In decentralized finance (DeFi), there is a centralisation problem that policymakers can use to regulate the sector. This finding appears in BIS’s new quarterly report.
The BIS Quarterly Review is out https://t.co/IDICYAByVc pic.twitter.com/fbxFTKnv26
— Bank for International Settlements (@BIS_org) December 6, 2021
In the report, DeFi faces an “inevitable need” for centralized governance.
“There is a limit to how far the financial system can operate purely on automated transactions. It is an open question. We need to monitor this closely”, said Heng Son Shin, BIS’s head of research.
He expressed confidence that there will be cases where DeFi will require reorganisations or reappraisals. The governance structures inherent to the protocols provide obvious starting points for public policy, the report says.
Analysts doubted that DeFi could disrupt a larger-scale financial system, despite rapid growth.
They allowed that as DeFi becomes more popular, financial stability could be under threat because of serious vulnerabilities of the protocols. Among them are lending projects, liquidity problems in stablecoins and the absence of banks able to cope with potential shocks.
In BIS they note that the thesis of full decentralisation in DeFi does not stand up to criticism. At the same time, the deployment of governance tokens and DAO can weaken it.
“This element of centralisation could form the basis for recognizing DeFi platforms as legal entities akin to corporations. For policymakers, these groups and governance protocols are natural subjects for regulation”, the report notes.
Experts pointed to the U.S. state of Wyoming, where, at the legislative level, DAOs were given the ability to register in a manner similar to this.
According to Shin, regulators’ interaction with DAOs and holders of governance tokens will help address consumer protection, anti-money-laundering, and the maintenance of financial stability. This would curb DeFi risks until the sector expands significantly.
The report mentions a potential concentration of decision-making authority in protocols in the hands of a small group of large investors. Analysts also note risks of insider trading and price manipulation by this group.
Separately, experts highlighted the danger of using borrowed assets in one protocol as collateral in another, which could put pressure on token prices during liquidations.
Regarding stablecoins BIS highlighted the risk of a “banking panic” in the context of collateralised by commercial paper that lacks liquid secondary markets. As an example they cited Tether (USDT).
Regarding algorithmic stablecoins like DAI, analysts noted market risk of the assets backing them, whose value could fall sharply below the nominal value of the stablecoin. In that case there is no back-up option in the form of banks that can provide liquidity in periods of stress, they added.
In BIS they allowed a narrowing of the “distance” between DeFi and TradFi due to the drive of participants in the latter to master cryptocurrencies, which can create a spillover effect.
The organisation urged national banks to start crafting the rules of the game for the unregulated sector.
“Regulatory guarantees will help unlock the common benefits from DeFi’s innovative potential”, the specialists concluded.
Earlier in November, FATF published the final version of guidelines for the crypto industry focusing on DeFi and NFT.
Later, US Treasury Secretary Janet Yellen stated that these rules align with the norms of the FinCEN and are only recommendations.
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