The Bank for International Settlements (BIS), often referred to as the central bank for central banks, has recently updated its assessment of the decentralized finance (DeFi) and crypto landscape. That change in mindset should be a game changer. Fortunately, global financial institutions have finally shed the decades-long view of the sector as “too small to care,” instead perceiving the economic sector as a potential systemic threat. For those navigating the Web3 space, understanding these evolving concerns is crucial for making informed decisions and staying ahead of the curve. At GreedyChain.com, we break down the mysteries of DeFi and crypto. We offer actionable, digestible intelligence to help you stay informed and prepared for what’s ahead.

The Evolving Perception of DeFi Risk

Up until recently the crypto market was seen as a completely different world, an alternative finance (AltFi) outside of TradFi. And today, the BIS has raised concerns that DeFi and crypto have developed into a “critical mass.” This superheated state creates a set of risks that could upend the entire financial system. This judgment extends further than the aforementioned market cap assessment and goes to the growing intertwining of DeFi and TradFi. Consider this a wake-up call. We need to pay much closer attention to the vulnerabilities in the still nascent DeFi ecosystem and how they might pose potential threats to global financial stability.

This early understanding of DeFi as a separate world has increasingly proven to be short-sighted as evidenced by the following developments. In parallel, academic research has increasingly focused on DeFi systemic risk, shedding light on potential contagion effects within the crypto space and beyond. Since the beginning of 2020, the DeFi ecosystem has increased exponentially. This growth paired with a reawakening of public interest has considerably boosted its reach and influence. Though this expansion is a clear sign of innovation, it introduces new regulatory, security, and stability related challenges. Now the BIS itself has adjusted its view, a signal of a mounting consensus. The DeFi space is too large and influential for regulators to overlook or dismiss as a niche or testbed.

The turmoil witnessed in crypto markets and DeFi during 2022 served as a stark reminder of the vulnerabilities inherent in this nascent sector. Operational fragilities, liquidity and maturity mismatches, and leverage and interconnectedness vulnerabilities were all laid bare during this stretch. The rapid insolvency of several major crypto companies revealed just how quickly value can be destroyed. It further highlighted the need for strong risk management practices. These events have been closely watched by the BIS and other regulatory bodies. They are getting to work developing policies to address the risks they’ve pointed out.

Transmission Channels of Risk

To that end, the BIS has identified four key channels through which risks are transmitted. These are the channels through which DeFi and crypto connect to the broader financial system. These channels are best understood through microeconomic and macroeconomic pathways, with distinct implications along each channel. It is imperative that investors and policymakers understand these transmission channels. By understanding these disparities, they are better situated to design the most tailored interventions and smartly plan risk mitigation strategies.

Microeconomic Channels

Microeconomic channels include the direct linkages between individual firms and institutions operating in DeFi and TradFi space. These linkages can take various forms, including:

  • Direct Investment: TradFi institutions investing directly in crypto assets or DeFi protocols.
  • Service Provision: TradFi firms providing services to crypto companies, such as custody, lending, or market making.
  • Interbank Lending: Banks lending to crypto companies or accepting crypto assets as collateral.

These straightforward links may be sufficient to allow shocks from the DeFi industry to spread to TradFi. When it comes to instances where a TradFi institution has had significant and sudden holdings of a volatile crypto asset, if that asset crashes in value overnight, there’s pressure on the institution’s balance sheet. This would be the catalyst for broader financial contagion across the market.

Macroeconomic Channels

Macroeconomic channels These are the indirect effects caused by the overall impact of DeFi and crypto on the economy at large. These channels include:

  • Wealth Effects: Changes in crypto asset prices affecting consumer spending and investment.
  • Capital Flows: Cross-border flows of capital into and out of the crypto sector impacting exchange rates and financial stability.
  • Monetary Policy: The potential for crypto assets to undermine the effectiveness of monetary policy by providing alternative means of payment and store of value.

