Crime and Decentralization: Preventing Criminal Activity on DeFi

Decentralization started out as a pretty good way to buy illicit goods and services. Cybercrime was already a category into which things like Silk Road fit into very easily.

Ten years on, what does decentralization’s impact on crime really look like? Criminals have gotten craftier with the tools of DeFi, but so have authorities.

DeFi has a lot of innovative potential for finance, but we need to also acknowledge that it has features that circumvent traditional rules.

Let’s look at a couple of categories of crime that have been driven directly by decentralization. And then what recovery and insurance has done to respond. 

New crypto-criminal business models

One of the biggest impacts of decentralization on crime has been the introduction of new business models for illicit transactions. The Silk Road was a prominent early example of a platform that used Bitcoin as a payment method for many categories of controlled goods and services. This business model allowed for greater user anonymity, as well as a considerably wider reach. The Silk Road was eventually shut down, but similar marketplaces emerged, such as AlphaBay and Hansa Market – also since shut down following a ‘landmark’ international law enforcement investigation.

A second new business model is the rise of ransomware – the type of malicious software that encrypts a victim’s files and demands payment in exchange for the decryption key. The use of cryptocurrencies makes it easier for criminals to demand payments in a way that doesn’t require foreign exchange or banks. It has even paved the way for an entirely new form of cybercrime known as ‘Cryptojacking’. Ransomware has become so prevalent that it has climbed the league tables of crime in terms of criminal earnings, surpassing even drug trafficking. It has also directly contributed to the rise of cyberinsurance, where insurance companies attempt to assess and mitigate its risks.

Cutting out the regulated middleman

At its core, DeFi uses distributed ledger technology (DLT) to eliminate the need for traditional intermediaries like banks and financial institutions. Instead, users can interact with decentralized applications directly, executing smart contracts that automate the terms of their transactions.

The problem for regulators is that existing rules are based on overseeing the activities of specific entities. If those entities are no longer involved in the transaction, there is no clear intervention point when things go wrong. This means that many innovative DeFi instruments and transaction types operate in a largely unregulated space.

The inability to regulate doesn’t presuppose a crime is happening, but it makes consumer protection considerably more difficult to execute. One recent example is the $600 million hack of the Poly Network, a cross-chain DeFi platform, which was one of the largest crypto heists in history. Unlike traditional financial institutions, which have established protocols for reimbursing customers who are victims of fraud or theft, DeFi is less likely to have such safeguards in place.

As DeFi continues to grow in popularity, it’s crucial that we find ways to balance the benefits of decentralization with the need for security and consumer protection. This may involve things like self-governance by DeFi communities or the development of decentralized regulatory frameworks that can keep pace with the rapidly evolving DeFi landscape.

Balancing innovation with security and resilience

The same features that we talked about above are also being used to improve security and monitoring of transactions in ways that are helpful to regulating the sector.

The underlying distributed technology is empowered with transformative potential, especially within the financial landscape. By ‘cutting out the middleman’ and giving users more control over their money, DeFi can improve financial inclusion and empower individuals and communities around the world.

However, to realize this potential, we need to focus on improving the security and resilience of DeFi infrastructure. This means investing in better tools and protocols for securing smart contracts, detecting and mitigating attacks, as well as ensuring the integrity of blockchain networks. It also means building a strong recovery framework for DeFi users who fall victim to criminal activity.

To address this issue, some DeFi and DLT-based projects are exploring new forms of insurance schemes that can provide users with greater peace of mind. For example, some platforms are developing decentralized insurance pools, where users can pool their funds to create a collective insurance fund that can be used to compensate victims of fraud or other attacks.

Ultimately, the success of DeFi will depend on our ability to balance innovation with security and resilience. By working together to address the challenges facing the DeFi ecosystem, we can build a more open, trusted, and enduring digital financial system for the future.