The Need for Regulation in DeFi Projects according to Hong Kong SFC

On April 12th, it was reported that Cai Zhonghui, the interim head of the Intermediary Department of the Hong Kong Securities and Futures Commission, stated at today’s “2023 Hong Kong Web3 Carnival” that the DeFi project needs to be regulated by SFC, and automatic trading services are also under SFC supervision. If virtual assets are involved in the central trading platform, a license also needs to be applied for; Some DeFi protocols are nominally decentralized, while in reality, a small number of developers hold a large number of governance tokens, requiring analysis of their substance rather than superficial claims.

Hong Kong SFC requires DeFi projects to be licensed and regulated, and DEX involving virtual assets also requires application for a license

Introduction

On April 12th, the interim head of the Intermediary Department of the Hong Kong Securities and Futures Commission, Cai Zhonghui, spoke at the “2023 Hong Kong Web3 Carnival”, discussing the need for regulation in DeFi projects. In his address, Zhonghui mentioned that the SFC should regulate DeFi projects and that automatic trading services would also fall under their supervision. Additionally, he emphasized the importance of obtaining a license for virtual assets involved in the central trading platform. Moreover, some supposedly decentralized DeFi protocols are under the control of a few developers who hold significant governance tokens, which emphasizes the need for proper analysis of the DeFi projects’ substance rather than superficial claims. This article will cover the different aspects of DeFi regulations, the definition, and the current state of DeFi and how the Hong Kong SFC aims to regulate DeFi projects.

Defining DeFi

Decentralized Finance (DeFi) refers to an ecosystem of financial applications built on the blockchain technology, seeking to disrupt traditional financial intermediaries. DeFi protocols provide open-source, permissionless, and decentralized financial services such as lending, borrowing, trading, and insurance, among others. DeFi makes financial services more accessible to the people by removing intermediaries such as banks, financial institutions, or governments. Since DeFi is powered by smart contracts and blockchain technology, it is transparent, secure, and immutable.

The State of DeFi Regulations

The decentralized nature of DeFi protocols presents a big challenge when it comes to regulation. There is no central authority to regulate or control the DeFi ecosystem. Hence, DeFi protocols are not subject to any centralized governance framework; neither are they bound by any traditional regulatory frameworks.
Without effective regulation, DeFi protocols are susceptible to fraud, hacks, and other illegal activities. Reports of rug pulls, hacks, and scams are widespread in the DeFi space. For instance, in 2020 alone, Chainalysis reported that hackers and scams stole over $100 million worth of cryptocurrencies from decentralized finance protocols. With the growth of DeFi, the need for regulatory oversight is becoming more pressing.

How SFC aims to regulate DeFi

Regulators such as the Hong Kong SFC are looking for ways to regulate DeFi projects. Cai Zhonghui mentioned that to apply for regulation, DeFi projects need to register with the SFC. He emphasized that if virtual assets are involved in central trading platforms, a license must be obtained. Moreover, the SFC will regulate automatic trading services that operate on DeFi protocols.

The Need for Substance Analysis

DeFi protocols are expected to be decentralized, but in reality, few developers often hold significant governance tokens, influencing the direction of the projects. This presents a challenge for regulators who need to analyze the substance of each DeFi project rather than relying on superficial claims. Regulators need to ensure that the governance of DeFi protocols is decentralized, ensuring a fair and transparent system.

Conclusion

The growth of DeFi protocols calls for robust regulations to ensure their safety and legitimacy. Regulators such as the Hong Kong SFC have earmarked DeFi regulation as an important aspect of their mandate. They will regulate all automatic trading services in DeFi protocols and require licensing for virtual assets in central trading platforms. For decentralized protocols, regulators need to analyze each project’s substance to ensure that governance is truly decentralized. Such regulations would undoubtedly contribute to the growth and sustainability of DeFi projects by giving investors more credibility and confidence.

FAQs

Q1. What is DeFi?

DeFi refers to an ecosystem of financial applications built on blockchain technology, providing decentralized, open-source, and permissionless financial services.

Q2. Why does DeFi need regulation?

DeFi protocols are susceptible to scams, hacks, and other illegal activities without adequate regulation. Moreover, the DeFi ecosystem will continue to grow, making regulatory oversight necessary.

Q3. How will the Hong Kong SFC regulate DeFi projects?

The Hong Kong SFC will regulate automatic trading services in DeFi protocols, and licensing will be mandatory for virtual assets in central trading platforms. The SFC will also ensure that the governance of the protocols is decentralized.