The international Bank for International Settlements (BIS) has been closely tracking the stability risks posed by decentralized finance (DeFi) and crypto assets. Their connection with traditional finance (TradFi) is quickly becoming a make-or-break factor. The BIS has identified four key transmission channels through which these risks could materialize, warranting a "containment" approach to ensure TradFi firms adequately assess and manage potential threats.
The second big worry involves traditional finance’s direct exposure to crypto assets. This includes crypto-linked products and entities with deep connections to the cryptocurrency market. Consequently, depending on market volatility, there’s potential for surprisingly large confidence effects to grow. At the same time, large price fluctuations in the crypto market can create powerful wealth effects. The BIS has been deeply engaged in understanding the potential implications of crypto assets on payment and settlement systems. This is doubly so in emerging market economies, where IMF has recently highlighted the risks of cryptoization.
DeFi, which is largely built on crypto assets, adds even more layers of complexity. The BIS, meanwhile, is more interested in research that investigates the financial stability implications of real-world asset (RWA) tokenization. They too are looking into the systemic risks that arise from a tighter relationship between DeFi and TradFi. These worries become only more acute with the prospect of DeFi smart contracts moving into traditional finance. Furthermore, proprietary trading firms in traditional finance are leaning towards DEXs.
The BIS analysis further outlines four ‘transmission channels’ through which this risk is introduced, covering risks from a financial stability perspective. These channels include: TradFi exposures to crypto, crypto-linked products or other entities with exposures; confidence effects; wealth effects from price movements; and the use of crypto in payment or settlement.
Unfortunately, regulators are still sussing out the intricacies of DeFi governance. Regulators view decentralized applications (dApps) as the primary touchpoints with which they can exercise oversight. Yet it is the nature of these platforms—decentralized and distributed—that poses the largest challenge to regulation. Under the Basel banking crypto rules, permissionless blockchains are considered to be high-risk. This decision serves as an indication of the skittish nature of international regulatory bodies.
In early January 2024, the US Securities and Exchange Commission (SEC) finally approved the launch of spot Bitcoin ETF. Yet more significantly, this decision further illustrates the increasing mainstream establishment acceptance of crypto assets. This development further highlights the necessity of strong risk management frameworks in TradFi to avoid potential contagion effects.
Worries about the dangers of crypto assets have increased under the new administration. Some environmental critics contend that such assets can function to redistribute wealth rather than produce tangible value.
"a means for redistributing wealth from the late investors to earlier ones, who tend to be wealthy" - Ulrich Bindseil, ECB's
The BIS emphasizes the importance of proactive measures to contain potential risks and ensure the stability of the broader financial system. This includes enhanced monitoring of TradFi exposures to crypto, rigorous risk assessments by firms engaging with crypto assets, and the development of clear regulatory frameworks for DeFi activities.
