The Bank for International Settlements (BIS) just published a welcome new paper. It explores the systemic financial stability risks posed by cryptocurrencies and DeFi as the crypto market reaches a tipping point. The report paints a dangerous portrait of several growing areas of concern. These factors range from the increasing influence of traditional finance (TradFi) players, the development of stablecoins, tokenization of real-world assets (RWAs) to potential regulatory issues posed by dApps. The BIS paper offers insights into how these developments could impact the broader financial system and suggests potential policy approaches.
Though the crypto markets have few direct connections to TradFi, this is rapidly changing. TradFi asset managers and broker dealers are showing increasing interest in the crypto space. The emergence of Bitcoin ETFs and the increasing use of decentralized exchanges (DEXs) by TradFi firms are contributing to this growing integration. As the BIS report points out, this convergence may open up new channels for risk transmission between the two sectors.
The report lays out the four main ‘transmission channels’ that risks may flow from crypto into the traditional financial system. Those are direct exposures, indirect exposures via intermediaries, macroeconomic effects, and contagion effects. BIS calls for vigilance about how these channels operate, lest they produce new fragilities.
One area of great focus is the tokenization of RWAs. Understandably, the authors of the BIS paper call for more research on the effect of RWA tokenization on financial stability. They consider this a key space to explore. This means creating digital representations of physical assets such as stocks, bonds, or real estate as tokens on a blockchain. Highlights of RWA tokenization include increased efficiency and liquidity. It also introduces new valuation, legal certainty, and operational resilience risks.
Stablecoins also present a complex challenge. Their increasing adoption and ability to rapidly evolve into systemically important payment systems is concerning. These include the effects of reserve management, risks from redemption and runs, and systemic stability. The BIS report underscores the need for robust regulatory frameworks to address these risks and ensure stablecoins operate safely and efficiently.
The regulatory landscape for these crypto assets is still highly fragmented and developing. In June 2021, the Basel Committee on Banking Supervision (BCBS) proposed very loan capital requirements for banks that hold crypto assets. In practice, they are defining permissionless blockchains as high-risk. The BIS report dives deeper into the challenges of regulating DeFi, most notably the decentralized nature of dApps. A recent UK Dept for Transport consultation even suggested a new legal role whose responsibilities would include “establishing or operating a protocol.” This points to an increasing awareness of the important issue of how to address DeFi’s novel governance arrangements.
The BIS report outlines three potential policy approaches to crypto assets: ban, contain, or regulate. A ban attempts to eliminate all crypto activity as much as possible. Containment prioritizes limiting its exposure to the illicit side of the financial system. Such regulation should seek to incorporate cryptocurrency into existing regulatory structures. Nobody wants these things to exist on the fringe. It does so by enforcing appropriate standards and accountability. Which approach to choose will depend on a jurisdiction’s unique circumstances and risk tolerance.
Additionally, the report recognizes — correctly so — that there are significant opportunities for TradFi firms to use DeFi smart contracts to enhance their current operations. That’s a promise of improved data efficiency and innovation, but it comes with the need to understand and self-regulate some of the new risks. As the BIS makes plain, we urgently need clear regulatory frameworks. These frameworks need to address the distinct issues posed by DeFi, such as anonymity, cross-border nature, and the lack of a centralized intermediary. Decentralized exchanges (DEXs) are quickly becoming key regulatory focal points. This trend is especially important at a time when traditional finance (TradFi) firms begin to adopt them more broadly.
