That banks and financial institutions can no longer ignore the cryptocurrency space may be a bygone conclusion. But are they ready for decentralized finance within that space?

Cryptocurrency has seen rapid adoption, with estimates that 23% of Americans now own crypto, a panel said yesterday at the Association of Certified Anti-Money Laundering Specialists (ACAMS) conference in Las Vegas. Consumers are buying the currency primarily as an investment, and a variety of economic factors have helped spur that movement.

But a new complexity that banks and financial institutions (FIs) in the space must now be aware of is decentralized finance, or DeFi. Institutions now trading or involved in the cryptocurrency space are “more comfortable with the more established [crypto] exchanges, and now this has kind of thrown a new wrench in it,” Caitlin Barnett, director of regulation and compliance at Chainalysis, said at the conference.

“It’s just an example of how, in this space, it is constantly changing,” she added. “I don’t think we expected to see [DeFi] pop up as quickly and the adoption really come [this quickly].” Barnett noted that Chainalysis — a blockchain analysis company serving FIs and others that engage in cryptocurrency — is working on solutions to help its clients “get more comfortable” interacting with DeFi platforms.

Melissa Strait, chief compliance officer at cryptocurrency exchange Coinbase, delved into the DeFi concept. “When most of you think about cryptocurrency, you’re probably thinking about exchanges like Coinbase, like Gemini, like Kraken. Those are actually generally centralized finance, like banks, or ‘C-Fi,'” she said.

Strait explained that DeFi refers to financial services that have no third-party intermediary, such as a bank or typical cryptocurrency exchange. DeFi generally runs on public blockchains ― primarily the Ethereum blockchain.

“I think that this is an area that is blowing up, and there are a ton of different [DeFi] exchanges,” she said. “Essentially, how you can think of this is as an individual person accessing financial services without having a third party or a financial institution in the middle of that transaction.”

She gave an example of an individual possessing an amount of USDC, a stable coin based on the U.S. dollar, and wanting to lend some of it. That individual can now use a growing number of DeFi providers to facilitate the transaction.

“There’s no human involved in that; it’s just executed on the Ethereum blockchain, essentially via smart contracts,” Strait said. “There’s no institution and there are no employees in the DeFi space, as opposed to centralized finance, where obviously, you have an institution and employees that are managing operations.”

DeFi proponents claim an advantage is the public code that allows everyone to view all transactions on the blockchain ― as opposed to something like a traditional bank, where “you’re not going to be able to see the financial records of JPMorgan Chase if you are JPMorgan Chase customer, for example,” Strait said.

Additional risk in DeFi

Banks and FIs face some additional risk in dealing with DeFi entities, Chris DePow, senior advisor for financial institution regulation and compliance at blockchain analytics and monitoring firm Elliptic, told Bank Automation News. Even so, he pointed to the transparent nature of blockchain transactions.

“Unlike the fiat world, where someone can show up with a duffel bag full of cash and hand it to somebody else, if you’re effectuating a transfer value on the Bitcoin blockchain, all of that data is publicly available and can be analyzed,” DePow said, to determine if there are connections to bad actors.

“There’s certainly incremental risk in the sense that these are new financial products, and there are new [anti-money laundering] risk technologies that exist that haven’t existed in the past, just because it’s a developing technological sector,” he added.

Banks and FIs that engage in cryptocurrency and DeFi should recognize that there are varying levels of risks involved and “leverage some sort of analytics and monitoring provider in order to ensure that they’re identifying the bad actors,” DePow said.

Cryptocurrency and DeFi will become an area of greater focus for regulators.

“I think there’s also going to be a question that emerges,” he said. “If you are an entity that provides your customers access to the DeFi world, what is your ultimate responsibility? And how much vicarious liability do you have?”