Financial Stability Board pledges closer evaluation of DeFi risks

The Financial Stability Board will more closely monitor decentralized financial markets following a number of high-profile bankruptcies and ongoing concerns over potential spillovers to the traditional financial system. .Decentralized finance applications allow consumers to interact directly with each other to borrow, lend, insure and exchange digital assets without a centralized intermediary. DeFi includes financial services offered through smart contract protocols using pieces of computer code that automatically execute transactions when specified conditions are met.."A key element to consider would be the entry point of DeFi users (including retail investors and traditional financial institutions), such as through stablecoins and centralized cryptoasset platforms," said the Feb. 16 report from the international financial body. "The FSB may consider whether subjecting these cryptoasset types and entities to additional prudential and investor protection requirements, or stepping up the enforcement of existing requirements, could reduce the risks inherent in closer interconnections." . The FSB plans to collaborate with standard-setting regulatory authorities to measure the connections between decentralized finance and traditional finance and explore how international crypto-related regulations might need to be revised to acknowledge DeFi-related risks. .There are differences between cryptocurrencies and decentralized finance. Cryptocurrencies such as bitcoin are stored within their own blockchains, while DeFi is considered a theoretical marketplace that offers cryptocurrencies on the Ethereum network. DeFi allows cryptocurrency holders to lend their digital coins and earn interest on them. They can also borrow against the cryptocurrencies they hold in their digital wallets. ."In attempting to replicate some of the functions of the traditional financial system, DeFi inherits and may amplify the vulnerabilities of that system," the FSB said. "This includes well-known vulnerabilities such as operational fragilities, liquidity and maturity mismatches, leverage and interconnectedness.". The FSB said DeFi platforms have several operational vulnerabilities, including run risks on stablecoin and lending platforms; lack of sound governance frameworks; and dependence on potentially unreliable blockchain networks. The regulatory agency noted that those risks, though limited so far, are more likely to be realized if the industry substantially grows. After a stunning pace of growth, crypto tokens lost $1.3 trillion in value in the first half last year. The "crypto winter" included the November collapse of crypto trading platform FTX and subsequent criminal indictment of founder and CEO Sam Bankman-Fried. Last month, the lending arm of U.S. crypto firm Genesis filed for U.S. bankruptcy protection.. "The fact that crypto-assets underpinning much of DeFi lack inherent value and are highly volatile magnifies the impact of these vulnerabilities when they materialize, as recent incidents demonstrate," the FSB said.