BIS report on Financial stability risks of DeFi

The Bank for International Settlements – BIS and the Financial Stability Board (FSB) created a report on the financial stability risks associated with Decentralised Finance. We read it for you and summarised it for you.

Decentralised Finance (DeFi) is a one of the fastest growing segment within the cryptoasset ecosystem. It aims to replicate traditional financial system functions by disintermediating their provision and decentralizing their governance, making it more accessible, efficient and fair.

But over the past 2 years, turmoil in the crypto markets exposed vulnerabilities in DeFi, including operational fragilities, liquidity mismatches, and issues related to leverage and interconnectedness, which can lead to theft of funds, cascading liquidations and more.

While these vulnerabilities haven't impacted the traditional financial system yet, the report argues that the growth and potential interconnection of DeFi with traditional markets through Real-World-Assets (RWA) could pose threats to financial stability.

The report suggests that DeFi markets are largely driven by institutional participants in advanced economies and whales. Currently it remains mostly self-referential, with DeFi products interacting mainly within their own ecosystem.

The FSB report emphasizes the need to monitor DeFi vulnerabilities and potential threats to financial stability, especially given the lack of quality data and non-compliance with reporting requirements.

The FSB plans to continue to analyze DeFi's financial vulnerabilities, explore its interconnectedness with traditional finance, and consider enhancing policy recommendations for cryptoasset regulation through the BIS.

As DeFi continues to evolve to replicate traditional financial functions, it's crucial to understand potential risks, such as inheriting and even amplifying existing traditional vulnerabilities, such as liquidity mismatches and interconnectedness.

Thank you for reading this thread. We hope you learned something. Stay informed and keep an eye on this space for more insights on DeFi and its impact on the financial world. Subscribe to this newsletter to stay up to date!