The TradFi eestablishment has taken a long, hard look at DeFi. And it does not like what it sees.
The Financial Stability Board (FSB), an international body that helps shape policy in the world’s biggest nations, said yesterday that DeFi protocols could undermine confidence in the global financial system.
While the FSB has been sounding the alarm over stablecoins for several years, the organization has only briefly focused on their use in DeFi dapps until now. The FSB fears the lack of DeFi regulation and market oversight, systemic stablecoin risks, and cybersecurity breaches are a serious threat.
“If the sector were to continue to increase in size, the crystallizsation of these vulnerabilities might have consequences for the functioning of, and confidence in, the broader financial system,” the FSB said in a report published Feb. 16.
Unregulated Financial Services
The FSB’s report, entitled Assessment of Risks to Financial Stability from Crypto-assets, describes DeFi as “a fast-emerging sector” that provides “financial services using both unbacked crypto-assets and stablecoins… purportedly without the need for intermediaries.”
DeFi dapps are described as offering a broad collection of “unregulated financial services” mimicking those offered by the legacy financial industry, including borrowing, lending, trading, insurance, and derivatives products.
The FSB, which also includes the International Monetary Fund and the Bank for International Settlements, brings together top central bankers and finance ministers from the U.S., Europe, and leading emerging economies. Although it recognizes the innovative qualities of blockchain technology, the organization said decentralized governance poses a challenge to financial regulators. The report highlighted the absence of a single person or entity that can held responsible for a project’s operations. The lack of a clear legal jurisdiction overseeing global protocols or KYC procedures is another concern.
The report also warns of third-party protocols offering “additional privacy-enhancement” and even “law evasion techniques” to DeFi users. “It can therefore be difficult to trace transactions, increasing the risk of these platforms attracting illegal activities, money laundering, terrorist financing, or circumventing sanctions restrictions,” FSB added.
However, the report questioned claims of decentralization, asserting that projects “often exist along a spectrum of decentralization.” It warns that founding teams often hold admin keys allowing them to make unilateral decisions concerning a dapp’s operations.
Cybersecurity Breaches
also highlights the increasing scale of DeFi hacks, warning that the concentration of capital in the sector’s top protocols increases the threat posed by cybersecurity breaches. The report estimates that DeFi protocols represented 75% of the funds lost to hacks targeting the crypto sector during the first nine months of 2021.
The report also notes that the Total Value Locked in DeFi far exceeds the sum raised by Initial Coin Offerings (ICOs) between 2016 and 2019. With DeFi Llama estimating that $208.5B is currently locked in DeFi protocols, the sector currently represents six-times the $35B taken in by ICOs.
The report argues that DeFi protocols have been a major catalyst for recent growth in stablecoin adoption, emphasizing perceived system risks between the two sectors.
The FSB describes “facilitating trading/ lending/borrowing and acting as collateral in DeFi” as among the three most common use-cases for stablecoins. It warns that should a major stablecoin fail, “it is possible that liquidity within the broader crypto-asset ecosystem (including in DeFi) could become constrained, disrupting trading and potentially causing stress in those markets.”
“The FSB and other standard-setting bodies are already working to address threats associated with so-called ‘global stablecoins’,” the report adds.
