• Web3 offers an alternative to traditional wet code in the form of computer code, or “dry code” which can protect investors and users by encoding rules in verifiable, permissionless and self-custodial protocols.
• Regulations are important because they can promote orderly and efficient markets and protect investors from those who may take advantage of them.
• Leverage involves borrowing money that must be paid back, and without proper regulations the risk of the losses can be significantly higher than the potential gains.
The world of decentralized finance, or DeFi, has opened up new possibilities for creating and implementing financial policies. While traditional laws and regulations set the parameters for how financial activity should be conducted, they can often be cumbersome and slow to update. In the world of Web3, code has the potential to be a better policy tool than law.
Computer code, or “dry code”, can be used to encode rules in verifiable, permissionless and self-custodial protocols, providing an alternative to traditional “wet code”. This approach relies on incentives and the transparency of the technology itself.
Regulations are important because they can promote orderly and efficient markets and protect investors from those who may take advantage of them. One example is the problem of leverage, i.e., when people trade on margin, or borrow money they have to pay back. Without going into detail, the math behind leverage is such that gains and losses increase linearly while risk increases quadratically. In other words, if you have 5x leverage you only gain or lose five times the amount of money, but the risk is twenty-five times higher.
Dry code can be used to create incentives for prudent lending, for example, by limiting the amount of leverage that can be used in a given transaction. This can help protect investors from taking on more risk than they can afford to lose. By taking advantage of code, DeFi protocols could also make sure that users are aware of the risks associated with their investments, and provide them with the tools they need to make informed decisions.
In addition to limiting leverage, DeFi policies could also be used to create a more equitable market by requiring participants to disclose their positions and ensuring that the market is open to all parties. This could help to prevent insider trading and market manipulation.
Ultimately, the best tool for designing effective DeFi policies is Web3 itself. By leveraging the power of code, DeFi projects can ensure that their policies are transparent, verifiable, and enforceable. This will help to ensure that investors are protected and that the markets remain efficient and orderly.