The Financial Stability Board (FSB) are getting more and more active about stablecoins and crypto assets. In a letter to G20 ministers published yesterday, FSB Chair Klaas Knot Many said that many existing stablecoins would not meet the “high-level” recommendations to be set by global standard setters like the FSB. This is related to the fact that the FSB are soon to release guidance targets for the strengthening of stablecoin governance frameworks, redemption rights and stabilisation mechanisms. The FSB is set to finalise its recommendations for regulating crypto and stablecoins by July.
Meanwhile last week, the FSB released an interesting report about DeFi (download the FSB report here). Here’s the Executive Summary:
Within the crypto-asset ecosystem, so-called decentralised finance (DeFi) has emerged as a fast-growing segment. DeFi is an umbrella term commonly used to describe a variety of services in crypto-asset markets that aim to replicate some functions of the traditional financial system (TradFi) while seemingly disintermediating their provision and decentralising their governance. The DeFi ecosystem has a multi-layered architecture that includes permissionless blockchains, self-executing code (or so-called smart contracts), DeFi protocols and purportedly decentralised applications (DApps).
To date DeFi is mainly self-referential, meaning its products and services interact with other DeFi products and services rather than with the traditional financial system and the real economy, but TradFi players are beginning to enter the market. In addition, DeFi has integral connections to centralised crypto-asset trading, lending and borrowing platforms, through which participants exchange crypto-assets for one another or for fiat currency, often using stablecoins.
While the processes to provide services are in many cases novel, DeFi does not differ substantially from TradFi in the functions it performs. In attempting to replicate some of the functions of the traditional financial system, DeFi inherits and may amplify the vulnerabilities of that system. This includes well-known vulnerabilities such as operational fragilities, liquidity and maturity mismatches, leverage and interconnectedness. DeFi’s specific features may result in these vulnerabilities playing out at times differently than in traditional finance, for example as a result of the risks of fire sales related to the automatic liquidation of collateral based on smart contracts, reliance on oracles for external information or dependence on infrastructure over which the DeFi developers may not have direct control (i.e. the underlying blockchain). The fact that crypto-assets underpinning much of DeFi lack inherent value and are highly volatile magnifies the impact of these vulnerabilities when they materialise, as recent incidents demonstrate.
Operational fragilities include unclear, opaque, untested or easy-to-manipulate DeFi governance frameworks, where the actual degree of decentralisation varies broadly; dependence on blockchain networks, which may become congested or are unreliable; oracles and cross-chain bridges, which can expose users to disruptions and thefts; and coding errors in smart contracts which are exacerbated given the immutability of DeFi transactions.
Arguably the most concerning vulnerabilities in DeFi relate to the different liquidity and maturity profile of liabilities and assets of relevant entities. Such mismatches can give rise to run risks with possible adverse spillovers to other parts of the financial system. In DeFi, these types of liquidity risks are particularly prominent in the case of stablecoins and lending protocols.
A key feature of crypto-asset markets, including DeFi, is the outsized impact of leverage on market dynamics. Due to pseudonymity, financial intermediation in DeFi largely rests on the use of collateral and on the leverage that such usage entails. The automatic liquidation of collateral in smart contracts, which can be applied unevenly among participants depending on the protocol design, is a primary reason why deleveraging dynamics in DeFi can be especially disruptive. In TradFi, such self-reinforcing dynamics can be alleviated via orderly liquidation at central counterparties or by market circuit breakers, but both of these mechanisms are absent in DeFi today. Leverage in DeFi is also difficult to gauge, in part because borrowed funds are often used as collateral for other loans, giving rise to “collateral chains” (akin to re-hypothecation).
The DeFi ecosystem features a complex set of interconnections within DeFi and with outside entities – notably with other segments of crypto-asset markets (e.g. centralised finance, or CeFi) and to a lesser degree with TradFi, but also with third-party technology providers. The complexity of interconnections in DeFi gives rise to vulnerabilities relating to the composability of DeFi protocols; concentration of activity in a small number of protocols; and exposure to distress of centralised trading platforms and third-party providers.
Other vulnerabilities of DeFi, and crypto-assets more broadly, consist of market integrity issues (including the evasion of existing regulation); unsustainable business models that rely on continuous investor inflows to remunerate early adopters; and potential for cross-border regulatory arbitrage because of the opaqueness of DeFi organisational structures and lack of a clear domicile. DeFi may also contribute to currency substitution, especially in countries with weak macroeconomic conditions.
