The Bank for International Settlements has released a new report on the growing influence of cryptocurrencies and decentralized finance. The report states that crypto and DeFi have now reached a point where they could impact the stability of the traditional financial system.
It points out that this change has the potential to amplify inequality by distributing wealth from poorer investors to richer investors at times of economic downturns. The BIS comments that whereas crypto used to be isolated, it has become more closely linked to mainstream finance.
The advent of Bitcoin ETFs as well as the evolution of tokenization of real-world assets has enabled easier exposure to digital assets for investors. These changes are bringing mainstream financial institutions into the crypto world, increasing the likelihood of spillover into other wider markets.
Crypto growth in emerging markets raises red flags
The report outlines four ways by which crypto can be destabilizing. They include direct financial exposure, losses of confidence, wealth effects of price changes, and crypto use for settlement.
The authors worry that conventional finance is adopting instruments of DeFi, that crypto is spreading among emerging economies, and that they might miss out on DeFi innovation, which continues to develop.
There are two significant trends that are broadening the connection between DeFi and traditional finance. The first is the listing of Bitcoin ETFs, bringing institutional participants into DeFi. The second is tokenization of traditional assets, which takes DeFi out of crypto.
These may bring about the usage of decentralized platforms in mainstream finance. In an attempt to mitigate these risks, BIS suggests increasing controls on DeFi. These involve introducing requirements for know-your-customer controls, transparency, and professional standards.
UK explores legal roles for DeFi management
The report suggests the UK’s recent consideration of new legal functions for governing DeFi systems as one possible solution. The BIS also emphasizes learning about decentralized organizations and the place of such organizations within financial systems.
It recommends regulators target user interfaces and applications since these are the probable points of control. The report emphasizes that researchers must better understand tokenization and the risks it may introduce as DeFi becomes increasingly interwoven with traditional finance.
Stablecoins are the other priority, with the report issuing a warning about them potentially destabilizing if they lose stability. The authors also express concern about the use of cryptocurrency in countries where the currency is weak, with individuals potentially reverting to digital assets for stability. The BIS is urging stakeholders to do more to mitigate those risks without suppressing innovation.
