Decentralized finance (DeFi), while a transformative force, has the potential to become destructive if smart contract risks and other vulnerabilities are not effectively addressed. This article adopts a critical analytical perspective to examine three substantial challenges associated with DeFi: the likelihood of a DeFi crisis escalating to affect the entire financial system, money laundering through the DeFi ecosystem, and DeFi as a new tax haven. Given that DeFi’s core feature (decentralization) is inherently in tension with centralized authority such as the nation-state, this article suggests that governments should act as DeFi facilitators, promoting the development of heathy private ordering to create a fair, integrated, and efficient on-chain environment that prevents illegal activity. It also suggests that state regulatory agencies should distinguish genuine DeFi from on-chain but centralized finance (CeFi) by adopting a systematic decentralization assessment framework. Effective regulation of DeFi also relies on industry-led bodies to establish standards, blockchain bug bounty programs to identify smart contract risks and protocol flaws, and blockchain intelligence firms and decentralized enforcement networks to trace suspicious on-chain activities, detect money laundering networks, and uncover fraud and tax evasion schemes.

Keywords: DeFi, shadow banking, money laundering, tax haven, private ordering, supervised self-regulation.