The promise of decentralized finance (DeFi) is intoxicating: an open, borderless financial ecosystem that operates without the need for intermediaries. But along with its meteoric rise, DeFi has also stumbled hard. Billions of dollars have been lost through carpet tampering, hacks and protocol errors, leaving consumers in jeopardy and the industry’s credibility in tatters. From the demise of Terra and Celsius to the countless smaller projects that collapsed under poor governance or outright fraud, the DeFi experiment has often looked less like a revolution and more like a high-stakes casino.
Why did this happen?
At its core, blockchain technology does not govern the people who write the logic that makes smart contracts possible. It does not take into account the operational risks of running a chain or the pitfalls of human error. There are no universally accepted best practices or protocols that dictate how decentralized finance should function. Even simple smart contract audits – the supposed protection for users – are woefully inadequate given the complexity and risks involved.
This raises uncomfortable but necessary questions:
Who is responsible for governing the architects behind blockchain smart contract logic?
Who should be held responsible for malicious activity or faulty code embedded in a smart contract?
Are all blockchain-based agreements inherently trustworthy?
Would you be willing to trade on a blockchain or with a smart contract, knowing these risks?
The truth is becoming unavoidable: some risks cannot be automated.
Insider threats, cybersecurity gaps, governance shortcomings, and failed smart contract upgrades all expose DeFi to vulnerabilities that no algorithm can solve. And the consequences have been devastating.
The golden age of DeFi, once heralded as the future of finance, has frozen in a bitter winter. Funds have disappeared, optimism has eroded and trust – perhaps the most valuable currency in any financial system – has been decimated. By some estimates, more than $3 billion was lost to DeFi-related hacks and fraud in 2022 alone. The sector remains in recovery mode and limps forward in search of the next chapter.
Herein lies the hard truth: DeFi cannot survive on code alone.
If the sector wants a future, it must embrace regulation – not as a betrayal of its ethos, but as an evolution of it. Regulation does not have to eliminate decentralization; it can complete it and provide the structure and accountability that DeFi sorely lacks.
Regulatory frameworks are already being debated, with strategies ranging from regulating entities and coders to overseeing specific activities and embedding oversight mechanisms directly into blockchains.
The goals are clear: make DeFi a more secure place with clarity in responsibility, improving user protection and a better risk management mechanism.
These are not against the ideals of DeFi; they form the basis needed to make these ideals sustainable.
Responsibility
Liability ensures that those who build and maintain DeFi platforms can be held accountable for their actions (or their inactions). This does not mean that innovation is suppressed; it means creating a system where trust is not just based on code, but also on the people behind it.
For example, when the Terra ecosystem imploded, billions of dollars were wiped out almost overnight, devastating countless investors. No one was responsible for the flawed design of the algorithmic stablecoin or the reckless scaling of the ecosystem. Regulations could impose clearer disclosure requirements or liability frameworks for developers and project managers, leaving those responsible for such failures to face the consequences.
Similarly, imagine a decentralized exchange (DEX) that knowingly introduces a vulnerability in its smart contract but fails to disclose it, leaving users exposed. Without accountability mechanisms, there is no recourse for these users. Regulations may require audits and disclosure of security measures, aligning the interests of developers and users.
User protection
DeFi is often compared to the digital Wild West, where the lack of safeguards leaves users vulnerable to bad actors. From phishing scams that target wallets to rug pulls that drain liquidity sources, users often bear the brunt of the industry’s growing pains.
Take for example the Poly Network hack, where over $600 million was stolen in one of the largest DeFi exploits to date. The hacker eventually returned the money, but only after significant public outcry and negotiations. What if there had been protocols to freeze or recover stolen assets in real time? While critics argue that this could undermine decentralization, such user protection mechanisms could save billions and increase trust in the system.
Another concern is access to reliable information. Projects often exaggerate returns or gloss over risks, leaving users in the dark about what they are really getting into. Regulatory frameworks could introduce standardized risk information, just as the traditional financial sector does with investment fund prospectuses. This would allow users to make informed decisions and eliminate bad actors who rely on opacity.
Risk management
Risk management is perhaps the most pressing challenge in DeFi as the industry continues to grapple with complex threats ranging from insider exploitation to systemic vulnerabilities.
Take, for example, the infamous 2016 DAO hack, where $60 million was siphoned off due to a flaw in the smart contract code. Although Ethereum chose to fork the blockchain to get the money back, this solution was divisive and highlighted the lack of contingency planning in decentralized systems. A regulated approach could require projects to implement robust risk management practices, including rigorous testing, real-time monitoring and contingency mechanisms.
Another critical issue is liquidity risk, especially in protocols that rely on pegged assets such as stablecoins. The collapse of Terra’s UST stablecoin was not only a failure of algorithmic design, but also a failure of risk management. By enforcing capital adequacy rules or requiring collateral reserves to support linked assets, regulators could prevent similar crises in the future.
Ultimately, regulations provide DeFi with a lifeline. It promises to transform the space from a digital Wild West to a safer, more trusted ecosystem where users can participate without fear of losing everything to the next exploit or implosion. After all, trust isn’t just the cornerstone of traditional finance; it is the bridge that DeFi must cross to truly reach the mainstream.
The question is no longer whether DeFi should embrace regulation, but how. And the sooner the industry stops seeing regulation as a threat and starts seeing it as an opportunity, the closer we will come to realizing the promise that sparked the movement in the first place.
