Powerful International Bank Body Urges ‘Systemic Regulation’ of DeFi

The Bank of International Settlements urged financial regulators to address the “systemic risk” of DeFi protocols and other non-bank entities.

Powerful International Bank Body Urges ‘Systemic Regulation’ of DeFi

Calling DeFi’s decentralization “an illusion,” the Bank for International Settlements (BIS) urged policymakers worldwide to apply “systemic regulation” of the rapidly growing industry and the broader non-bank financial sector.

In its quarterly review released on Dec. 6,  the BIS said non-bank financial intermediaries (NBFIs) offer “a broad range of investment and funding opportunities” that differ from those provided by legacy financial firms. NBFIs include DeFi protocols, open-ended bond markets, and private markets. The BIS describes DeFi as “finance activity based on automated smart contracts on distributed technologies, involving mainly permissionless mechanisms and anonymous transactions.”

BIS says the “massive” growth of NBFIs since the 2008 global financial crisis “represents a long-term structural trend” and warns that NBFIs may “affect how monetary policy is transmitted to the economy [and] implemented on a day-to-day basis,” in addition to “amplify[ing] market stress.” 

Regulating DeFi

Known as the central bank for central banks, the BIS is an influential body that shapes guidelines and action taken by the Federal Reserve, the European Central Bank, the Bank of England, and similar institutions. The report is bound to make waves with policymakers as they reckon with DeFi’s impact on the global financial system.

The report challenges the perception that regulating DeFi may prove “insurmountable” as a result of the sector’s decentralized design. BIS asserts that “DeFi’s decentralization is an illusion” as pivotal entities such as developers and founders exert control over core aspects of said protocols. “Policymakers cannot afford to fall behind the curve,” the report warns.

It’s possible that lawmakers and regulators will take the BIS’s views as a cue to formulate policy that could affect DeFi. Despite the sector’s potential to address the disadvantages of traditional finance, BIS says DeFi “appears to be operating largely within its own ecosystem, with little in the way of financial intermediation services being provided to the real economy.”

Moreover, with NBFIs attracting “increasing policy attention,” BIS advocates for “a systemic approach to regulating NBFIs is the key to better addressing their structural vulnerabilities, notably liquidity mismatches and hidden leverage, and building adequate shock-absorbing capacity.

Vulnerable to Bank Runs

The BIS describes stablecoins as the “grease” that lubricates the wheels of DeFi and warns that stable tokens are vulnerable to bank runs. BIS says that “the backing of liquid claims with less liquid reserve assets can touch off downward price spirals akin to those stemming from redemptions in the investment fund industry.”

“In the crypto ecosystem, risks have so far surfaced mainly in frequent and sizable price crashes,” writes BIS. “Whether such fragilities are limited to this ecosystem or can spill over to the traditional one is still unclear. But the potential for spillovers should not be underestimated, especially since the stablecoin arrangements themselves can create important links.”

The report also warns that the use of leverage in DeFi has recently become “high and pervasive.” “As history confirms, anything that grows exponentially is unlikely to remain self-contained and thus merits the closest attention.”

However, BIS concedes that the global nature of DeFI will require international regulatory coordination, adding: “Any final coherent and inclusive framework may also have to include prohibitions for some DeFi activities.”

The document highlights the sharp economic downturn witnessed in response to the Trump administration’s March 2020 travel ban — which saw many crypto assets fall by more than 50% in less than 48 hours — concluding that NBFIs exacerbated market instability.

Volatile Markets

Like banks, BIS states NBFIs are “vulnerable to fluctuations in leverage and liquidity runs that have system-wide consequences.” During March 2020, “liquidity evaporated and markets froze amid deleveraging and feedback loops” as a result of NBFIs pulling back or stagnating, resulting in an amplification of the volatile global market conditions.

“The mechanisms underlying this instability are quite familiar from previous episodes of financial stress,” states the report. “At their core is the interaction between liquidity mismatches and leverage […] and risk management practices, influenced in part by regulation.”

The report adds that reforms have strengthened banks and reduced their “systemic impact,” suggesting similar standards should be applied to NBFIs.