A new report from the Financial Stability Board takes aim at the world of decentralized finance (DeFi), adding that the “rapidly evolving” niche “does not differ substantially from traditional finance.”
The FSB is an international organization representing all of the major G20 economies that issues advice and recommendations on the world’s financial system.
“In attempting to replicate some of the functions of the traditional financial system, DeFi inherits and may amplify the vulnerabilities of that system,” the report reads.
The wide-ranging report touches on the similarities with traditional finance, as well as criticizing the niche’s “actual degree of decentralization,” the danger of crypto bridges, and bugs found in the smart contracts that underpin DeFi’s applications.
The FSB argued that the “most concerning” vulnerability, however, remained that of “run risk” on lending platforms and stablecoins.
“The automatic liquidation of collateral in smart contracts, which can be applied unevenly among participants depending on the protocol design, is a primary reason why deleveraging dynamics in DeFi can be especially disruptive,” the report reads.
Conversely, traditional finance and its network of compliant consultants avoid such disruption via “orderly liquidation.” The FSB also said that measuring the amount of leverage in DeFi is “difficult to gauge,” making it especially difficult to identify what the organization has termed as “collateral chains.”
Crucially, the FSB’s laundry list of vulnerabilities and risks is a concern to the group insofar as they affect “traditional finance and the real economy.”
Though these connections are “limited” currently, the organization said that “if the DeFi ecosystem were to grow significantly and become more mainstream as a result of the broader adoption of crypto-assets and the development of real-world use cases, then interlinkages would deepen and the scope for spillovers to [traditional finance] and the real economy would increase.”
The report thus recommends that DeFi be included in the FSB’s monitoring framework, as well as determining whether current regulatory regimes should be “enhanced to acknowledge DeFi-specific risks.”
DeFi in a post-FTX industry
The now-defunct crypto exchange FTX is referenced a grand total of 28 times in the FSB’s report on decentralized finance. The company’s high-profile collapse last November sent shockwaves throughout the industry and, reads the report, led to various decentralized alternatives grabbing additional market share immediately after.
Still, argues the FSB, “DeFi protocols are subject to various operational and governance issues that may limit their reach and appeal vis-à-vis CEXs.”
Other catastrophic implosions including Terra and Celsius are also included in the report.
The former event saw roughly $40 billion in investor money vanish as the project’s algorithmic stablecoin plummeted and is cited as an example of the “run risk” first mentioned by the organization. The bankrupt crypto lender is highlighted as a knock-on effect of Terra’s collapse as Celsius needed to halt withdrawals at the time.
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