The Bank for International Settlements (BIS), often referred to as the bank for central banks, has been ringing alarm bells. They explain that crypto and DeFi have achieved a “critical mass,” creating the potential for financial instability. The BIS report highlights the increasingly merger of crypto with TradFi. Specifically, it points to important advancements like Bitcoin ETFs and the tokenization of real-world assets (RWAs) as catalysts for this change. Instead of calling for a complete ban, the report supports a “contain and regulate” approach.
Second, the rapidly evolving crypto landscape is fostering a trend toward deeper integration between the crypto industry and the broader financial system. Spot Bitcoin ETFs and the tokenization of RWAs are major forces behind this integration. As the Wall Street saying goes, “everyone’s broker now,” with brokers and asset managers increasingly heading into crypto markets.
Transmission Channels of Risk
The BIS report names four “transmission channels” through which crypto assets could threaten financial stability. These channels are direct TradFi exposure to crypto products, market confidence shocks, wealth volatility due to price swings, and the use of crypto for payments and settlements. The effects of these changes are shifting exposure patterns, even among legacy institutions—as seen in this report co-authored by BIS economist Raphael Auer.
The increasing encroachment of TradFi into DeFi is a point of contention. Looking back on events, the report finds that retail investors tend to increase their market exposure at times of heightened stress. By contrast, institutional investors tend to retreat from the market. This behavioral difference, if it exists, could greatly increase volatility in the market.
Wealth volatility driven by continual fluctuation from price swings in the crypto market can lead to a much deeper economic fallout. Severe losses on crypto asset investments can produce second-order effects on consumer purchasing and capital allocation decisions that may result in broader financial instability.
Regulatory Recommendations
The BIS is indeed calling for stricter regulation on DeFi based on these dangers. Which is why they’re calling on them to adopt Know Your Customer (KYC) requirements, enforce clear disclosures, and institute strong risk management structures. The BIS adopts a “contain and regulate” position rather than advocating for a ban. Crypto should not be free from risk and the organization’s members feel that targeted regulation can reduce those risks while enabling innovation to flourish.
These recommendations are part of a national trend toward increased transparency and accountability in the crypto world. The BIS calls for greater cooperation between countries. Working together, this collaboration will aim to ensure crypto regulations are as consistent and effective as possible across jurisdictions and sectors.
Concerns Over Crypto Adoption
The report discusses the opportunity to redistribute wealth through widespread crypto adoption. Ulrich Bindseil, a Director General of the European Central Bank, just published an opinion piece trashing early crypto adopters. He noted how they tend to pad their profits on the backs of latecomers. Those early adopters are usually more well-off, better educated, and whiter than the general population.
This dynamic exacerbates the risk of wider inequality as consumer adoption of crypto increases. As regulators draft rules, they must be mindful of the distributional effects of crypto on underserved communities and communities of color.
