A new report from the Bank for International Settlements (BIS), sometimes referred to as the central bank of central banks, finds a somewhat surprising finding that decentralized finance (DeFi) may play an “important role” in the traditional financial system, but warns of potential financial instability.
According to a report entitled DeFi Risks and the Decentralization Illusion, DeFi could, with certain technical and regulatory improvements, become a much more important and integrated part of the broader financial system than it is today.
“History shows that the early development of new technologies is often accompanied by bubbles and loss of market integrity, even when innovations are created that have the potential to find wider application in the future,” the bank said in a report.
However, he also added that if blockchains improved scalability, if large-scale tokenization of traditional assets occurred, and if “appropriate regulation” were introduced in the market, DeFi could play “an important role in the financial system”.
However, while the bank acknowledged the potential importance of DeFi, it also said its growth “poses problems for financial stability.”
“As collateral prices fall and margins rise during the crisis, there are often downward price spirals that could spill over into the rest of the financial system,” the report said.
He added that the reason it hasn’t happened yet is because the DeFi space is still “pretty much autonomous.”
Moreover, the report highlighted stablecoins of particular concern and stated that they “are not central or commercial bank money.”
He claimed that,
“[S]tablecoins are susceptible to launch, which will jeopardize their ability to transfer funds in the DeFi ecosystem. ” This can cause “financial shocks” for both banks and companies, with the potential for “serious impact” on the financial system and the economy.
To better control these risks, BIS has proposed that the regulatory framework that already exists in traditional finance should also be applied to the DeFi space, and that the tools already used to regulate and supervise banks could be expanded to also include stablecoin issuers.
Finally, the report focuses on so-called “illusory” decentralization in DeFi, which states that protocols “inevitably need to be centrally managed,” in particular when it comes to strategic and operational decisions.
He went on to suggest that the distinctive governance structures of the DeFi protocols, which he says “promote the concentration of power,” may also serve as “natural entry points” for regulators.
“Governments will need to interact with DeFi’s inherent governance structures to provide sufficient assurances of financial stability, as well as build confidence by addressing investor protection and illegal activities,” says BIS.
Today’s BIS report follows massive growth in the use of DeFi protocols over the course of 2021. Since the beginning of the year, the Total Locked Value (TVL) in DeFi protocols has grown from $ 21.55 billion as of January 1 to $ 253.6 billion. as of Sunday, according to DeFi Llama.
BIS is an international financial institution headquartered in Basel, Switzerland. The institution is owned by 62 central banks around the world and is headed by the former Governor of Banco de México, Agustin Carstens.
The bank has repeatedly announced the growth of DeFi and stablecoins, most recently, in October, it was officially announced that the aging financial system has entered an “era of destruction” due to these new innovations.