Powerful international banking organization calls for “systemic regulation” of DeFi

Calling the decentralization of DeFi “an illusion,” the Bank for International Settlements (BIS) urged policymakers around the world to enforce “systemic regulation” of the rapidly growing industry and the broader nonbank financial sector.

In his quarterly review Released on December 6, the BIS said that non-bank financial intermediaries (NBFIs) offer “a wide range of investment and funding opportunities” that differ from those offered by traditional financial firms. NBFIs include DeFi protocols, open-ended bond markets, and private markets. The BIS describes DeFi as “a financial activity based on automated smart contracts on distributed technologies, mainly involving unauthorized mechanisms and anonymous transactions”.

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

DeFi regulation

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

The report questions the perception that DeFi regulation may prove to be “insurmountable” due to the decentralized design of the sector. BIS claims that “the decentralization of DeFi is an illusion” as pivotal entities such as developers and founders exercise control over fundamental aspects of said protocols. “Policymakers cannot afford to fall behind,” the report warns.

It is possible that lawmakers and regulators are taking the BIS ‘views as a signal to formulate policy that could affect DeFi. Despite the industry’s potential to address the drawbacks of traditional finance, BIS says DeFi “appears to operate largely within its own ecosystem, with little financial intermediation services provided to the real economy.”

In addition, with NBFIs attracting “growing political attention”, the BIS advocates that “a systemic approach to the regulation of NBFIs is key to better address their structural vulnerabilities, including liquidity mismatches and hidden leverage, and strengthen adequate shock absorption capacity.

Vulnerable to bank panics

BIS describes stablecoins as the “grease” that lubricates DeFi’s wheels and warns that stablecoins are vulnerable to bank runs. BIS states that “backing liquid claims with less liquid reserve assets can trigger downward price spirals similar to those resulting from buyouts in the investment fund industry.”

“In the crypto ecosystem, the risks so far have mainly manifested themselves in frequent and significant price drops,” writes BIS. “Whether these weaknesses are limited to this ecosystem or can spread to the traditional ecosystem, it is still not clear. But the potential for spillovers should not be underestimated, especially since stable agreements themselves can create important connections. “

The report also warns that the use of leverage in DeFi has recently become “high and ubiquitous”. “As history confirms, anything that grows exponentially is unlikely to remain self-sufficient and therefore deserves the utmost attention.”

However, BIS concedes that the global nature of DeFI will require international regulatory coordination, adding: “Any cohesive and inclusive final framework may also need to include bans for certain DeFi activities. “

Document highlights the sharp economic slowdown seen in response to the Trump administration’s March 2020 travel ban – which has seen many crypto assets falls by over 50% in less than 48 hours – finding that NBFIs have exacerbated market instability.

Volatile markets

Like banks, the BIS states that NBFIs are “vulnerable to fluctuations in leverage and liquidity races which have system-wide consequences.” In March 2020, “liquidity evaporated and markets froze amid deleveraging and feedback loops” due to the withdrawal or stagnation of NBFIs, causing volatile global market conditions to amplify.

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

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

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