Real-world asset tokenization is drawing institutional interest in DeFi while also highlighting its primary obstacle—the absence of clear regulations.
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There have always been two poles in finance: traditional and decentralized. The most audacious cryptocurrency visionaries dared to hope that they would ever combine.
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But the wave of tokenization surrounding Real World Assets (RWA) is altering perceptions and creating history. In addition to drawing institutional attention to DeFi, it also draws attention to its primary obstacle: DeFi regulation.
DailyCoin investigates the regulatory environment for DeFi and the main obstacles it faces.
RWA Tokenization Offers DeFi a Historic Opportunity
With the launch of its tokenized asset fund earlier this year by wealth management behemoth BlackRock, real-world asset (RWA) tokenization has emerged as the most talked-about story in the cryptocurrency space.
Furthermore, BlackRock is not the only player in the area. The biggest banks in the world, including Citi, HCBC, and JPMorgan Chase, are looking into tokenizing RWA.
RWA tokenization opens up access to trillions of dollars’ worth of capital by allowing physical assets, like gold, debt securities, and real estate, to be represented on the blockchain, connecting traditional and decentralized finance markets.
Industry participants concur that tokenizing physical assets could finally make blockchain useful, revolutionize DeFi, and advance the financial system.
For DeFi, the arrival of Wall Street heavyweights such as BlackRock represents a critical turning point. The involvement of large institutional players does more than just accelerate the growth of the tokenized asset market. The market is expected to rise higher as money continues to flow in and investments become more stable.
The numbers already show how interested the market is in RWA-related protocols. By April 2024, the value of RWA protocols will have increased from $146 million to over $6.31 billion, a gain of more than 4,000% in just one year.
However, it still only accounts for 6.1% of the $102 billion in value that is locked in DeFi protocols.
Tokenized RWAs have enormous potential when taking into account the entire value of real-world assets, such as the $380 trillion real estate market alone. By 2030, experts estimate that the market for tokenized physical assets could grow to $16 trillion.
But in order for this merger to happen, traditional finance and DeFi must seamlessly integrate. As always, in these kinds of situations, regulatory clarity is crucial.
Regulations Continue to Be Ambiguous
Clear regulatory frameworks for DeFi, which functions differently from traditional finance, have not yet been implemented by any government.
Because DeFi is decentralized, regulating it continues to be difficult on a global scale. DeFi relies on automated smart contracts to facilitate operations rather than centralized authorities, which makes it challenging to enforce regulations and guarantee compliance. Furthermore, the swift advancements and changing technologies add to the difficulty of enforcing regulations.
There is currently no officially adopted policy on DeFi regulation, despite the fact that various countries are seeing the emergence of individual initiatives on the regulation of crypto assets.
DeFi regulation is completely excluded from the EU’s Markets in Crypto Assets (MiCA) initiative, which is slated to be the most comprehensive crypto regulatory standard in the world when it goes into effect in December 2024.
Decentralization of the DeFi Protocol Varies
Although it does not address how decentralized finance should be treated and regulated, the EU’s MiCA framework establishes guidelines for stablecoin issuers and providers of crypto asset services.
The document only requires an 18-month review of DeFi sector progress by EU authorities following the implementation of MiCA. Additionally, it mandates that the European Commission determine whether MiCA laws are adequate to address DeFi and whether or not specific DeFi regulations are necessary and workable.
If EU legislators take the Financial Action Task Force’s (FATF) recommendations, which are a worldwide authority on anti-money laundering regulations, into consideration, the strategy may differ.
According to FATF, entities or individuals with a substantial amount of control over DeFi may be classified as Virtual Asset Service Providers (VASPs) and be subject to AML/CFT (anti-money laundering and counter-terrorism financing) regulations.
One of the main points of contention in the discussion surrounding DeFi regulation, though, is whether DeFi should be fully or partially decentralized.
According to Carolina Veas, a completion lawyer at CMS law firm, “only partially decentralized crypto services are subject to the MiCA regulation while fully decentralized services provided without intermediaries are excluded from its scope.”
The main issue, in her opinion, is that the DeFi industry operates across a broad decentralization spectrum, making it difficult to pinpoint the point at which protocols become fully or partially decentralized.
In spite of this, DeFi protocols feature a multi-layered architecture with varying degrees of decentralization among them. Determining which layers are most important for decentralization is still an open question.
Veas asserts that DeFi regulation is a political issue. While DeFi regulations are still being worked out, service providers will need to adapt and determine how decentralized their business model is.
Who May Qualify for an Exemption?
It is anticipated that the European Commission’s report will clarify certain matters pertaining to DeFI regulation, such as ownership, licensing, and jurisdictional concerns.
It can be difficult to define DeFi jurisdiction on its own; it needs to be clear whether assets should be governed by the laws of the regions in which their owners live or where their servers are situated.
The issues of governance and licensing also arise. In conventional finance, services are rendered by recognizable organizations that are governed by licensing policies.
In contrast, DeFi protocols are frequently managed by smart contracts, and investors or DAOs own the governance rights, which allow them to vote on changes to the protocols or their overall administration.
Currently, decision-making power is greater for investors with a larger number of tokens. Therefore, it’s critical to remove the possibility of voting power being concentrated in the hands of a small number of people for projects to be truly decentralized.
According to Maxim Galash, CEO of the Coinchange DeFi platform, initiatives that genuinely embrace decentralization may be spared from DeFi regulation.
“This depends on attaining de facto decentralization, restricting the power of influential individuals over the protocol, and guaranteeing a continuous user relationship, enabled by voting protocols or smart contracts.”
But in order to do so, the sector must restrict the holding of governance tokens or draw in more new investors to DeFi governance—possibly through a variety of incentive schemes.
Cybersecurity and AML as a Foundation
DeFi regulation is nuanced and has the potential to set long-lasting standards for how the market develops in the future. Making well-discussed decisions involving multiple parties is therefore essential.
According to Caroline Malcolm, global head of public policy at Chainalysis, “the implications of how we regulate DeFi are incredibly nuanced and must be grappled with by industry, government, academia, and civil society.”
Without waiting for clear regulatory guidance, she proposes that DeFi protocols could independently adopt measures that meet minimum security standards, such as anti-money laundering and cyber security safeguards.
In order to stop illegal financial activity, financial institutions are required to review the operating accounts of individuals or entities. This is why AML/CFT standards are common in the financial sector.
Malcolm claims that DeFi can already perform address or sanction screenings using the technologies currently in use, and that access and privacy pools can be managed with the aid of whitelisting and blacklisting solutions.
In terms of cybersecurity, the sector has also produced products that strengthen protocols’ defenses against smart contract flaws, which are frequently exploited by hackers. There are already tools available that provide visibility into on-chain governance and smart contract auditing.
DeFi needs to make its own decision.
Institutions are concentrating more on DeFi, creating avenues for entry into the $16 trillion real asset market. They are integrating with DeFi and bridging the gap between traditional and decentralized finance by tokenizing a variety of illiquid asset classes, such as real estate, commodities, security debts, and art.
This represents an unprecedented chance for the decentralized space to grow. But as is frequently the case, regulation is a prerequisite for legitimacy. DeFi must now make the crucial decision of whether to adhere to regulatory compliance or the fundamentals of decentralization.
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