Regulators are now turning their attention to the world of decentralized finance following a crackdown on Binance and other cryptocurrency firms.
Users can participate in traditional financial activities like lending without the involvement of a middleman thanks to "DeFi," or decentralized finance.
Authorities are worried that DeFi services may misrepresent themselves as decentralized, but they may not be the case.
The rapidly expanding decentralized finance industry may be about to be shaken to its core.
Cryptocurrency's "DeFi" trend, which stands for decentralized finance, first gained traction in 2020.
Cryptocurrency has been likened to the "Wild West," with hordes of computer programmers working feverishly to bring traditional financial products such as loans to the blockchain.
The concept has great potential. Digital money lending and borrowing could theoretically take place without the involvement of any third parties. With the promise of double-digit returns on savings in certain digital tokens, investors are attracted.
Regulators, on the other hand, are becoming increasingly concerned about the potential for criminal activity and consumer harm as a result of recent high-profile hacks and scams.
Maple Finance co-founder Sid Powell tells CNBC that "I think they're going to pay more attention to the space," he says.
According to data from The Block, Ethereum-based DeFi protocols have received deposits totaling nearly $90 billion.
The growth of DeFi will almost certainly necessitate additional regulation in the future, according to Powell.
The crypto industry is already being scrutinized more severely by regulators.
Binance, the world's largest digital currency exchange, has been the target of several countries' attempts to remove due to its out authorization. With no official HQ, Binance has thus far been able to avoid the attention of regulators, though the company says it wants to be a friend and not a foe.
A planned interest-earning savings product that the US Securities and Exchange Commission (SEC) felt looked too much like securities in September got Coinbase into a heated debate with the SEC. Later, Coinbase decided against releasing the feature.
An eagerly awaited report from the US government urged Congress to introduce regulation regarding stablecoins, digital assets tied to traditional currencies such as the dollar to preserve their stability of exchange price.
DeFi seems to be the next one on the list
U.S. Securities and Exchange Commission officials are investigating the decentralized crypto trading platform Uniswap, looking into how investors use it and the way it is marketed.
To ensure compliance with laws and regulations and to assist regulators, Uniswap Labs says it is "committed to providing information to regulators that will aid them in any inquiry."
Former US Treasury Secretary Henry Paulson likened DeFi's activities to Wall Street's scandal-plagued behavior before the 2008 financial crisis in a statement released at the end of September.
David Carlisle, director of policy and regulatory affairs at crypto analytics firm Elliptic, told CNBC that "one of the biggest questions facing regulators right now is how to deal with DeFi."
In the world of a few marketplaces, how do you apply regulatory standards designed for centralized intermediaries?
Regulators, according to Carlisle, are concerned that DeFi services claim to be decentralized but in fact, aren't. In some cases, the DeFi network's founding teams and developers have an impact on the network's governance.
The Financial Action Task Force, a global anti-money laundering watchdog, released updated guidance on cryptocurrencies last week. Individuals with "control or sufficient influence" over DeFi programs must be identified under the rules, in part.
As a result, some DeFi start-up founders may be required to comply with rules requiring them to provide information on the originators and beneficiaries of funds transferred.
During an interview with CNBC, Rick McDonell, the former executive secretary of the Financial Action Task Force, stated that while DeFi protocols may provide similar functionality in financial transactions, they do not provide the oversight regulators require to ensure safe and efficient financial markets.
These markets face a significant risk of fraud, money laundering, sanctions evasions, and other criminal activity because of a lack of effective surveillance.
It's too early to tell what the regulators will do in response.
However, while regulatory action can be deduced by looking at the hints left in the tea leaves, the specifics of that response have yet to be determined. However, McDonell, who is now the executive director of the Association of Certified Anti-Money Laundering Specialists, said that enforcement actions have already been taken.
According to regulatory officials, blockchain technology can offer end-users a wide range of advantages, but they aren't ready to trust the sector's ability to manage its financial crime risks.
US Comptroller of Currency Michael Hsu believes that DeFi must learn from the market crash of 2008 to avoid making the same mistakes again.
Underbanked minorities are at the greatest risk if the crypto market experiences a sudden DeFi downturn, according to the chief banking watchdog on Tuesday.
Hsu is speaking from personal experience, having worked as an economist for the US Securities and Exchange Commission during the 2008 market crash.
It was likened to a gold rush on Wall Street in 2000, and Hsu warned that a DeFi crash could happen for the same reasons.
"In the years leading up to the financial crisis of 2008, I witnessed a fool's gold rush firsthand. Cryptocurrencies and DeFi are on the verge of a new era, according to Hsu.
Today's crypto and DeFi markets follow a pattern that can be traced back to the early days of credit default swaps. Because this group is able to change course and avoid a crisis, "he said.
More was done by Hsu. According to him, it's "concerning and ironic" that cryptocurrency and DeFi are "replete with scams."
According to him, most ecosystem innovations are geared toward improving trading rather than making it easier to conduct traditional cash transactions.
After citing two recent polls that asked Americans if they owned cryptocurrency, Hsu concluded that the majority of Americans do.
10% of those who had their money in a bank account said yes.
They were joined by 12 percent of the unbanked.
The cryptocurrency was held by 37 percent of the unbanked population.
Thirteen percent of whites, 18 percent of African Americans and 20 percent of Hispanics reportedly own crypto according to a Harris poll conducted a few weeks later, according to Hsu.
“In terms of fool gold in the cryptocurrency space, some of the most hurt will be the most unbearable.”