DeFi and crypto are evolving quickly, exposing their macroeconomic impact. It’s becoming clearer by the day that these assets play a huge role in shaping larger economic trends. A sudden decline in the value of crypto assets could lead to a corresponding drop in consumer spending. This decline has a tangible, direct effect on economic growth. In the same way, sudden large capital outflows from a country’s crypto sector could stress the currency and financial system of that country.

The Role of ETFs and RWA Tokenization

TradFi is making its entry into DeFi in deeper waters through instruments such as Exchange Traded Funds (ETFs) and Real World Asset (RWA) tokenization. This movement, in turn, is making it hard to differentiate between tradfi and defii. While these developments are certainly exciting, they come with potential drawbacks. At the same time, they deepen the dangers flagged by the BIS.

ETFs: Bridging the Gap

Crypto ETFs offer a regulated, familiar vehicle for TradFi investors to get exposure to crypto assets. This induced accessibility magic can lead to large capital inflows to the crypto market, leading to large price inflation and increased volatility of assets. While ETFs can offer diversification benefits, they create a direct link between TradFi and crypto, making TradFi investors vulnerable to shocks in the crypto sector.

RWA Tokenization: Unlocking Value

RWA tokenization is the process of converting physical assets such as real estate, commodities, and debt instruments into digital tokens. These tokens are cryptographically protected and controlled on a blockchain. That’s a big deal, because this process has the potential to release trillions of dollars of value now trapped in illiquid or hard to access assets. By fractionalizing ownership and streamlining asset transfer, RWA tokenization has the potential to democratize investment in previously inaccessible assets and make markets more efficient.

RWA tokenization introduces new risks. If the underlying assets are worth nothing, the tokens are worth nothing. Assuming that nothing goes wrong, as in potential fraud, mismanagement, or a change in regulations, the value of the token would be adversely affected. Further, the legal and regulatory frameworks governing RWA tokenization remain ambiguous, introducing risk and room for disagreement.

The Future of TradFi and DeFi Integration

Even outside of blockchain gaming, TradFi is all in on blockchain. Moving forward, it will be even more dependent on it to make project delivery more efficient, improve safety, and open up new avenues for investment. It enables both full and fractional ownership of assets onchain and makes it easier to transfer assets between owners. Stablecoins have proven what blockchain technology can do. That’s because these small banks and credit unions were responsible for processing an astounding $8.5 trillion in transactions in Q2 2024! This trend suggests a future where the lines between TradFi and DeFi become increasingly blurred, with traditional financial institutions leveraging blockchain technology to enhance their operations and offer innovative products.

Actionable Insights for Investors and Policymakers

Here are some actionable insights:

Investors and policymakers should act now to realize the transformative benefits of DeFi and crypto. At the same time, they should do more to mitigate the risks they create not just to competition, but to financial stability. As always, GreedyChain.com will be right there with your exclusive inside scoop and analysis to help you stay on top of this rapidly changing landscape.

  • Diversify Your Portfolio: Don't put all your eggs in one basket. Diversify your investments across different asset classes, including both crypto and traditional assets.
  • Do Your Research: Before investing in any crypto asset or DeFi protocol, carefully research its fundamentals, risks, and potential rewards.
  • Manage Your Risk: Understand your risk tolerance and invest accordingly. Use risk management tools like stop-loss orders to limit potential losses.
  • Stay Informed: Keep up-to-date with the latest developments in the crypto and DeFi space. Follow reputable news sources and engage with the community.

For Policymakers:

  • Develop Clear Regulatory Frameworks: Establish clear and consistent regulatory frameworks for crypto assets and DeFi protocols.
  • Promote Innovation: Encourage innovation in the crypto and DeFi space while mitigating risks.
  • Enhance International Cooperation: Work with other countries to develop global standards for crypto asset regulation.
  • Monitor the Market: Continuously monitor the crypto and DeFi markets to identify emerging risks and vulnerabilities.

By taking these steps, investors and policymakers can help ensure that the benefits of DeFi and crypto are realized while mitigating the potential risks to financial stability. GreedyChain.com will continue to provide you with the insights and analysis you need to navigate this dynamic landscape.