Lack of defi, crypto regulation holding advisers back

Financial services law firm Holley Nethercote managing partner and speaker at the upcoming 2022 Adviser Innovation Summit, Paul Derham said clients have been regularly asking how they could invest in these products.

“But advisers are saying they can’t advise on that because it’s not covered under their insurance or for various other reasons.”

Mr Derham said these products would create more investment opportunities for both advisers and their clients and “it’s here to stay”.

“I think another opportunity is as defi protocols become more available and people start to understand them, advisers will discover that there are certain products that might provide better rates than traditional finance,” he told ifa ahead of his session on defi at the 2022 Adviser Innovation Summit.

“By making those better products available to their clients, they're providing them a pretty unique service.”

A defi protocol uses smart contracts that run on the blockchain network, with the source code of most defi projects available for anyone to check and audit around the globe.

Users of the protocol can communicate with these smart contracts using their wallets to transfer funds, borrow, lend, or use other available defi services.

“The protocol is open for people to look at and investigate and understand,” Mr Derham explained.

"They’re a set of rules that everyone agrees to and they participate in the protocol. It’s very transparent. Also, because they’re distributed, we’re essentially moving from brand-based trust to maths-based trust, which means they’re trusting a distributed protocol.

“That presents two opportunities: one is a wider range of products and the other is access to better products in terms of the yield that it generates and the features it could offer.”

However, Mr Derham cautioned that some of these defi protocols are currently offshore, making them increasingly “opaque”.

“So, we all hope that if and when the regulation comes in, it will provide clarity to everyone around what is and isn’t a financial product,” he said.

If they are not deemed financial products, advisers would be prohibited from providing personal advice or recommending them to their clients under the terms of their AFSL and professional indemnity insurance arrangements.

“We’re hoping that the regulation does solve some of these problems,” Mr Derham said.

Last year, Federal Treasurer Josh Frydenberg outlined the government’s plans to develop and introduce a licensing framework for digital currency exchanges and a custody regime for businesses that hold crypto-assets on behalf of customers.

Minister for the Digital Economy Jane Hume pledged minimalist regulation for the emerging blockchain and crypto sector earlier this year, and ensured it would be technology neutral.

Should the government return to power at the upcoming federal election and implement the crypto reforms, Mr Derham said “it will offer all of us lawyers and financial advisers hope that it will bring regulatory clarity around what is and is not a financial product”.

“Right now, an adviser could recommend that their client invest in a defi protocol, but that protocol might well be a financial product,” he said.

“And the only way of really knowing that will be if someone connected to that defi protocol pays lawyers to do an assessment, and then shares that view.”

Get your head around it

Mr Derham encouraged advisers to experiment in defi (with a focus on Australian-based products) using small amounts of money but cautioned against placing their capital at risk.

“Try things out but be very careful. Watch YouTube videos and participate in industry forums. Don’t do something you don’t understand,” he warned.

One method to understand these relatively new products is equating digital assets and defi protocols with traditional financial markets because many of the services on offer are blockchain-based equivalents of elements in the traditional financial market infrastructure, Mr Derham posited.

“You can think about products being similar to a fiat currency, transfer of money, a consumer credit loan, a deposit product, or a derivative,” he said.

“As soon as you start making those connections as a financial adviser, I think it will demystify what we’re talking about here.”

Mr Derham will take to the stage at the 2022 Adviser Innovation Summit in Melbourne on 1 June and Sydney on 8 June to demystify decentralised finance and offer tips on how advisers could prepare for the change and connect with defi services to gain a competitive edge.

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