The decentralization promised by DeFi is an 'illusion' and a threat to global financial stability, BIS warns
- DeFi poses risks to global financial stability and 'systemic regulation' is needed, the Bank for International Settlements said Monday.
- Decentralized finance "appears to be operating largely within its own ecosystem," the institution said in a quarterly report.
The Bank for International Settlements said Monday global "systemic regulation" is needed to oversee banking activity taking place outside of traditional financial institutions as DeFi, or decentralized finance, poses stability risks.
The DeFi market for peer-to-peer blockchain-based financial transactions surged beyond $100 billion in valuation this year. It most recently carried a $143 billion market capitalization in the wider $2.4 trillion cryptocurrency market. Stablecoins are a popular vehicle in facilitating DeFi projects such as crypto lending and borrowing platforms.
"DeFi supporters stress its potential efficiency gains," such as reducing high costs and slow speeds within traditional finance systems, said the central bank forum in a quarterly review published Monday about developments in banking and financial
"For now, these gains are difficult to detect: DeFi appears to be operating largely within its own ecosystem, with little in the way of financial intermediation services being provided to the real economy," wrote the institution known as the central bank of central banks.
"At the same time, besides giving rise to first-order money laundering and investor protection concerns, DeFi displays substantial financial vulnerabilities," that exceed more traditional forms of finance, it said. Stablecoins – "the grease between DeFi wheels" – are subject to classic runs and the backing of liquid claims with less liquid reserve assets can spark downward price spirals akin to those stemming from redemptions in the investment fund industry, said BIS.
The institution said there's the "illusion" that DeFi is decentralized. But DeFi needs centralized governance to take strategic and operational decisions, it said. "In addition, some features in DeFi, notably the consensus mechanism, favour a concentration of power."
DeFi carries the potential to complement traditional financial activities. But for now, BIS argued it "has few real-economy uses and, for the most part, supports speculation and arbitrage across multiple cryptoassets."
Risks in the crypto ecosystem have so far been in the form of frequent and sizeable price crashes. "Whether such fragilities are limited to this ecosystem or can spill over to the traditional one is still unclear. But the potential for spillovers should not be underestimated, especially since the stablecoin arrangements themselves can create important links," said BIS.
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