crash briefly wiped over $400 billion off its market value, dropping 17 percent before a steady recovery to close down 1.3 percent and fuels regulators concerns about its suitability for retail investors.

DeFi is often likened to the “wild west,” by regulators looking into flash loans, buggy smart contracts, and so-called “rug pulls” which blight the industry, however, the relentless growth of DeFi innovation continues at a blistering pace and nothing appears to deter VC funds from queuing up to invest in up-and-coming projects.

Bloomberg reported in mid-June that crypto projects had netted $17 billion worth of investment so far this year. In June, renowned investment firm a16z recently launched a new crypto-focused fund worth $2.2 billion – the largest ever of its kind. The firm, part of Andreessen Horowitz, already owns stakes in flagship DeFi apps, including Compound, Maker, and Uniswap. 

Cardano’s ADA recently skyrocketing to a market cap of $90 billion, making it the third-largest cryptocurrency by market capitalization, behind only bitcoin and Ethereum. This enthusiasm was dampened somewhat when ADA dipped 32 percent during the flash crash this week, but it swiftly rebounded, paring back much of its lost ground. Bulls are hopeful that a $3 price point is around the corner.

With all this investment flowing into the space there are emerging trends that look set to shape the DeFi landscape into the future. 

An Expanding Range of Credit Types

Decentralized lending pools like Compound’s and flash loans pioneered by apps like Aave are among the core features of DeFi. However, the lending arm of DeFi has evolved based on a model that requires users to overcollateralize their loans. In a business where KYC doesn’t exist, and cryptocurrency prices can change at the drop of a hat, it’s become the de facto means of offsetting credit risk. 

TrueFi, the DeFi lending protocol operated by the same team as TrustToken, launched in late 2020 with a slightly different model. In the first version, TrueFi allowed holders of its TRU token to assess the creditworthiness of borrowers. This model removes the ability for borrowers to participate pseudonymously. Even so, TrueFi has originated over $220 million in collateral-free loans since launching, with TRU holders approving loans, including Alameda Research and Poloniex. 

With the project’s latest iteration, it believes it can level up to another $250 million. Private borrowing introduces the ability for institutions to have their credit scored pseudonymously so that they can borrow without having to disclose their company particulars to a pool. Anonymity is contingent on meeting loan terms and the move is designed to enhance the appeal of TrueFi to a broader range of traditional and crypto-native firms. 

Connecting a Broader Range of Assets to DeFi

Another feature that’s characterized crypto lending to date is that borrowers are generally only able to deposit their crypto as collateral. Another emerging trend seems to be towards connecting a variety of other asset types to the DeFi ecosystem.

DeFi’s growth to date has been inside the walled garden of the blockchain, unconnected to any of the value that exists in other asset types. Allowing users to stake physical assets such as cars or real estate as collateral to take out a loan is a huge step forward. Over the last few months, Maker and Centrifuge have been offering this feature as a way to mint DAI stablecoins.

Yield farmers earn interest from trading fees when depositing cryptocurrency that was otherwise sitting idle in their portfolios. Many yield farmers shop around, moving assets from pool to pool in search of the best APY. The end result is greater liquidity within DeFi lending pools while simultaneously earning the depositor a return. 

The possibilities here are endless, allowing anyone to put any real-world assets to work earning yield or serving as loan collateral in DeFi. The Maker feature is a step in the right direction, but newer entrants are taking things further. Ufit is a DeFi protocol with an NFT abstraction layer, which wraps non-fungible tokens into a generic form of NFT which can be deposited into DeFi dApps to earn interest. 

You don’t need to limit thinking to NFTs as artwork or the other trends that have hit the space over recent months. Ufit states in a blog post, “Our understanding of NFT is not limited to the category recognized by most participants in the crypto circle. We envision the inevitable rise of a paradigm where crypto and real-world assets are combined to create a rich set of innovative financial instruments.”

The Omni-Chain DEX offered by Sifchain recently became the world’s first decentralized exchange to not just allow trade between the Cosmos ecosystem and the Ethereum blockchain, but any EVM-compatible chain, supporting Inter-Blockchain Communication (IBC) between Sifchain and Cosmos (for ATOM), Akash (for AKT), and Sentinel (for DVPN).

More connections are being worked on, including Iris (for IRIS), Persistence (for XPRT), Osmosis (for OSMO), Crypto-org (for CRO), Regen (for REGEN), and Starname (for IOV). This kind of work should enable blockchain assets to have greater adoption through ease of movement between blockchains.

Enterprise-grade DeFi 

The ability to stake other assets than crypto as a means of obtaining credit is likely to feed into another emerging trend with enterprise DeFi. While it’s an incredibly nascent segment, the potential here is vast. Tokenization of debt obligations such as invoices offers the opportunity for businesses to unlock liquidity via decentralized protocols without paying fees or percentages of their revenues to intermediaries. 

Invoice tokenization is a concept already being deployed by Coke One North America (CONA) which has integrated the Baseline Protocol and makes extensive use of blockchain throughout its distribution network. 

Trace Network leverages the same principles for its NFT-cum-DeFi platform aimed at enterprises. Trace Network is targeting the luxury goods industry for its supply chain traceability platform, which uses NFTs to provide proof of provenance. The protocol also allows businesses to access a range of financing options such as tokenized invoice factoring or using physical inventory as collateral to access lines of credit. 

All Eyes on the Regulators

So far, DeFi’s inexorable rise has been unimpeded by regulatory intervention and that looks as if it is about to change. The Financial Action Task Force (FATF) has subtly implied that DeFi operators could be classed as “virtual asset service providers,” which would put DeFi under the same KYC and compliance requirements as cryptocurrency exchanges. 

In June, representatives from the DeFi sector attended an event hosted by the International Organization of Securities Commissions (IOSCO) to begin the process of explaining how DeFi works to lawmakers. Even though the process is likely to be characteristically glacial, we can expect regulatory developments to feature as another defining trend of the DeFi sector from now on. 

Recently, U.S. Securities and Exchange Commission Chair Gary Gensler strongly indicated that as DeFi projects include more features that resemble other entities normally regulated by the SEC, they might wind up on the Commission’s regulatory radar.

“There’s still a core group of folks that are not only writing the software like the open-source software, but they often have governance and fees,” says Gensler, “There’s some incentive structure for those promoters and sponsors in the middle of this.”

The tension between regulators and industry players reached something of a boiling point this week, when Coinbase announced the delay of its “Lend” product until at least October, following a threat of legal action by the SEC, who determined the product meets its definition of a security. 

In a subsequent tweetstorm, Coinbase CEO Brian Armstrong criticized the Commission’s handling of the matter and pushed back on their assertion, insisting Lend is neither an investment contract nor a note.

Given the opportunities for the innovation of the global financial service sector that DeFi offers, with great benefits for consumers, industry and the economy, lawmakers will want to strike a careful balance between regulation and innovation. Suffice to say, DeFi will remain one of the most exciting and fast-moving segments of fintech for plenty of time to come.

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