BIS Investigates Financial Stability Risks of DeFi and Cryptocurrencies

The BIS has released a report evaluating the financial stability risks of cryptocurrencies and DeFi, asserting the crypto market has reached critical mass. Key themes include wealth redistribution dynamics in crises, rising TradFi interactions with crypto through Bitcoin ETFs and asset tokenization, and the potential regulatory needs for DeFi as it approaches mainstream integration. The report advocates for a containment approach to assess associated risks, while also proposing further research into DAOs and stablecoin stability.

The Bank for International Settlements (BIS) has published a fresh analysis focusing on the financial stability risks posed by cryptocurrencies and decentralised finance (DeFi). Unlike previous assessments, this report highlights that the crypto market has now reached a critical mass, especially with the increasing issuance of Bitcoin ETFs and the growth of stablecoins and real-world asset (RWA) tokenisation.

The BIS report includes a significant graphic indicating that during crises, smaller investors tend to increase their crypto holdings, while wealthier individuals typically divest. This suggests a mechanism by which the crypto market may facilitate wealth redistribution from poorer to wealthier individuals. A similar observation was made by Ulrich Bindseil of the European Central Bank, who noted that late investors in Bitcoin may unwittingly transfer wealth to earlier, wealthier investors.

According to the 2023 financial stability paper, policy options related to crypto include banning, containing, or regulating the sector, with a preference against a ban. The report outlines four primary transmission channels through which risks are introduced: exposures of traditional finance (TradFi) to crypto, confidence effects, price movement wealth effects, and the use of crypto in payment systems.

The report also raises concerns regarding potential TradFi engagement with DeFi smart contracts and the effects of ‘cryptoisation’ in emerging market economies, where people may seek refuge from local currency volatility in stablecoins. The authors advocate for protecting the interests of DeFi market participants, even as the impact of DeFi on the economy remains limited.

Linkages between crypto and TradFi are expanding in two key ways. The recent approval by the US SEC of spot Bitcoin ETFs facilitates greater exposure to crypto by traditional investors, alongside increased participation of TradFi asset managers. Furthermore, broader asset tokenisation in DeFi includes mainstream assets, which encourages TradFi firms to engage with decentralised exchanges (DEXs), possibly integrating them into the mainstream financial framework.

Therefore, the report supports a containment approach that mandates risk assessment by TradFi firms towards DeFi. For instance, Basel regulations treat permissionless blockchains as high-risk, discouraging banking institutions from participation in tokenisation on such platforms. As DeFi matures, it is proposed that similar compliance requirements to those in TradFi should be implemented, including KYC regulations and appropriate disclosures.

The issue of how best to regulate DeFi has prompted calls for additional research. The authors suggest further investigation into decentralised autonomous organisations (DAOs) and their governance implications for financial stability, alongside the distinctions between DeFi protocols and applications. Research into the financial stability risks linked to RWA tokenisation is seen as a priority, particularly regarding systemic risks arising from closer DeFi and TradFi ties.

Stablecoins are viewed as central to DeFi, signalling a need for deeper analysis of their potential instabilities. The report warns that disruptions within payment and settlement systems can lead to significant economic ramifications. Furthermore, it highlights the need to address the risks of ‘cryptoisation’ affecting emerging market economies, echoing concerns previously raised by the International Monetary Fund (IMF).