Decentralized Finance (DeFi): Disrupting Traditional Banking Systems and Their Regulatory Challenges

Abstract

Decentralized Finance (DeFi) is among the most revolutionary blockchain technology applications that changes how financial systems operate globally by eliminating the middlemen and allowing peer-to-peer transactions via smart contracts. DeFi platforms built on decentralized networks recreate core banking services (e.g., lending, borrowing, trading, and asset management) in a transparent, borderless, and programmable setting. This paper looks at the ways in which DeFi is disrupting conventional banking and the regulation issues that have emerged due to the phenomenon. It discusses the technical foundations of DeFi, its benefits of inclusiveness, efficiency, and innovation and its risks of volatility, security, and systemic vulnerability. Among the major regulatory issues identified in the paper are jurisdictional ambiguity, anti-money laundering (AML) and Know-Your-Customer (KYC) compliance, investor protection, and financial stability. Applications like Uniswap, Aave as well as MakerDAO example opportunities and threats. The same problem has dominated the United States, European Union and the emerging economies, as has been described in the comparison analysis of the response in regulation; tension of stimulation of innovation and protection of the financial structure. Research indicates that although DeFi has a revolutionary potential in relation to open finance, its decentralized form makes it difficult to regulate. It needs to be a middle ground between international coordination, hybrid sandboxes and technology neutral policy to not just promote resilience and consumer protection, but also creativity.