DeFi-ing the Odds: How People Are Empowered by Decentralized Finance

Decentralized finance is utilized for more than speculation, contrary to common opinion.

Regulators are naturally interested in new technology. Many people, no matter how well-intentioned, have a desire for power, even if it is at the expense of American families. 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. Despite the fact that these restrictions were enacted in the name of minimizing systemic risk and assisting consumers, they frequently increased compliance costs and bolstered incumbents' competitive advantage.

The argument around bitcoin legislation frequently devolves into dogmatism and oversimplification. The discussion isn't about whether or not we should have game rules and predictability; these elements are plainly necessary for a well-functioning market. Rather, the question is whether cryptocurrency exchanges need to submit to United States regulatory bodies.

Despite this, the fundamental premise of decentralized finance, or DeFi for short, is that no centralized authority is in charge. If regulatory organizations in the United States demand that cryptocurrency exchanges conform to them, exchanges will simply ignore the US market and concentrate their efforts elsewhere.

One of the main arguments for cryptocurrency regulation is that customers may be exploited, and exchanges are vulnerable to bad individuals. However, we must keep in mind that the worst of cryptocurrencies should not be compared to the finest of fiat currency. Prior to the Internet revolution in the early 2000s, the United States' financial system handled around $100 billion in drug-trafficking proceeds. Illicit transactions are clearly not a result of a lack of legislation.

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 pose a simple question: how much of the gain in DeFi can be attributed to value-creating initiatives like airdrops and governance tokens, vs regulatory arbitrage?

While both centralized and decentralized exchanges can theoretically use airdrops — or the distribution of tokens as a reward and benefit for early users — and governance tokens — or shareholder rights over the development of a protocol — they are most common for decentralized exchanges because they confer ownership to users.

We discovered that airdrops and governance tokens are particularly important in explaining DeFi's recent development; centralized exchanges do not benefit from them. This indicates that token users feel the tokens have worth; otherwise, there would be a short-term bump in volume and market capitalization, but not a steady growth.

We also examine transaction volume growth for centralized and decentralized exchanges before and after two major events: the KuCoin hack in September 2020 and a joint letter written by three US regulatory agencies in October 2019. Importantly, we observe a surge in decentralized-exchange volume following the KuCoin hack, but no discernible changes following the regulation notification that harmed centralized exchanges more.

If DeFi were increasing only due to regulatory arbitrage, growth would occur after the regulatory notice, not after the cybersecurity attack. Instead, these findings show that DeFi is valued, at least in part, because tokens are not connected to custodial accounts and 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.

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