BIS warns that DeFi’s vulnerabilities outweigh those of traditional finance

The Bank for International Settlements (BIS) recently published an article warning about the risks of the non-banking financial sector.

And one of the highlights of the report was the decentralized finance market (DeFi). According to the institution, the sector has vulnerabilities that surpass those of the traditional market. In addition, the institution claims that this sector is concerned with regard to money laundering:

“At the same time, in addition to raising concerns about first-rate money laundering and investor protection, DeFi has substantial financial vulnerabilities. These are parallel, but exceed those of more traditional forms of financing.”

Defi and stablecoins

Specifically on DeFi, the report explains that industry supporters emphasize its potential efficiency gains. After all,or being a new trading system, this ecosystem promises to overcome some of the drawbacks of traditional finance. This includes high costs and slow operations.

“For now, these gains are hard to detect: ​​DeFi appears to be operating largely within its own ecosystem, with few financial intermediation services provided to the real economy.”

The report also highlights the participation of stablecoins within DeFi ecosystems. The BIS claims that these stable cryptocurrencies are subject to classical executions.

For example, the illiquidity of stablecoin reserves can generate downward price spirals similar to those arising from redemptions in the investment fund industry.

On the price drops in the crypto market, the document says:

“In the crypto ecosystem, risks so far have arisen primarily from frequent and considerable price drops. Whether such weaknesses are limited to this ecosystem or can spread to the traditional one remains unclear. But the spillover potential should not be underestimated.”

The BIS also points out the risks of leverage in the DeFi market. More precisely, it says that price drops can make the lender demand loans or charge a higher haircut (decrease in the value of some debt), inducing a forced sale.

Regulatory Challenges for DeFi

Finally, the BIS points out that, although the regulatory challenges seem insurmountable in the case of DeFi due to decentralization, this is an “illusion”:

“However, Aramonte, Huang, and Schrimpf (2021) show that DeFi’s decentralization is an illusion: essential entities (usually application developers) are ultimately in control.”

Thus, BIS believes that, with the necessary adjustments to the legal systems, these entities can become the natural entry points for the necessary regulation of the sector.

In this way it will be possible to confront money laundering and “other abuses” to achieve financial stability.