The Financial Stability Board (FSB) recently published a report stating that it will team up with other international standard setters to assess how decentralized finance (DeFi) activities should be regulated in various jurisdictions. Additionally, the FSB will investigate whether its proposed policy recommendations for the crypto sector need further enhancement to account for DeFi risks.
In collaboration with other international standard-setters, the FSB also plans to research ways to fill data gaps that could help measure and monitor the interconnectedness of DeFi with traditional finance. The report concludes that DeFi does not differ substantially from traditional finance in the functions it performs or the vulnerabilities it faces.
DeFi vs Traditional Finance
The FSB acknowledges that DeFi and traditional finance share similarities in functions and vulnerabilities. It notes that the risks associated with operational fragilities, liquidity and maturity mismatches, and leverage make the DeFi sector vulnerable. In its findings, the FSB has discovered that the interlinkages between DeFi, traditional finance, and the real economy are limited. However, the FSB warns that if the DeFi ecosystem were to grow significantly, the scope for spillovers would increase. Therefore, the FSB is taking a closer look at DeFi-specific risks and vulnerabilities.
Regulators worldwide have been monitoring the crypto industry’s interlinkages with the real economy since businesses and banks entered the sector during the crypto boom that began in 2021. Since then, billions have been wiped out of crypto markets, resulting in successive collapses, including those of token issuer Terra, crypto lender Celsius Network, and crypto exchange FTX. The market turmoil has prompted regulators to establish better safeguards for those investing in crypto, and the FSB is no exception. In October 2021, the FSB proposed a framework for the international regulation of crypto activities. In December 2021, it pledged to take a closer look at DeFi-specific risks and vulnerabilities. The FSB expects to publish its final crypto regulatory framework in July 2022.
The FSB recognizes that it is essential to fill data gaps in measuring and monitoring the interconnectedness of DeFi with traditional finance. Working with other international standard setters, the FSB plans to research ways to do this. By doing so, the FSB can obtain a better understanding of the risks posed by DeFi to the global financial system.
The FSB notes that asset tokenization could increase the linkages between the DeFi market and the real economy. As a result, the FSB will conduct further analysis to assess the implications of asset tokenization. If the DeFi ecosystem were to grow significantly, tokenization could amplify the risks posed to the global financial system. Therefore, the FSB must determine whether current regulatory measures are adequate to address the risks that tokenization could bring.
Prudential and Investor Protection Requirements
The FSB may consider subjecting crypto-asset types and entities to additional prudential and investor protection requirements, or stepping up the enforcement of existing requirements, to mitigate the risks inherent in closer interconnections. The FSB recognizes that additional regulatory measures may be necessary to reduce the risks associated with DeFi.
Decentralized finance has emerged as a disruptive force in the financial industry, offering new and innovative ways of accessing financial services. However, with the growth of the DeFi sector comes the potential for increased risks and vulnerabilities.
Regulators around the world are recognizing the need to ensure that the growth of DeFi is sustainable and that the risks associated with it are minimized. The Financial Stability Board’s report highlights the importance of international cooperation in regulating DeFi activities and outlines a plan for how it will work with other standard setters to address the risks associated with DeFi.
The FSB’s report provides a roadmap for how the DeFi sector can be regulated in a way that ensures its growth is sustainable and that the risks associated with it are minimized. It emphasizes the need for international cooperation and collaboration in regulating DeFi activities and acknowledges the potential risks associated with increased adoption and interconnections with the traditional financial system.
As the DeFi sector continues to grow and evolve, it will become increasingly important for regulators to ensure that it operates within a safe and stable framework. The FSB’s report is an important step towards achieving this goal and ensuring that the growth of DeFi benefits both the industry and the broader financial system.