The exponential growth seen in decentralized finance (DeFi) in recent years may be set to slow down because of hurdles such as regulation and overcollateralization, Morgan Stanley said in a research report.
Central bank easing programs forced investors to look for returns in new places, helping boost the total assets locked in DeFi to about $200 billion from around $600 million in 2020, the bank said. DeFi projects offer high returns to attract users, which in turn increase the value of the platform, it added.
DeFi is an umbrella term used for lending, trading and other financial activities carried out on a blockchain, without needing to use traditional intermediaries.
While the promise of no middlemen may seem appealing, and proponents pitch DeFi as a way of improving the existing financial system, Morgan Stanley says it hasn't seen much evidence that DeFi protocols are more efficient than the current system.
“Rather DeFi protocols often seem to us as a way to attract cash flow to enrich the protocol operators,” the report from last week said. “DeFi is hack-prone and at risk of financial crime given anonymity is a key feature.”
Lack of know-your-client (KYC) and anti-money laundering (AML) information will limit institutional adoption, the bank said. Introducing KYC/AML requirements will “force DeFi to be more centralized.”
KYC is the process of identifying and verifying a client’s identity, and is used to combat fraud as well as money laundering.
“Overcollateralization in lending/borrowing means DeFI lending doesn’t expand the money supply (for the same cryptocurrency), which means, without centralization, it will be harder for DeFi to be seen as an alternative to the current fractional reserve banking approach,” the note said. Therefore, the bank expects DeFi to remain fairly small in the coming years.
Regulators have been slow in catching up with the boom in DeFi, as protocols aren't controlled by a central entity and don’t have to be registered, but scrutiny will increase, the note added.
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