DeFi Ledgers Can Help Regulators Oversee Sector, BIS Official Says

Decentralized finance (DeFi) can be regulated by relying on its own trust-creating mechanisms to collect compliance data, said Raphael Auer, head of the Bank for International Settlements' (BIS) Eurosystem Innovation Hub.

A working paper authored by Auer titled "Embedded supervision: How to build regulation into decentralized finance," published Wednesday, argues the compliance of DeFi players can be automatically monitored by "reading the market's ledger."

"This reduces the need for firms to actively collect, verify and deliver data," the paper said.

DeFi is a term used to describe a range of intermediary-free financial applications built on a blockchain. The applications are built on distributed ledgers used to record transactions and for verification purposes. Although it is often championed by the crypto world and Web 3 enthusiasts, DeFi has left regulators around the world sounding an alarm over the urgent need to supervise the space.

But aside from a 2021 quarterly review by the BIS, an umbrella group for central banks, that called "decentralization" in DeFi an "illusion," and argued that centralized points within DeFi could allow regulators ways into establishing control over the space, little practical headway has been made in establishing oversight.

The technology of embedded supervision, however, has attracted interest from policymakers. At the request of lawmakers, the European Commission, the executive arm of the European Union responsible for proposing new legislation, is currently preparing to charter a study on the potential impact of linking supervisory data applications to decentralized finance, as a precursor to potential further legislation.

But some have expressed skepticism about whether it is even possible to carry out such supervision on smart contracts where the code is unchangeable. Embedded supervision is "both nice to have and unworkable in practice," George Giaglis, professor at the University of Nicosia Department of Digital Innovation, told CoinDesk.

"You cannot enforce this at the protocol level. Unless you did something totally stupid like, you know, embedding code in smart contracts that would allow regulators to peer into transactions or something like that, which are things that cannot happen in practice," he said.