[FOCUS] State watchdog proposes national strategy to nurture decentralized finance

By Lim Chang-won Posted : February 9, 2021, 17:52 Updated : February 10, 2021, 17:05

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SEOUL -- As a frontrunner in disseminating 5G mobile services, South Korea has a well-earned reputation as a global leader in accepting and popularizing new gadgets quicker than any other country. Digital transformation is a new industry buzzword under a strong government campaign to spread a digital economy.

There are plenty of IT jargons and terminologies being used across society. However, decentralized finance, or DeFi, is still an unfamiliar concept even to many tech-savvy young people when the Korea Internet & Security Agency (KISA), a state internet watchdog, released a special report in which experts proposed a national strategy to support the growth and technology development of domestic firms so that they can take the upper hand in the global DeFi market by 2026.

Without relying on central financial intermediaries, DeFi utilizes smart contracts on blockchains. DeFi platforms allow people to lend or borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts. DeFi revolves around applications known as decentralized applications. Transactions are directly between participants, mediated by smart contract programs using open-source software that can be easily copied to set up competing platforms.

An incorrect transaction with a DeFi platform or even deployment of smart-contract code containing errors cannot always be easily corrected. The person or entity behind a DeFi protocol may be unknown, and may disappear with investors' money. DeFi is largely non-compliant with anti-money laundering rules. Inexperienced investors are at particular risk of losing money using DeFi platforms.

There are no domestic or global standards, but experts stressed that South Korea should grow DeFi into a national strategic industry, saying it would provide an opportunity to lead a new financial system based on virtual assets and digital currency that will definitely come. "In order for individuals, companies and countries to succeed, they must prepare for future growth in advance," the KISA report said, suggesting DiFi services may become an axis of the financial industry and converge with traditional finance in various countries.

Despite some negative factors, the report emphasized the necessity of establishing a domestic DeFi alliance and gave a somewhat positive assessment of the future of DeFi, citing the possibility of stable virtual asset transactions in major countries, low entry barriers and South Korea's ICT competitiveness.

"If the DeFi sector is gradually fostered from 2021, our technology and product competitiveness will lead the world by 2025, and Korean services will be a big force," the report said. "We can become a leading group in the tightly connected future digital finance by creating a K-DeFi alliance with overseas DiFi services and global financial companies at this time."

Currently, DeFi is very inconvenient as each service has a different user experience and implements the same function differently. "It is a high obstacle for ordinary consumers, not early adopters, to enter the market," the report said. "The standardization of user experience is essential for the popularization of DeFi, and South Korea can gain an advantage over competitors in the standardization process if the government take in the initiative and let startups follow."

Traditional financial companies will be able to work with DeFi startups for their inroad into the global market, the report said. "Fostering DdFi at the national level can provide a long-term positive opportunity to strengthen the international competitiveness of the Korean financial industry."

Blockchain FinTech is somewhat related to real financial services, just as payment settlement operators introduce virtual assets as a means of payment, but DeFi created financial services in the blockchain network by itself. "It is not yet institutionalized and somewhat experimental, so it may be difficult to call it a financial service, but DeFi is forming a market at a fast pace. In a word, it is the birth of a new financial system," the report said.

Risk factors highlighted by the report included a sharp increase in the amount of deposit in the DeFi market, the so-called "interest farming" to receive virtual assets issued by each service, and growth on the basis of speculation. "The total amount of deposits continues to increase, but there are no indicators and services that accurately measure how much the original currency was deposited at first."

Even considering such limitations, there are many market opportunities expected in the future, the report said, adding that DeFi services can be operated worldwide as long as virtual assets exist, due to the ambiguity of regulatory targets, difficulty to track and censor and technology limitations that make it difficult to identify users.

The KISA report presents directions and strategies to create a DeFi ecosystem, develop technology, expand the base of users, enhance convergence between products, and support start-ups. The first stage calls for the creation of a DeFi ecosystem to train professionals, the third-party audit of smart contracts to secure stability and trust, and marketing support to help secure users.

The second stage, which is from 2023 to 2024, is the expansion of a user base. The creation of exclusive investment funds was proposed, along with a test lab to be used by companies. The report stressed the importance of developing and distributing standards and guidelines on user interface and experience since a good UI and security-proven standard library can be safely certified by international bodies.

From 2025 to 2026, the report recommended enhanced convergence between products, the establishment of decentralized identification and an exclusive anti-money laundering platform. "The day will come when customer identification and anti-money laundering are important in DiFi. At that time, South Korea will be a country that has preemptively built and commercialized solutions that are needed worldwide."
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