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Bank of France discussion paper explores the risks and regulation of DeFi

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(Kitco News) - The emergence of the largest banking crisis since 2008 has led many to reevaluate the benefits of Bitcoin and the digital asset ecosystem, especially decentralized finance (DeFi), which has been promoted by cryptocurrency proponents as the future of finance.

In response to the rising interest in DeFi, the Bank of France (APCR) has released a discussion paper outlining the risks that it believes DeFi poses to the financial system and their recommendations on the regulation of the industry moving forward.

One of the main concerns highlighted by the paper is the high level of concentration that exists within the DeFi ecosystem and the fact that the governance of applications is “sometimes highly centralized.”

“In this respect, it seems that the term ‘decentralized finance’ misrepresents the reality of DeFi and that it is more appropriate to speak of ‘disintermediated finance’,” the authors wrote.

According to the APCR, DeFi is comprised of three main layers: “blockchain infrastructure, ‘services’ application layer, and mechanisms allowing users to access these services.” Weaknesses and vulnerabilities for each layer were noted, with the central bank saying that “all the advantages of disintermediated finance are also factors of its vulnerability.”

“User access to these services raises more traditional issues for a financial sector supervisor: the high volatility and complexity of products, and their non- or little regulated access expose users to high risks of capital loss and may threaten the internal stability of the ecosystem,” the paper warned.

To help mitigate the risks posed by DeFi, the APCR recommended several regulatory options. “The main idea developed in this paper is that the regulation of disintermediated finance cannot simply replicate the systems that currently govern traditional finance,” the authors wrote. “On the contrary, regulations must take into account the specific features of DeFi. Moreover, such regulation should not be conceived as a monolithic block, but rather as a combination between traditional financial regulations and regulations inspired by other economic sectors.”

One proposal focuses on strengthening the security of blockchain infrastructures by requiring a network “to be certified according to minimum security standards.” This includes the certification of computer code, a minimum number of validators, and a cap on validation capacity concentration.

A second proposal recommends that all financial functions be transferred to private blockchains “in order to guarantee appropriate governance and security levels; these functions would then be managed by trusted private or public players, although this could limit the innovation capabilities of disintermediated finance,” the paper said.

For the application layer, the authors recommend establishing a certification process for smart contracts that covers the “security of the computer code, the nature of the service provided, and governance.” Certifications would be obtained after completing an auditing process performed by a human expert.

Another proposal was the creation of “an improved framework for the provision of services and user access to these services.” Included in this framework would be a requirement for service providers offering “sensitive services” to incorporate, which would subject them to supervision. The paper also recommends “assigning a legal statute to ‘decentralized autonomous organizations’ (DAOs),” which would allow them to be supervised.

A final proposal is to use intermediaries to regulate the majority of DeFi users as “only a few users have the skills needed to interact directly with DeFi applications.” The APCR recommends that access to DeFi “be made contingent on the level of financial literacy and risk appetite of the customer, both of which should be objectively assessed.”

Bank of France governor calls for the country to establish crypto regulations ahead of the MiCA

The considerations outlined in the paper are intended to “contribute to ongoing discussions, especially at the European level, in the wake of the MiCA Regulation,” the authors wrote.

The French Economy Ministry also has its sights set on regulating the metaverse, according to the text of a public consultation they opened Tuesday, with the goal of blocking large multinational internet companies from dominating the metaverse.

The government of France has called on the public to provide comments on policy issues like privacy, health and the environmental risks of a virtual world as part of an effort to create “digital sovereignty” for Europe.

“The virtual immersive universes of tomorrow will be able to take on several forms and methods of use, relying on various technological bases: virtual reality, augmented reality, mixed reality, blockchain, digital twins, 3D creation software, game engines, etc,” the announcement said. “The purpose of this questionnaire is to allow the various stakeholders (citizens, companies, associations, researchers) to express themselves on their expectations in the face of this novelty in order to design a French strategy capable of anticipating this transition.”

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