Decentralized finance is a growing threat to economic stability that must be reined in and regulated by international cooperation.
That’s the message that Federal Reserve Chair Jerome Powell and Bank of England Governor Andrew Bailey brought to the Bank for International Settlements’ Innovation Summit on Wednesday (March 23).
The central bankers’ call yesterday for the creation of a single global strategy on decentralized finance (DeFi,) regulation must happen “quickly,” Bailey said, warning, “if we try to do it within our own locations, we’re going to fail because it will escape us … it’ll always be somewhere else.”
Read more: PYMNTS DeFi Series: What Is DeFi?
Controlled by self-executing smart contracts, blockchain-based decentralized finance includes projects that can create cryptocurrency and derivatives exchanges, lending and borrowing projects, manage assets, and make payments locally and across borders without any centralized human control, among other things.
See also: PYMNTS DeFi Series: What Is a Smart Contract?
They’re not alone in that call. On Thursday, the International Organization of Securities Commissions (IOSCO), a global association of regulators, released a report warning that DeFi is both poorly understood and more dangerous than it may appear, with risks both obvious and hidden.
While acknowledging that financial innovation can bring investors many benefits, IOSCO noted that “DeFi appears to present many similar risks to investors, market integrity and financial stability as do other financial products and services.”
But, it added, DeFi “also poses specific and unique risks and challenges for regulators to consider.”
Chief among these, in some ways, is that “there is no generally accepted definition of ‘DeFi,’ or what makes a product, service, arrangement or activity ‘decentralized.’”
Growing Pressure
Powell and Bailey are hardly the first to call for such global cooperation.
In January, Indian Prime Minister Narendra Modi told attendees of the World Economic Forum’s annual Davos conference that cryptocurrency is a challenge “we are facing as a global family with a changing global order.”
Modi, who’s government nearly banned cryptocurrency outright and is in the process of passing a law that would ban its use in payments and impose harsh taxes, called for a united front.
Read also: India’s Prime Minister Calls for Global Action on Crypto
“To fight this, every nation, every global agency needs to have collective and synchronized action,” he said.
And on March 22, the European Central Bank (ECB) doubled down on its call for a crypto crackdown, with President Christine Lagarde citing its use in evading sanctions on Russia — despite widespread agreement among U.S. regulators that crypto is a poor way for oligarchs to move fortunes, but a good way for average consumers to protect assets and evade authoritarian governments.
See: Crypto’s Impact on Russian Sanctions Could Lead to Tougher Regulation
ECB Executive Board member Fabio Panetta added that crypto is a “major loophole” at the heart of the international financial system, according to Bloomberg.
“These markets must be required to comply with the strictest standards — including as regards know your customer, anti-money laundering and disclosure requirements,” he said.
Control, Not Destruction
At the same time, calls for an outright ban on DeFi are few, and many global banks and financial institutions are investigating ways they can use decentralized finance’s smart contract and techniques to offer products that are faster, cheaper and more efficient than is possible under the current system.
That’s something proponents of a softer regulatory touch on DeFi agree on, warning that tough regulation of the cryptocurrency-powered, peer-to-peer financial projects managed without any centralized human control will simply “stifle innovation” and cause a brain drain as developers flee to more friendly jurisdictions.
Powell echoed the innovation argument at the BIS summit, saying that “a lot of the progress that we make along this road will depend on really high levels of international collaboration if we’re going to unlock the potential of digital assets and services.”
That’s an argument he’s made before when it comes to the broader cryptocurrency industry, most recently disagreeing publicly with Treasury Secretary Janet Yellen in a December Senate hearing about stablecoins, calling the administration’s plan to require issuers to be FDIC-insured banks “perplexing.”
Read more: Powell, Yellen Clash Over Stablecoin Regulation at Senate Hearing
New Watchdogs Needed
The biggest challenge regulators face, according to the IOSCO board, is that the core mechanism of DeFi is to remove traditional financial intermediaries to create “faster, cheaper and more efficient execution of transactions.”
The problem is that “it also eliminates market participants that have traditionally acted as gatekeepers, performing central roles of ensuring investor protection and market integrity,” the report noted, citing things like helping investors understand risks, ensure the fair flow of market information, and impose structural constraints like capital and liquidity requirements, anti-money-laundering (AML) compliance and sanctions monitoring.
“These are important investor and market protections that seek to minimize fraud, reduce systemic risk and contribute to fair, efficient and equitable markets,” it said. “Absent these intermediaries — and without appropriate substitute mechanisms — the risk for investor and market harm may be exacerbated.
Emerging Threats
The “Key Risks and Considerations” section of the reports runs seven pages with fairly succinct discussions of each risk.
A number are specific to crypto, involving both structural aspects and the ways bad actors can game the system.
On the human side of decentralized projects, there is the ability of blockchain miners and validators to “front run” the market by seeing transactions before they enter the public ledger, the risk that “decentralized” projects can be under the de facto control of creators or big investors with large token holdings, and the vulnerability of smaller blockchains to double spending via 51% attacks.
On the technology front, problems include DeFi transactions’ reliance on fiat-backed stablecoins who liquidity is not necessarily subject to regulatory oversight, the ability to evade AML by using cryptocurrencies’ “pseudonymity” and mixing services, the inability to modify smart contracts, the reality that many blockchains and DeFi projects are effectively in the beta stage of development, and concerns about the security of custody services and of course cybersecurity.
And, finally, there is the growing exposure of traditional markets to DeFi: Banks have made loans to and invested in projects, as well as holding the multi-billion-dollar funds that back stablecoins’ dollar pegs, and providing fiat on- and off-ramping services.
“To date, the interconnectedness of DeFi to traditional financial institutions may be limited, but it is growing,” the report warned. “This activity may present risks to the traditional businesses and their operations which, if they grow, may become material to their business operations.”
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