The extent to which these highlighted vulnerabilities can lead to financial stability concerns largely depends on the interlinkages and associated transmission channels between DeFi, TradFi and the real economy. These channels include financial institutions’ exposures to DeFi; confidence and wealth effects stemming from the involvement of households and firms in DeFi; and the extent to which DeFi applications may facilitate the use of crypto-assets for payments and settlement. To date, these interlinkages are limited, as shown by the modest impact of the May/June 2022 crypto-asset market turmoil and the November 2022 FTX collapse on TradFi. However, if the DeFi ecosystem were to grow significantly and become more mainstream as a result of the broader adoption of crypto-assets and the development of real-world use cases, then interlinkages would deepen and the scope for spillovers to TradFi and the real economy would increase.
Data on crypto-asset markets in general and DeFi specifically, lack transparency, consistency, and reliability. This is due to the difficulty in aggregating, reconciling, and analysing the vast amount of data available on distributed ledgers; the pseudonymous nature of information on public ledgers, which inhibits the ability to ascertain the types of crypto-asset investors; the large number of off-chain transactions and other off-chain data; complex ownership structures and loan/investment relationships; the lack of, or non-compliance with, reporting requirements producing consistent and reliable data; and the fact that some data providers (e.g. trading and lending platforms) may be incentivised to manipulate their data.
Notwithstanding the data limitations, the report identifies some indicators that can be used to incorporate DeFi developments in the broader financial stability monitoring of the crypto-asset ecosystem. These indicators help to gauge the overall size and evolution of DeFi; the identified financial vulnerabilities of DeFi; and the interconnections and possible transmission channels between DeFi, TradFi and the real economy, in order to gauge the scope for spillovers.
In light of these findings, several considerations are warranted. First, the FSB should proactively analyse the financial vulnerabilities of the DeFi ecosystem as part of its regular monitoring of the wider crypto-asset markets. In turn, the FSB’s crypto-assets monitoring framework should be complemented with DeFi-specific vulnerability indicators. Also, the FSB will explore the growth 3 of tokenisation of real assets as it could increase linkages between crypto-asset markets/DeFi, TradFi and the real economy.
Second, the FSB, in collaboration with standard-setting bodies (SSBs) and regulatory authorities, will explore approaches to fill data gaps to measure and monitor interconnectedness of DeFi with TradFi, with the real economy, and with the crypto-asset ecosystem. In the interim, consideration can be given to greater sharing of existing data and market intelligence and use of ad-hoc information collection methods.
Third, the FSB will explore the extent to which its proposed policy recommendations for the international regulation of crypto-asset activities may need to be enhanced to acknowledge DeFi-specific risks and facilitate the application and enforcement of rules. DeFi-specific risks may include, for example, the use of smart contracts; governance arrangements (including concentrated ownership); dependence on blockchain networks; and use of oracles and crosschain bridges. The FSB, working with SSBs, could also consider potential policy responses to the risks stemming from DeFi’s interconnectedness with the broader financial system and the real economy. Potential policy responses may include, for example, regulatory and supervisory requirements concerning traditional financial institutions’ direct exposures to DeFi, as well as concerning other ways that such institutions may seek to become more integrated with DeFi (e.g. by serving as trustees or custodians, or by transacting with other firms engaging in DeFi).
As part of this work, the FSB could also consider, in coordination with the SSBs, assessing the regulatory perimeter across jurisdictions to determine which DeFi activities and entities fall or should fall within that perimeter (in which case enforcement of compliance with applicable regulations is warranted) or outside of it (in which case policies should be developed to achieve appropriate regulation of activities giving rise to similar risks). In this respect, a key element to consider would be the entry points of DeFi users (including retail investors and traditional financial institutions), such as through stablecoins and centralised crypto-asset platforms. The FSB may consider whether subjecting these crypto-asset types and entities to additional prudential and investor protection requirements, or stepping up the enforcement of existing requirements, could reduce the risks inherent in closer interconnections. SSBs can play an important role in such perimeter assessments, as well as in strengthening cross-border cooperation and data sharing together with the FSB.
Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, TheFinanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal's Financial News. To learn more click here...