‘Risky’ DeFi comes with challenges – Here’s what analysts think

• DeFi has introduced cyber vulnerability challenges and misuse risks, setting it apart from traditional finance’s risk factors
• There’s a need for DeFi-specific laws to address cybersecurity and manage high-risk wallets

The emergence of decentralized finance (DeFi) has presented both revolutionary opportunities and significant risks. Unlike traditional finance (TradFi), DeFi operates on blockchain technology, offering a peer-to-peer financial system that avoids centralized financial intermediaries. 

However, the novelty of DeFi comes with its unique set of challenges, particularly in the domain of illicit finance, prompting a closer examination by experts and regulators.

Unveiling the potential risks with DeFi

The inherent risks in DeFi significantly differ from those in TradFi due to its decentralized nature and reliance on technology. Experts have identified three primary risk vectors in the DeFi ecosystem: Cyber risk, system management risk, and usage risk. 

Cyber risk encompasses issues arising from poorly written code or inadequately audited smart contracts that hackers can exploit. System management risk, contrary to the decentralized ethos of DeFi, can lead to vulnerabilities through social engineering or other forms of manipulation. 

Rebecca Rettig, the Chief Legal and Policy Officer at Polygon Labs, was recently asked to define the system management risk in a recent podcast interview. Rettig commented,

“It is a scenario where you say something is decentralized, but everyone is holding all of the admin keys.”

Finally, usage risk involves using DeFi protocols for illicit financial activities, such as money laundering, by leveraging transaction obfuscation techniques and privacy-preserving technologies.

The inherent need for new governing laws

💵 @RebeccaRettig1 discusses her idea for allowing DeFi protocols to exist and not be subject to sanctions while also preventing North Korea from laundering money through Tornado Cash.

💬 What do you think of this idea?

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— Unchained (@Unchained_pod) February 6, 2024

The challenges these risks pose increase because of the difficulty of applying traditional regulatory frameworks to the DeFi space – The decentralized and global nature of DeFi, combined with its technological complexity. This makes it challenging for regulators to monitor and mitigate illicit activities effectively. 

Consequently, stakeholders have an ongoing discussion on developing new laws and regulatory approaches tailored to the ecosystem.

One of the critical areas under consideration is the identification and management of high-risk wallets. Regulators and blockchain analytics companies are exploring mechanisms to trace illicit activities. Moreover, they also determine the risk associated with particular wallets without imposing a “social credit scoring” system. 

The goal is to strike a balance between giving the security and integrity of the ecosystem and preserving the privacy and freedom that form the core of its appeal.

Depicting the future: A regulatory shift in DeFi space? 

Michael Mosier, Co-founder of Arktouros PLLC, clearly agreed on the need for new cybersecurity laws around the financial space. In a recent interview, he mentioned,

“This is not like proposing social credit scoring for wallets. I think it is important to make it clear that this is within the cybersecurity and critical infrastructure space.”

Such efforts include defining high-risk wallets, enhancing cybersecurity measures, and developing best practices for system management and usage to safeguard against illicit financial activities.

As DeFi matures, the collaboration between regulators, developers, and the community will be crucial in shaping an ecosystem that is both innovative and secure. Finally, it ensures that DeFi can fulfill its promise of transforming the financial landscape without becoming a haven for illicit activities.