The week the BIS, the central bank of central banks, released a paper exploring the financial stability risks of cryptocurrencies and decentralized finance (DeFi). While this is a topic that has been covered many times, including by some of the same authors a couple of years ago, the paper is articulate and fresh. Most central bankers have argued that cryptocurrency is too small and self-contained therefore does not yet present a financial stability risk. This report states that the crypto market has “reached critical mass”, although it still considers it as having minimal linkages to traditional finance (TradFi). However, the issuance of Bitcoin ETFs and the expansion of stablecoins and real world asset (RWA) tokenization are changing that.
Wealth transfer from poor to rich?
It also included a noteworthy graphic showing that in crises, small investors increase their crypto exposures, while wealthier ones get out. Hence, they conclude that the crypto market can be “a means for redistributing wealth from the poorer to the wealthier.”
We’d note that another central banker, the ECB’s Ulrich Bindseil, has made the same observation but for a different reason. He sees bitcoin as redistributing wealth from late investors to earlier ones, who tend to be wealthy.
Crypto spillover effects
The 2023 financial stability paper concluded that the policy approaches to crypto could take three forms: ban, contain or regulate, suggesting a ban would be a bad idea. This week’s paper starts from this perspective and explores TradFi risks and the extent to which they exist in the crypto and DeFi worlds.
From a financial stability perspective, it sees four ‘transmission channels’ that introduce risk:
- TradFi exposures to crypto, crypto-linked products or other entities with exposures
- confidence effects
- wealth effects from price movements
- the use of crypto in payment or settlement.
It also had three other concerns. Beyond crypto, TradFi might start using DeFi smart contracts within TradFi. There’s the potential cryptoisation of emerging market economies, where residents flee volatile local currencies for stablecoins or crypto. Plus, even if DeFi doesn’t currently impact the wider economy, the authors want to “safeguard the interest of market participants in DeFi”.
Links between crypto, DeFi and TradFi expand
The authors noted two major ways that the crypto and TradFi linkage is expanding. Firstly, in January 2024 the US SEC authorized the issuance of spot bitcoin ETFs. This made it easier to gain exposure to crypto. Plus, TradFi asset managers and broker dealers are now more involved.
The second is real world asset tokenization. Today DeFi is largely based on crypto. But tokenization will broaden the range of assets to include more mainstream ones. Additionally, decentralized exchanges (DEXs) could start to be used more widely by TradFi firms and “become part of the mainstream”.
Hence, the authors assert that a “containment” approach is warranted to ensure that TradFi firms properly assess the risks. We’d observe that an example of this is the Basel banking crypto rules that currently consider permissionless blockchains as high risk. Hence, they discourage banks from getting involved in tokenization on permissionless chains.
As DeFi becomes more mainstream, the authors propose imposing similar requirements to TradFi. In particular that would include know your customer compliance, disclosures and adequate training and qualifications for market professionals. The paper highlighted a UK consultation that suggested a potential new legal role of “establishing or operating a protocol”.
Financial stability – next steps
There has been much debate about how to go about regulating DeFi. Hence, the paper’s conclusion suggests further research to explore the role of decentralized autonomous organization (DAOs) in governance, how that impacts financial stability, and how regulators could engage. When outlining how DeFi works, the authors note the difference between a DeFi protocol and an application, which usually has a user interface and has a “centralization vector”. In other words, dApps are potential regulatory touchpoints.
The authors consider research into the financial stability implications of RWA tokenization as a top priority, including systemic risks of tighter linkages between DeFi and TradFi.
They also see stablecoins as having a central role in DeFi and their potential instability is an area needing further analysis. Earlier in the paper, they noted that payment and settlement system instability or disruption can have the most widespread economic knock on effects.
Finally, they want to explore how to address the cryptoisation risks for emerging market economies, a topic that the IMF has been highlighting for some time.
