Complete decentralization in DeFi is illusory: BIS report

Key points to remember

  • On Monday, the Bank for International Settlements, an international financial institution owned by central banks from different countries, released a report on DeFi.
  • Decentralization of DeFi is illusory, according to the report, and policymakers should take advantage of it to regulate the industry.
  • The BIS argued that DeFi is extremely vulnerable due to high leverage, liquidity mismatch, integrated interconnection and lack of shock absorbing capacity.

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In its last quarterly review, the Bank for International Settlements (BIS) asserted that the decentralization of decentralized finance (DeFi) is an illusion and argues that policymakers should take advantage of it to regulate the sector.

BIS report qualifies DeFi’s main proposition as “illusory”

The Bank for International Settlements (BIS), an international financial institution owned by central banks from different countries, published a research paper on Monday containing a special article on DeFi and its implications for financial stability.

In the report, BIS argues that full decentralization in DeFi is an illusion, citing the inevitable need for some form of centralized governance and the tendency for blockchain consensus mechanisms to concentrate power.

According to the report, all DeFi platforms “have central governance frameworks outlining how to set strategic and operational priorities”, thus necessarily containing “an element of centralization”. On this point, the BIS specifically highlighted governance token holders and stakeholders who exercise “managerial or ownership advantages” as typical examples of points of centralization.

“These groups, and the governance protocols upon which their interactions are based,” the report says, “are the natural entry points for decision makers.” Interestingly, the BIS made no specific policy recommendations for lawmakers, but instead emphasized the need to regulate DeFi before the ecosystem attains “systemic importance.”

Despite its impressive growth, the BIS has described DeFi as “largely self-sufficient” and its potential to disrupt the financial system as a whole as limited. However, the report acknowledges that if DeFi’s exponential growth continues, its “severe” vulnerabilities could spill over and undermine the financial stability of the real economy.

The BIS specifically highlighted high leverage, liquidity mismatches, integrated interconnection and lack of shock absorbing capacity as the main vulnerabilities of DeFi. High leverage and built-in interconnectivity exacerbates procyclicality, while liquidity mismatches and the absence of shock absorbing entities like banks in the marketplace increase the possibilities for investors to race over stablecoin issuers. , according to the report.

The report also referred to the unlicensed nature of DeFi, claiming that the anonymity of transactions and the absence of anti-money laundering and know-your-customer provisions “expose DeFi to illegal activity and market manipulation.” . Finally, the BIS said that DeFi’s main proposal to reduce rents accruing to centralized intermediaries is “yet to be realized”.

Regulatory guarantees are needed, according to the report, as they could also help “ensure that the innovative potential of DeFi brings global benefits to finance”.

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