Decentralized finance (DeFi) has been touted as the future of finance, promising a decentralized and democratized system free from the shackles of traditional finance (TradFi). However, according to a report by the Financial Stability Board (FSB), DeFi does not differ substantially from traditional finance in its functions.
In its report, the FSB has highlighted the major vulnerabilities, transmission channels, and the evolution of DeFi and called for the regulation of DeFi’s entry points, including stablecoins and centralized crypto asset platforms.
What is DeFi?
DeFi is a blockchain-based financial system that enables individuals to access financial services and products without the need for intermediaries like banks or brokers. It runs on decentralized blockchain networks like Ethereum and allows users to lend, borrow, trade, and earn interest on their digital assets. DeFi has gained immense popularity in recent years due to its ability to provide financial services to anyone, anywhere in the world, without any barriers to entry.
FSB Report on DeFi
The FSB is the financial regulator funded by the Bank for International Settlements (BIS), responsible for developing and promoting international regulatory policies for the financial industry. The FSB has issued a report on the financial stability risks of DeFi, highlighting the potential vulnerabilities, transmission channels, and evolution of DeFi.
In its report, the FSB states that DeFi provides many “novel” services but does not differ substantially from TradFi in its functions. By trying to replicate some functions of TradFi, DeFi increases potential vulnerabilities due to the use of novel technologies, high degree of ecosystem interlinkages, and the lack of regulation or compliance.
Moreover, the authority claimed that the actual degree of decentralization in DeFi systems “often deviates substantially” from the stated claims of the founding originators. This creates significant risks to the DeFi ecosystem, including financial stability risks.
Regulation of DeFi
To prevent the development of DeFi-associated financial stability risks, the FSB is cooperating with global standard-setting bodies to assess DeFi regulations across multiple jurisdictions. In this regard, the FSB considers the entry points of DeFi users, including stablecoins and centralized crypto asset platforms, as a key element to consider.
The FSB emphasized that asset-backed stablecoins like Tether (USDT) and algorithmic stablecoins like Dai play an important role within the DeFi ecosystem through their use in purchasing, settling, trading, lending, and borrowing other crypto-assets. The regulator suggested that the rise of stablecoins would also likely increase the adoption of DeFi solutions by retail and corporate users, as well as facilitate the adoption of crypto assets as a means of payment.
“With respect to liquidity and maturity mismatch issues, stablecoins are a crucial area of focus,”
the FSB wrote, stressing the need to understand the peculiarities of different stablecoins to monitor the risk they pose to the crypto industry, including DeFi ecosystems.
Increasing Scrutiny of Stablecoins
The news comes amid the increasing scrutiny of some major stablecoins by global regulators. On Feb. 13, blockchain infrastructure platform Paxos Trust announced that it would stop issuing Binance USD stablecoins amid an ongoing probe by New York regulators. The New York Department of Financial Services ordered Paxos Trust to stop BUSD issuance, alleging that BUSD is an unregistered security.
Conclusion
In conclusion, DeFi has revolutionized the financial sector with its innovative services and decentralized nature. However, its rapid growth and lack of regulation pose significant risks to the financial stability of the global economy. The FSB, funded by the BIS, is working on assessing DeFi regulations and identifying potential entry points for risk mitigation, including stablecoins and centralized crypto asset platforms. While stablecoins play a crucial role in the DeFi ecosystem, they also pose unique risks that require close monitoring and understanding. With increased regulatory oversight and collaboration, DeFi can continue to thrive while minimizing its associated risks.
