Embedded supervision of decentralized finance

The European Commission has just published a report presenting the outcome of a study undertaken by IBM Promontory for the Commission on embedding supervision in decentralized finance (DeFi).

The project comprised four distinct phases: identifying use cases and protocols to assess, defining elements of comparison (benchmarks) with supervision in traditional finance (TradFi), developing a software application to collect data from the ledger, and analyzing the collected data to assess the potential of embedded supervision.

After analyzing four use cases and eight protocols, the report concluded that ledger technologies offer real-time access to core transaction information. IBM Promontory also identified available data that could support the supervision of DeFi activity and the development of tools to meet regulatory objectives. However, the data remains limited compared to traditional financial markets, banking, and insurance activities due to the differing maturity levels of TradFi and DeFi.

Significant challenges arose when assessing the potential of embedded supervision in the DeFi ecosystem, including the lack of standards, the need for expertise across both DeFi and TradFi, and the pseudonymization of wallets. A risk-based approach targeting the largest protocols and liquidity pools, along with the collection of reference data, is crucial for overcoming these obstacles.

The paper also examined insurance use cases. Nexus Mutual and Unslashed Finance hold significant positions within the DeFi insurance sector, offering users ways to hedge against risks associated with smart contracts and DeFi protocols. While they may be smaller in size and volume compared to decentralized exchanges (DEXs) and lending protocols, their role is vital in providing decentralized insurance coverage, primarily addressing risks such as smart contract failures, exchange hacks, and custody risks.

From an insurance perspective, the study concluded that while the products advertised on the front pages of relevant protocol websites may resemble traditional insurance products, their similarities to conventional insurance are limited. For instance, the Nexus Mutual DAO operates a risk-sharing pool funded by its members, using these funds to settle claims. Nexus Mutual engages its community in assessing and approving coverage proposals, as well as funding the pools that ensure coverage, with additional rewards offered through the NXM token.

In terms of supervisory objectives, IBM Promontory's findings indicate that basic transaction information can be technically extracted from the ledger and consolidated to provide an accurate macro view of the studied protocols.

Furthermore, the Nexus Mutual protocol mandates Know Your Customer (KYC) checks for all members. However, it is important to note that the Unslashed protocol has encountered internal disputes among developers, leading to the shutdown of its website mid-project. This highlights the potential risks associated with using such protocols.

The topic is getting regulatory attention beyond Europe. The Bermuda Monetary Authority (BMA), the financial regulatory authority of Bermuda through its Innovation Hub activities, invites proposals for a collaborative pilot project aimed at testing Embedded Supervision practices within the context of DeFi.

Recognising that DeFi’s rapid growth compels regulators to revisit traditional regulatory principles to fulfil their public protection objectives, this pilot project aims to explore the potential of embedded regulatory supervision1 within the technological framework of these projects for embedded regulatory oversight, compliance, and automated reporting. BMA welcomes all stakeholders. including Digital Asset Businesses, Foundations, Protocols, FinTech companies, DeFi operators, technology developers and academic institutions to apply for this novel and unique initiative and contribute to shaping the future of regulatory supervision in digital finance.

The insights derived from this pilot will directly inform the evolution of BMA's supervisory mechanisms in response to the rapidly evolving DeFi sphere.