DeFi-ing the Odds: How Decentralized Finance Empowers People

N ew technologies naturally attract the attention of regulators. However well intentioned, many display a lust for control — even at the expense of American households. While former SEC chairman Jay Clayton recently expressed his interest and belief in the value of cryptocurrencies, the current chairman, Gary Gensler, views the space as a wild west in need of regulation.

Unfortunately, financial services is already one of the most regulated sectors, and the surge in regulatory requirements the past two decades has significantly crowded out many lower- and middle-income jobs. Although advanced under the guise of preventing systemic risk and helping consumers, these regulations have often raised compliance costs and strengthened incumbents’ competitive advantage.

The debate about cryptocurrency regulation often gets dogmatic and oversimplified. The debate is not about whether we should have rules of the game and predictability — clearly such factors are integral for a well-functioning market. Rather, the question is whether cryptocurrency exchanges need to submit to United States regulatory bodies.

And yet, the whole point of decentralized finance, or DeFi for short, is that there is no centralized body that calls the shots. If U.S. regulatory bodies demand cryptocurrency exchanges submit to them, exchanges will simply ignore the U.S. market and focus elsewhere.

A major rationale for cryptocurrency regulation is that consumers can be taken advantage of and exchanges are ripe for abuse by malicious users. However, we must remember not to compare the worst of cryptocurrency with the best of fiat currency. Even before the Internet revolution in the early 2000s, roughly $100 billion of drug-trafficking profits was moved through the U.S. financial system. Evidently, the problem of illicit transactions is not a lack of regulation.

In a recent paper, my coauthors and I hand-collected data on all the major cryptocurrency exchanges, tracing the volume of transactions and their market capitalization over time. We ask a simple question: Given the surge in DeFi, how much of the increase can be explained by value-creating strategies, such as the use of airdrops and governance tokens, versus regulatory arbitrage?

While airdrops — or the disbursement of tokens as a reward and benefit for early users — and governance tokens — or shareholder rights over the development of a protocol — can theoretically be used to some extent by either centralized or decentralized exchanges, they are most common for decentralized exchanges because they confer ownership to users.

We find that airdrops and governance tokens play a uniquely pivotal role in accounting for the growth of DeFi over the past few years; centralized exchanges do not reap benefits from them. That suggests that users of the tokens believe that the tokens have value — otherwise there could be a short-run blip, but not a sustained increase in volume and market capitalization.

We also compare the growth in transaction volume for centralized versus decentralized exchanges, before versus after two significant events: the KuCoin breach in September 2020 and a joint letter signed by three U.S. regulatory agencies in October 2019. Importantly, we find an increase in decentralized-exchange volume following the KuCoin breach, but no meaningful changes after the regulatory announcement that was more detrimental to centralized exchanges.

If DeFi were growing simply because of regulatory arbitrage, the opposite would be true — growth would follow the regulatory announcement, not the cybersecurity breach. Instead, these results suggest that DeFi is valued, at least in part, because it is more secure – tokens are not tied to custodial accounts, but rather they are fully decentralized across all users.

The cryptocurrency market is still in its infancy — new tokens are entering the market each day, and technological advances are being made on how to facilitate trade and investment. However, requiring these exchanges submit to regulatory bodies defeats one of their main net benefits — that decentralization creates stronger incentives for security, stability, and freedom.