In a rapidly changing market environment such as the one surrounding cryptocurrencies (“crypto”), it is important to understand the different forces that contribute to shaping it. In this article, I focus on describing some features of a growing subset of the crypto universe known as decentralized finance (henceforth, DeFi). I then provide a brief description of the current regulatory and legal landscape.

Unlike the traditional financial system, DeFi is purported to eliminate or greatly reduce the need for traditional financial intermediaries, such as bankers and brokers, thanks to blockchain technology. Let me first provide some background to put DeFi in context.

Crypto assets generally refer to digital assets that “utilize cryptographic primitives and distributed ledger technology (“DLT”),” also known as blockchain technology.¹In terms of DLTs, these assets generally follow either the Bitcoin or the Ethereum design.²This distinction is relevant because Ethereum’s blockchain, unlike Bitcoin’s, supports additional applications and tokens, as I next explain.

Native tokens, those directly tied to a given blockchain, are generally used for transaction purposes and as a store of value.³ Non-native tokens, on the other hand, can have multiple other purposes. Specifically, they include tokens created by so-called smart contract applications. A smart contract application is executable, automated, open-source software programs run on a permissionless blockchain (Ethereum for the most part).⁴ The tokens created by smart contract applications are similar to native cryptocurrencies in that they can be used to pay for transactions or as a storage of value, but they also are a claim on the platform’s economic value. ^{5, 6}

Tokens from smart contract applications can generally be classified depending upon their use or characteristics. A relevant category in this space are decentralized stablecoins.⁷ Stablecoins generally are designed to maintain a peg to other currencies, either “traditional” currencies such as the U.S. Dollar, or other cryptocurrencies (i.e. “algorithmic stablecoins”). For example, Tether (USDT) is supposed to be pegged to the U.S. Dollar, i.e., one Tether is equivalent to one U.S. Dollar. Decentralized stablecoins in particular, such as DAI, rely on smart contracts to function.

Tokens that do not share the pegging feature described above can then be further classified as: utility tokens, governance tokens, and equity tokens.⁹ Figure 1 below illustrates the crypto asset landscape according to this categorization.

Figure 1: Crypto Assets by Category

The types of fungible tokens just listed are all relevant to the DeFi segment. DeFi applications offer financial services (borrowing, lending, trading, etc.) using smart contracts in lieu of a traditional financial intermediary (bank, broker, etc.). To give a sense as to the relative importance of the different crypto assets, Figure 2 shows the total market capitalization associated with smart contract platforms and DeFi, according to cryptocurrency data websites CoinGecko and IntoTheBlock. The total market capitalization associated with smart contract platforms is about 1/4 of the total crypto market capitalization. DeFi tokens overall, as identified by IntoTheBlock, were jointly priced at $52 billion, or 2% of the total crypto market capitalization. DeFi’s combined total value locked (or TVL), a commonly used metric in this space calculated as the value of all assets locked in a smart contract’s protocol, was about $105 billion.

Figure 2: Smart Contract Platform and DeFi Tokens Market Capitalization ($ U.S. Billion)

Decentralized Finance

The universe of DeFi applications can be broadly described based on the financial service they provide. A large part of DeFi are decentralized exchanges—or DEXs—where users can exchange crypto assets without a centralized trading venue.¹⁰ One way a DEX achieves this is with automated market makers (AMMs).¹¹ Under this model, the smart contract pools crypto assets from individual liquidity providers and any incoming “buy” orders are executed against that pool. Tokens are created (minted) to keep track of the assets that individual liquidity providers contribute to the pool. These are utility tokens known as LP tokens. The utility of these tokens is that they represent ownership in the underlying pool of assets. Governance tokens are often also created to manage the fee structure that compensates liquidity providers and other aspects of the exchange. Governance tokens are effectively voting rights: their owners can vote on design aspects as well as modifications of the parameters underlying the protocol.¹²

Decentralized lending protocols are also an important part of the DeFi landscape. As with DEXs, lending and borrowing is automated with smart contracts. Since the lender does not know who the borrower is (and there is no bank to intermediate), most of these loans are secured with collateral – typically other crypto assets. The borrowing is not the only aspect that is coded and automated, the interest rate is as well. Here too, tokens are created to represent interest earned/owed. And governance tokens allow their owners to vote on proposals to change the design of the protocol. Economists Makarov and Schoar argue that “similar to DEX, the lending space is dominated by a few large players.”¹³

Additionally, industry experts have emphasized derivatives trading and yield farming as other financial services in the DeFi universe. Derivatives trading protocols are based on tokens whose value is tied to “an underlying asset’s performance, the outcome of an event, or the development of any other observable variable.”¹⁴ Yield farming on the other hand refers to smart contracts that aim to optimize returns by allocating investments across multiple DeFi applications.¹⁵

Another decentralized application that has been linked to DeFi, named liquid staking, does not have a counterpart in traditional financial transactions. Proof-of-stake, or “staking,” is part of the validation of transactions in Ethereum-like blockchains. In contrast to proof-of-work validation by demonstrating superior computational efforts to certify blockchain transactions, proof-of-stake (“POS”) validates transactions by demonstrating superior financial resource commitments. With liquid staking, a holder of Ether (Ethereum’s native token) can use its holdings for the purpose of validating transactions in the Ethereum blockchain (and earn fees) without having to lock those assets. Lido Staked Ether is an example of a token created by the Lido protocol for the purpose of creating liquidity to Ether tokens used for staking.

