Decentralized finance (DeFi) can be regulated by relying on its own trust-building mechanisms to collect compliance data, according to Raphael Auer, head of the Eurosystem Innovation Hub at the Bank for International Settlements (BIS).
A working paper authored by Auer, titled "Embedded supervision: how to build regulation into decentralized finance," and published Wednesday, argues that compliance by DeFi actors can be monitored automatically by "reading the ledger of the market."
"This reduces the need for companies to actively collect, verify and deliver data," the paper says.
DeFi is a term used to describe a set of intermediary-free financial applications built on a blockchain. The applications rely on distributed ledgers used to record transactions and for verification purposes. Although DeFi is often championed by the crypto world and Web3 enthusiasts, regulators around the world have sounded the alarm that this area needs urgent oversight.
Aside from a 2021 quarterly report from the BIS, an umbrella organization for central banks, calling "decentralization" in DeFi an "illusion" and arguing that centralized points within DeFi could allow regulators to gain control of the space, little practical progress has been made in implementing oversight.
However, embedded oversight technology has attracted interest from policymakers. At the request of lawmakers, the European Commission, the European Union executive responsible for drafting new legislation, is currently preparing a study on the potential impact of linking supervisory data applications to decentralized finance as a precursor to possible further legislation.
However, some have expressed skepticism about whether it is even possible to conduct such surveillance on smart contracts where the code is immutable. Embedded monitoring is "both beautiful and unfeasible in practice," George Giaglis, a professor at the University of Nicosia's Department of Digital Innovation, told CoinDesk.
"You can't enforce this at the protocol level. Unless you were to do something completely stupid, like embed code in smart contracts that would allow regulators to look into the transactions or something like that, which is not possible in practice," he said.