Crypto-currencies are attracting increasing interest: the global market was estimated at $1.6 billion in 2022 and will exceed $2.7 billion by 2030, according to Vantage Market Research. Crypto-currencies are at the heart of decentralized finance.
DECENTRALIZED FINANCE: HOW DOES IT WORK?
Based on Blockchain infrastructures, Decentralized Finance or DeFi is defined as a decentralized technology using encryption functions to secure, make reliable and transfer information within a network in which trust is distributed via mathematical algorithms, thus removing itself from trusted third parties. The association Blockchain France defines it as a " Technology for storing and transmitting information, transparent, secure and operating without a central control body."
In concrete terms, the Blockchain is a vast database that records the history of all transactions between those who use it. Exchanges are thus recorded in near-real time, and this database is secure and distributed: it is shared by its various users, without intermediaries, enabling everyone to check the validity of the chain.
According to a report by the AMF (Autorité des marchés financiers), almost 2,000 DeFi protocols would have been counted by early 2023, more than double the number (855) registered by early 2022.
THE THREE INGREDIENTS OF DECENTRALIZED FINANCE: PROTOCOLS, CONTRACTS AND APPLICATIONS
- Management protocols: these are rules that enable computers to format, manage and transmit data (like http for web pages). These protocols represent a break with traditional financial services, with banks as the main players, as they enable total disintermediation/automation.
- Smart contracts replicate the provisions of a conventional contract, but transactions are executed automatically according to defined criteria and parameters, including regulatory requirements.
- Innovative applications: these provide users with the interface they need to access smart contract functionalities. Users submit their transaction requests, which are checked against the provisions of the smart contracts. If these are validated, the transaction is carried out.
INDISPUTABLE ASSETS...
Compared with so-called traditional finance, decentralized finance offers three key advantages:
- No intermediaries and guaranteed transparency: users interact directly via decentralized protocols on the Blockchain and smart contracts, eliminating the need for traditional banks, brokers or financial institutions.
- Security and interoperability of protocols, which can work together. By design, blockchain guarantees the security of data and transactions.
- Innovation to develop new services. Thanks to smart contracts, it's possible to create sophisticated financial services that run automatically under certain conditions (for example, automatic repayment of a loan). Decentralized finance can be used, among other things, to borrow, lend and trade cryptocurrencies, or manage digital assets by, for example, delegating the management of their cryptocurrency portfolios to automated asset managers.
Recall that a crypto-currency (or crypto-asset) is defined, by the Autorité des marchés financiers, as " any digital representation of value that is not issued or guaranteed by a central bank or public authority, that is not necessarily attached to a legal tender, and that does not have the legal status of a currency, but that is accepted by natural or legal persons as a means of exchange and that can be transferred, stored or exchanged electronically. " The best-known digital asset is bitcoin, which is bought and sold via specialized platforms.
... BUT REAL RISKS
While decentralized finance offers undeniable advantages, we also need to be aware of the associated risks. There is a major difference between centralized finance (as we know it from banks) and decentralized finance: with the former, all financial activity is linked to the identity of the parties involved (according to the KYC principle: Know Your Customer), and banks can refuse certain people access to their services. With the latter, transactions are instantaneous, anonymous (no identity verification) and anyone can use the services.
WHERE IS REGULATION? NOWHERE...
So, unlike traditional financial systems, DeFi transactions are not regulated. In the event of fraud or dispute, there is therefore no central authority to intervene leaving the door open to financial losses. Indeed, the cryptocurrencies used are often highly volatile, and a sudden drop in their value can lead to significant financial losses, particularly in services such as lending. It's also an area ripe for fraud, for example when the creator of a project raises funds, issues a token that has no value in exchange for real currency or other cryptos, and disappears with the funds.
Phishing operations are also on the increase. DeFi protocols have already been attacked. The Inferno Drainer group, for example, has been active since August 2023, stealing over $180 million and claiming more than 189,000 victims. Hackers can also manipulate the price of assets, the order of transactions, or alter the terms of a smart contract. In 2022, $3.1 billion was embezzled via decentralized finance, according to a Chainanalysis study, fifteen times more than in 2020!
AN OPEN DOOR FOR MONEY LAUNDERING AND TERRORIST FINANCING?
The immediacy and anonymity of transactions for buyers and sellers (unlike traditional bank accounts) make decentralized finance an ideal vehicle for money laundering and the financing of hidden activities, particularly terrorism. These two criteria (speed and discretion) are particularly appreciated by money-laundering networks, which exchange real money for virtual currency. Several techniques of varying degrees of sophistication are used, and we refer you to the Tracfin studies for details.
IS TOUGHER LEGISLATION ENOUGH?
The public authorities have naturally tried to limit these risks. Thus, a 2020 ordinance (2020-115 of February 12, 2020) strengthened the fight against money laundering and the financing of terrorism applicable to digital assets. More recently, Ordinance no. 2024-937 of October 15, 2024 relating to the tightening of anti-money laundering and counter-terrorist financing obligations with regard to the transfer of crypto-assets, subjects crypto-asset providers to European rules, with adapted vigilance measures.
Despite these much-needed measures, it is unlikely that money laundering and terrorist financing will be radically eradicated in the short to medium term. In fact, a United Nations study has highlighted the four "assets" of crypto-currencies for money launderers: anonymity, the instantaneity/freedom of transactions, the possibility of laundering large amounts with thousands of small transactions and, finally, the volatility of crypto-currency prices, which makes it possible to justify rapid enrichment.
THE THREE KEYS TO COMPLIANCE: COOPERATION, AWARENESS... AND SOFTWARE SOLUTIONS
Progress in this area depends above all on strengthened (and sustained) cooperation between public authorities and companies. While awareness-raising on the part of regulatory authorities is the order of the day, this is less the case for businesses, which are in the front line in the fight against money laundering and the financing of terrorism.
In addition to raising the awareness of all stakeholders, as regulations remain complex and the financial stakes colossal, the right software tools are crucial: this is the only way to ensure compliance, eliminate the associated risks (fines, criminal liability of managers, etc.) and prove to regulators that objectives have been met. It is essential to have the essential functionalities for traceability, compliance audit trails, data security and centralization, filtering, monitoring and real-time alerting.