Table 1 below ranks DeFi tokens based on market capitalization, utilizing publicly available data from IntoTheBlock. As of October 25, 2024, Lido Staked Ether had the largest market capitalization. In second place came DAI, a decentralized stablecoin, and in third place came Uniswap, native to one of the best-known decentralized exchanges.

Table 1: DeFi Tokens Ranked by Market Capitalization

Regulatory and Legal Landscape

The traditional financial services sector is highly regulated. The Federal Reserve and the FDIC, for example, are agencies specific to this sector tasked with regulation and oversight. Regulating the financial sector has, at least, three goals: (1) prevent the use of funds for illegal purposes (such as money laundering or terrorism); (2) protect customers against fraud and manipulation; and (3) ensure the overall stability of the payments and financial system.¹⁶ As of now, these two agencies do not directly oversee DeFi. In fact, economists Makarov and Schoar conclude that, at present, “DeFi solutions do not comply with the three goals.”

Against the pursuit of the goals above, economists and legal scholars have argued that the main challenge in regulating cryptocurrencies, including DeFi, is pseudonymity and its “jurisdiction-free nature.”¹⁸ According to the IMF, the “lack of intermediaries [in DeFi applications] means that traditional AML/CFT regulation, in which AML/CFT requirements are imposed on the private sector and compliance is monitored by supervisors, cannot be applied.”¹⁹

Additionally, if financial institutions (or any company for that matter) issue securities and/or engage with securities trading, they are subject to securities laws to protect investors against fraud and manipulation. Enforcement actions by the SEC in the crypto space have led to lawsuits, both on behalf of the agency as well as on behalf of investors. Broadly speaking, efforts have centered around whether a given token is legally a security. If it were, existing securities laws requiring that a security is registered as such with the SEC would apply to them. For example, a notable case concerns XRP, the token issued by Ripple Labs.

Crypto exchanges have also been the object of similar allegations. For example, a 2023 suit alleged that Coinbase, a centralized exchange, failed to register with the SEC despite operating as a national securities exchange, broker and clearing agency with respect to 12 crypto assets on the Coinbase platform. In the DeFi space, another recent example is Lido DAO, which provides liquid staking. Of the 89 crypto lawsuits reported by Stanford Law School’s Securities Class Action Clearing House, approximately 44% (or 39 cases) contain allegations regarding unregistered security violations. Table 2 below lists these cases.

In summary, decentralized finance (DeFi) potentially represents a disruptive shift in financial systems by leveraging blockchain technology to operate without traditional intermediaries. However, as DeFi’s applications proliferate, its “jurisdiction-free” and pseudonymity nature pose regulatory challenges. Policymakers and the legal system face the complex task of protecting investors and maintaining systemic financial stability.

Table 2: List of Crypto Cases Subject to Alleged Unregistered Securities Violations (Private Litigation)

References

¹ Auer, R., B. Haslhofer, S. Kitzler, P. Saggese, and F. Victor, “The Technology of Decentralized Finance,” BIS Working Papers No. 1066, January 2023 (“Auer et al.”), p. 8.

² In technical terms, these designs are known as UXTO- or Account-based DLTs, respectively.

³ Makarov, I., and A. Schoar, “Cryptocurrencies and Decentralized Finance (DeFi),” Brookings Papers on Economic Activity, Conference Drafts, March 24-25, 2022 (“Makarov and Schoar”), p. 21.

⁴ Auer et al., p. 1.

⁵ Makarov and Schoar, p. 22.

⁶ Another distinction is based on their fungibility. Non-fungible tokens (or NFTs) are associated with a claim to a unique digital or physical asset, or a license to use the asset for a specified purpose. Unlike other crypto assets, and as the name indicates, they distinguish themselves because they are non-fungible. In this article, I focus on fungible tokens since they are relevant to DeFi.

⁷ Centralized stablecoins, while using smart contract features, rely on off-chain entities for governance and reserves.

⁸ Makarov and Schoar, p. 20.

⁹ Here I follow the classification chosen in Auer et al. although other classifications exist.

¹⁰ Centralized exchanges are companies that execute trades on behalf of investors. For example, Coinbase, Binance, and others.

¹¹ For a brief discussion of how a typical AMM works on a DEX, see “Decrypting Cryptocurrency by Focusing on Decentralized Exchanges.”

¹² LP tokens can represent both a claim to the pool of assets as well as used for governance purposes.

¹³ Makarov and Schoar, p. 25.

¹⁴ Schar, F., “Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets,” Federal Reserve Bank of St. Louis Review, Second Quarter 2021, p. 166.

¹⁵ Makarov and Schoar, p. 26.

¹⁶ See Makarov and Schoar, p. 39.

¹⁷ Ibid.

¹⁸ Ibid.

¹⁹ AML/CFT regulation refers to Anti-Money Laundering and Countering the Financing of Terrorism. International Monetary Fund, “Elements of Effective Policies for Crypto Assets,” IMF Policy Paper, February 2023, p. 27. See also Harvey, C., J. Hasbrouck, F. Saleh, “The Evolution of Decentralized Exchange: Risks, Benefits, and Oversight,” Working Paper, October 2024, pp. 19-20.