The burgeoning pace with which the decentralized finance (DeFi) industry has made inroads has set alarm bells among regulators worldwide. Caught off guard by the meteoric rise of the DeFi industry, the regulators are now scrambling to bring new regulatory frameworks, unsure of the extent to which they will be able to exercise their control over it.
With the crypto market recently hitting fresh heights this year, in-line with the optimism around Bitcoin’s first ETF and the latest halving, the regulatory conversation has taken on even more importance. However, given the complexities associated with the DeFi industry, a global regulatory framework is not in the cards any time soon. Therefore, in such a volatile atmosphere, the DeFi sector has to come up with self-regulation and out of the box thinking to ensure that the trust of investors remain intact in the sector.
Why does DeFi regulation sound complex?
DeFi regulation is a complex topic because of the unique nature of decentralized protocols, which no single entity controls. For over a hundred years, financial regulations have evolved based on the concept of a trusted intermediary that has complete authority over every participant within its financial ecosystem.
That centralized entity can be held accountable, giving consumers and businesses legal recourse in the event they feel cheated. DeFi replaces those intermediaries with programmable, autonomous smart contracts that are beholden to no one. Such a decentralized model offers a unique set of challenges for regulators who are used to bringing changes in centralized systems.
Bringing Accountability To DeFi
Having already discussed the problem of regulating the DeFi industry, there is also a need to introduce accountability to this sector. Without any regulations to govern it, the best that the DeFi protocols can do is to lean on existing rules and processes of the traditional finance industry that can help them to avoid taking unnecessary risks.
For instance, lending protocols might be able to utilize existing best practices from traditional finance to identify the most suitable borrowers. They can also borrow existing structures that help to streamline the lending process and improve the efficiency of their operations.
How can DeFi protocols utilize data from traditional markets?
World’s biggest economy, the USA has built up an extensive structure and model for underwriting loans and attracting capital. Credit ratings agencies such as S&P Global Ratings, Moody’s, and Fitch Group have extensive data that can be used to establish rules regarding who is and isn’t eligible for borrowing. Such data can enable DeFi protocols to make better decisions around risk management.
Moreover, the U.S. boasts a strong legal system that can be leveraged by DeFi companies in creative ways, to ensure their users still have potential avenues for legal recourse.
Zivoe: Out-of-the-box approach to bring accountability
One company that’s trying to get creative to reassure its users is Zivoe, a real-world asset protocol that provides an alternative source of credit to consumers who have grown tired of the predatory lending practices of the traditional lending market.
Zivoe is able to provide a more affordable, alternative source of credit by issuing on-chain loans to consumer lending companies, which can, in turn, offer fiat-based loans to their customers at attractive rates. To manage risk, Zivoe secures the loans it provides to lenders by establishing a “special purpose vehicle” or SPV, maintaining authority over this entity in case the originating lender doesn’t perform.
It’s a novel structure that reduces credit risk while optimizing capital use. Under this model, Zivoe’s SPVs can allocate non-lent funds to other DeFi protocols to create an additional revenue stream. It means the capital under Zivoe’s control is never lying idle, but instead working to boost the protocol’s overall health.
Zivoe’s initial lending partner is a company created by itself, called Zinclusive, which is largely run by the same management team.
Every loan provided by Zivoe to Zinclusive is collateralized, and the consumer-focused products created by the latter will be put into an SPV, which serves as a form of real-world collateral. The SPV notably doesn’t have any interactions with the blockchain-derived capital provided by Zivoe’s liquidity providers, but its legal agreements with Zinclusive mean that those on-chain activities are connected to its off-chain assets. Notably, those agreements decree that in the event of a default by Zinclusive, Zivoe has the authority to take control of the related SPV and the portfolio of consumer loans under its management.
Zivoe’s unique model was conceptualized by a founding team led by CEO Jay Abbasi and general counsel Kristal Gruevski. Meanwhile, Zivoe’s risk advisor Walt Ramsey previously helped develop risk management strategies for Lloyd’s Bank, JP Morgan Chase, and other financial firms.
Conclusion: DeFi has to win the trust of investors
Just as with traditional finance, there can be no guarantees that investors’ DeFi deposits will generate a profitable return. However, a set regulatory framework in the Trad Fi industry has at least ensured that investors have an authority figure whom they can approach to lodge complaints.
It is here that the DeFi industry lags behind and it is upto new firms using creative thinking, that can win trust of the investors. Zivoe is an example of creative thinking where investors are given confidence that the dynamic and pioneering new form of finance is trustworthy.
