Decentralized finance (DeFi) is touted as a new form of intermediation in crypto markets. The key elements of this ecosystem are novel automated protocols on blockchains – to support trading, lending and investment of crypto assets – and stablecoins that facilitate fund transfers.
There is a “decentralization illusion” in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power. If DeFi were to become widespread, its vulnerabilities might undermine financial stability. These can be severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers such as banks, write BIS’ senior economist Sirio Aramonte in the Monetary and Economic Department of the Financial Markets division; Wenqian Huang, an economist in the Monetary and Economic Department of the Financial Systems & Regulation division; and Andreas Schrimpf, head of Financial Markets in the Monetary and Economic Department of the Financial Markets division.
Although it has grown rapidly, the DeFi ecosystem is still developing. At present, it is geared predominantly towards speculation, investing and arbitrage in crypto assets, rather than real-economy use cases. The limited application of anti-money laundering and know-your-customer (AML/KYC) provisions, together with transaction anonymity, exposes DeFi to illegal activities and market manipulation. On balance, DeFi’s main premise – reducing the rents that accrue to centralized intermediaries – seems yet to be realized.
Leverage
DeFi is characterized by the high leverage that can be sourced from lending and trading platforms. While loans are typically overcollateralized, funds borrowed in one instance can be re-used to serve as collateral in other transactions, allowing investors to build increasingly large exposure for a given amount of collateral.
Derivatives trading on decentralized exchanges (DEXs) also involves leverage, as the agreed payments take place only in the future. The maximum permitted margin in DEXs is higher than in regulated exchanges in the established financial system. And unregulated crypto centralized exchanges (CEXs) allow even higher leverage.
Financial intermediation in DeFi relies exclusively on private backstops, ie collateral, to mitigate risk and enable transactions when participants cannot trust each other. Thus, there are no shock absorbers in DeFi that can cut in during stress periods. By contrast, in traditional finance, banks are elastic nodes that can expand their balance sheets (extending loans or purchasing distressed assets) via the issuance of bank deposits, which are a widely accepted medium of exchange. ‘
Liquidity mismatches
Liquidity mismatches and exposure to market risk raise the possibility of investor runs. The viability of stablecoins hinges on investors’ trust in the value of the underlying assets. Opaqueness and lack of regulation can easily erode this trust. If investors have doubts about the quality of the assets, they have an incentive to be the first to sell stablecoins or convert them to fiat currency.
In turn, such a first-mover advantage can set off runs, leading to fire sales of the collateral. Furthermore, an evaporation of trust in stablecoins could have wide repercussions for DeFi. Transfers of funds across investors and platforms would become more costly and cumbersome, impinging on the “networked liquidity” that is a key feature of DeFi.
While DeFi is largely separate from the traditional financial system at present, connections could increase. This would raise the potential for spillovers, which would stem from linkages through both the asset and liability side of banks, as well as the activities of non-bank institutions that bridge the two systems.