DeFi Gets Defanged as Investor Doubts and Regulatory Scrutiny Grow

The year 2023 was supposed to be when decentralized finance (DeFi) platforms proved their value.

Cryptocurrency observers predicted an ascension for the DeFi sector after the public fallout from the collapse of FTX, in tandem with other industry implosions, undermined trust in centralized digital asset platforms.

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

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

The act imposes new safeguards designed to root out crypto’s use in money laundering and specifically targets DeFi platforms and services, requiring them to meet the same anti-money laundering (AML) and economic sanctions compliance obligations as other financial companies, including centralized crypto trading platforms, casinos and pawn shops.

“This is a trend we are seeing in 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 illicit activity,” Jill DeWitt, senior director of financial crime compliance at Moody’s Analytics, said in a statement to PYMNTS.

“All companies involved in the U.S. financial system should know who they are doing business with, including ownership, traceability of the transactions origins, and sanctions screening,” she added.

By design, DeFi provides anonymity. Maybe that’s why the sector isn’t faring so well in the spotlight.

See also: Is DeFi Infrastructure ‘Tailor-Made’ for Managing Crypto Risks?

DeFi Under Siege as Sentiment Shifts

The crypto sector’s real-world utility, more than a decade into its commercialization, remains somewhat shrouded, while the shiny-object appeal of digital assets is increasingly being dulled by ongoing industry turmoil and regulatory scrutiny.

Decentralized crypto platforms facilitate digital asset trading by leveraging smart contracts that allow users to retain custody of their tokens rather than handing them over to centralized custodial or intermediary institutions.

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

By connecting buyers and sellers directly without any middlemen, DeFi platforms are meant to remove the risk of fund misappropriation or platform mismanagement (a la FTX) by relying on algorithmic automation to anonymously match interested parties.

This wholly technical approach also helps obscure the various parties and is rife for money laundering and abuse by bad actors.

Criminals, drug traffickers and hostile state actors such as North Korea have all demonstrated a propensity for using DeFi as a preferred method of transferring and laundering ill-gotten gains.

Per an April U.S. Treasury Department report, “illicit actors, including criminals, scammers and North Korean cyber actors, are using DeFi services in the process of laundering illicit funds.”

Broadly speaking, DeFi services appeal to sophisticated crypto adherents who can deftly navigate complex and technical user interfaces. The absence of an ease of use makes it challenging for institutions to trade on them, as does the inherent compliance difficulties.

Read also: Crypto Continues to Serve as Case Study in Behavioral Economics

Crypto’s Regulatory Outlook

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

That’s because the crypto sector is increasingly embattled, as a historical lack of regulatory clarity empowered bad actors who then tarnished the industry’s reputation among retail and institutional investors, as well as policymakers.

Despite a landmark precedent in the Securities and Exchange Commission’s (SEC) Ripple case, the outlook on Capitol Hill for crypto is shifting as lawmakers look to rein in what they see as a history of past abuses.

Congress has introduced 50 bills that touch on crypto and digital assets since the beginning of this year, with two of them facing committee votes Wednesday (July 26) and Thursday (July 27).

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