Taiwan Central Bank's views on DeFi and NFT, what are the potential risks? What is the progress of regulation?

On the 16th of this month, the Central Bank of Taiwan held its routine joint meeting of directors and supervisors, during which discussions were held regarding the current development and associated risks of DeFi and NFT. This article will summarize the viewpoints and key points of the central bank. For any uncertainties, please refer to the original text.

Central Bank's Views on DeFi and NFT

According to this meeting report, the central bank believes that many new products or services derived from blockchain technology are often given unique names to attract media and public attention. However, once the speculative hype fades, these services and products disappear from the public eye. This was the case with the Initial Coin Offerings (ICOs) that were popular in 2017-2018, and the same goes for DeFi and NFTs.

Furthermore, the central bank stated that cryptocurrency assets still serve as tools for speculation or investment in the virtual world and contribute little to real economic development. Not only does it lead to energy consumption by human society, but it also becomes a tool for various criminal activities. The speculative atmosphere in the crypto market also leads people to be addicted to money games resembling gambling.

Risks Hidden in DeFi

Since the cryptocurrency industry is full of crises, the central bank also reminds investors and consumers of the necessity to understand the market development and risks before entering the market. The central bank has identified 6 risks associated with DeFi:

1. Information Asymmetry and Fraud Risks

2. Market Integrity Risks

The central bank illustrated the concept of "front-running" to explain how miners observe large transactions on the chain and engage in arbitrage, highlighting the potential risks of trading and price manipulation, as well as conflicts of interest in DeFi.

3. Illegal Activity Risks

Since most DeFi protocols do not comply with Anti-Money Laundering and Counter Financing of Terrorism (AML/CFT) regulations, there may be gaps that lead to money laundering and terrorist financing.

4. Operational and Technical Risks

Due to DeFi's reliance on blockchain for executing smart contracts and clearing encrypted assets, any issues with blockchain operations directly affect its functioning. Additionally, excessive trading within a short period can lead to slower speeds, higher fees, impacting transaction efficiency and costs.

Smart contract code not audited is also a common issue, as programming errors and vulnerabilities may be susceptible to cyber attacks.

5. Governance Risks

The central bank noted that while DeFi operations appear decentralized, the actual governance power lies with the development team, indicating that the real governance authority is controlled by the development team, leading to insufficient transparency in the governance mechanism.

6. Risk Spillover to Traditional Financial Markets

As the DeFi industry develops, its connections with traditional financial markets are increasing. For example, stablecoins commonly used in DeFi may be backed by traditional financial products; private funds may invest in DeFi projects, etc. The central bank believes that without corresponding regulatory frameworks in place, there is a risk of spillover.

Regulatory Compliance for DeFi

While the central bank did not discuss the specific regulations or regulatory requirements that Taiwan's DeFi industry should comply with in the report, it mentioned the Financial Action Task Force's (FATF) views on DeFi. FATF believes that while DeFi does not fit the definition of Virtual Asset Service Providers (VASPs), the creators, owners, operators of DeFi, or others who can control or influence DeFi, may fall under VASP and must comply with relevant AML/CFT regulations.

Risks and Issues with NFTs

After discussing DeFi, let's look at the central bank's concerns and views on NFTs:

1. Ownership Attribution and Misuse of NFTs

The central bank stated that blockchain technology can only guarantee the uniqueness of NFTs on that blockchain; solely relying on blockchain technology itself does not clearly establish the ownership rights of the goods represented by NFTs under current legal systems. Additionally, the connected goods are usually digital files on the internet, accessible for download and use by anyone, making it difficult to have complete ownership rights like physical goods.

Moreover, since anyone can mint and issue NFTs, the misuse and fraud of NFTs are rampant.

2. Investment Risks of NFTs

The central bank mentioned that currently, NFTs mainly represent digital artworks, collectibles, and in-game items, with subjective values that cannot be reasonably priced. In addition, the NFT market being niche with poor liquidity increases the investment risks, making it unsuitable for the general public.

Furthermore, the central bank pointed out the common issue of "left-hand trading with the right hand" in NFTs, with numerous false and insider trades done solely to create an illusion of a vibrant market for investments.

3. Investor and Consumer Protection Issues

The central bank mentioned that since NFTs are still in the early stages of development, with unclear legal positioning and not being typical financial products, major countries have yet to formally include NFTs within the scope of financial supervision. Depending solely on service terms provided unilaterally by overseas NFT trading platforms makes comprehensive protection difficult.

Furthermore, NFT consumers are typically at a disadvantage, as they are susceptible to false, fraudulent advertisements, market price manipulation, and may end up purchasing fakes or buying at prices not in line with market conditions.

4. Technical Risks of Cryptocurrency Assets

Blockchain-related issues have the potential to occur in NFTs as well. Problems like lost private keys, smart contract vulnerabilities, and cyber attacks are possible.

5. Fragmentation of NFTs Involving Securities Issuance and Financial Activities

The central bank mentioned that dividing NFT rights into several smaller holdings and publicly selling them through issuing new tokens may resemble asset securitization. Several countries have taken actions regarding this financial activity, with the SEC in the U.S. initiating investigations; the Hong Kong Securities and Futures Commission believes it crosses the line between collectibles and financial assets, subject to regulation under the Securities and Futures Ordinance; and China has directly banned such activities to prevent them from becoming alternative ICO fundraising methods.

6. Money Laundering and Illicit Trading Funds with NFT Buying and Selling

Traditional artworks are already prone to money laundering transactions, and the central bank believes that NFTs exacerbate this issue due to their anonymity and ease of transfer, making money laundering problems more serious in NFTs. Many illegal funds have already flowed into NFT trading platforms, and with the widespread adoption of this technology, the amount will only increase.

Central Bank's Conclusion

Despite the multitude of issues mentioned above, the total market value of cryptocurrency assets remains significantly smaller compared to the global financial asset scale, with limited impact on financial stability. Most of the problems lie in investment risks, malicious behavior, and issues concerning consumer protection. However, major countries are increasingly focusing on regulating cryptocurrency assets, and international efforts are underway to establish consistent regulatory standards.