The Bank for International Settlements (BIS) warns that the growing popularity of decentralized finance (DeFi) and cryptocurrencies, especially stablecoins, poses a threat to financial stability, particularly in countries with low trust in national currencies.
BIS analysts presented a report based on their analysis of the DeFi sector, noting that DeFi replicates key functions of the traditional financial sector (TradFi). However, unlike traditional institutions, DeFi solutions suffer from severe information asymmetries and a lack of mechanisms for reputational accountability. Moreover, the increased use of digital assets and DeFi platforms introduces additional risks, from the opacity of smart contracts to the threat of cryptoization in emerging economies.
In the BIS report, cryptoization is defined as the process by which national currencies are displaced by digital assets, particularly stablecoins. In countries with high inflation or weak confidence in local currencies, such as Nigeria and Indonesia, cryptoization could weaken monetary sovereignty and destabilize the economy.
The report emphasizes the urgent need to establish a legal framework for oversight of participants in the DeFi ecosystem, including protocol operators and decentralized interfaces through which users interact with platforms.
A two-tiered regulatory model for DeFi is proposed, including:
- Traditional-style requirements for disclosure and qualification of service providers.
- The use of programmable rules embedded in smart contracts, such as automated execution of obligations and price control mechanisms.
“Decentralized finance is rapidly evolving, remaining a space for tech-savvy individuals that allows people to borrow and lend without going through a bank, using crypto-assets as collateral. Conversely, users can also earn interest on their deposits. On top of that, DeFi is turning into a decentralized 24/7 currency market, where stablecoins pegged to various fiat currencies are traded. Market spreads are determined by participants, and arbitrage opportunities help ensure fair pricing,” said Max Krupyshev, CEO of CoinsPaid, in the Purpose Driven FinTech podcast, noting that DeFi overall enables users to extract extra value from their assets.
Analysts are also particularly concerned about the spread of stablecoins. Over 90% of their market cap is made up of fiat-pegged assets like USDT and USDC. Despite being pegged to the U.S. dollar, BIS research shows that even fiat-backed stablecoins are vulnerable to capital outflows during market or monetary shocks, challenging their image as a “safe haven.”
The report also pays special attention to central bank digital currencies (CBDC), which BIS views as a potential alternative to stablecoins that can be used in DeFi protocols and for settlements. It highlights that rCBDCs can function as digital cash, while wCBDCs can act as digital reserves. CBDCs, therefore, can provide a safer settlement infrastructure for DeFi services, reducing systemic risks associated with private stablecoins and cryptocurrencies.
According to BIS, CBDCs can serve as a tool to counter cryptoization, a government-backed response to the spread of cryptocurrencies and dollar-pegged stablecoins. As of September 2024, retail CBDC pilots were launched in 25 countries, including the Bahamas, Nigeria, and Jamaica. Overall, according to the OMFIF think tank, more than half of the world’s central banks plan to issue CBDCs within the next five years.
