A new report by the Bank for International Settlements( BIS), also known as the central bank, found that decentralized finance ( DeFi) could play an “important role” in the traditional financial market. However, it warned of financial instability.
The report, DeFi risks & the decentralisation illusion states that DeFi could become an integral part of the wider financial system if it makes certain regulatory and technical improvements.
The report stated that “History has shown that early development of new technologies often leads to bubbles and loss in market integrity, while also generating innovations that could be of greater use down the line,” according to the bank.
It also stated that DeFi could play an important role in the financial sector if blockchains are able to increase scalability and if traditional assets are tokenized on a large scale, and if appropriate regulation is put to the market, DeFi could be a viable option.
Despite acknowledging DeFi’s relevance, the bank also stated that DeFi’s growth “poses financial stability problems.”
The report stated that “collateral prices fall and margins rise in times of distress, so downward price spirals frequently arise and could spread to other parts of the financial system.”
The DeFi space is still “largely self-contained,” it said.
The report also highlighted stablecoins, pointing out that they are both “neither central banks money nor commercial bank cash.”
It was argued that
“[S]tablecoins can be prone to runs which would compromise their ability transfer funds within DeFi ecosystem.” This could lead to “funding shocks,” for both banks as well as companies. It also has the potential to have a “severe effect” on the financial sector.
The BIS recommended that these regulatory tools, which are already in place for traditional finance, should be extended to DeFi. This would allow banks to be regulated and supervised more effectively.
The report also addressed the “illusory” decentralization in DeFi. It stated that protocols have an “inescapable necessity for centralised governance,” particularly when it comes to operational and strategic decisions.
The DeFi protocol’s governance structure, which it described as favoring a concentration in power, could be used to provide “natural entry points” for regulators.
The BIS stated that “public authorities would need interface with DeFi’s inherent governance systems, so as to provide sufficient financial stability safeguards and to increase trust by addressing investors protection issues.”
Today’s report by BIS follows a dramatic increase in DeFi protocol use over the course 2021. According to DeFi Lama, the total value locked (TVL), in DeFi protocols, has increased from USD 21.55bn at the start of the year to USD 253.6 as per Sunday.
Basel, Switzerland is home to the BIS, an international financial institution. The institution is owned and managed by 62 central banks around the globe. It is headed by Agustin Carstens, an ex-HT0_Banco de Mexico Governor.
The bank has spoken repeatedly about the rise in DeFi and stablecoins. A representative stated that, due to these innovations, the legacy financial system had entered “an era of disruption”.