A recent paper released by BIS exploring risks in DeFi states that the cryptocurrency market has “reached critical mass”, and although it currently has minimal linkages to traditional finance (TradFi), that situation is changing with the issuance of Bitcoin ETFs and the growth of stablecoins and tokenized assets. This paper comes at a timely moment when many central bankers still argue that the crypto market is too small and self-contained to present a financial stability risk at the macro level. In a 2023 paper on financial stability, BIS concluded that the policy approaches to crypto could take one of three forms: ban, contain, or regulate. Banning was recognized as an inferior option as bans can be circumvented, and the act of banning hinders innovation and may not be acceptable in free societies. Ringfencing crypto as a means of limiting its overlap with TradFi is one potential method of containment. However, there is still the issue of investor protection which requires action to be taken in the form of regulation.
The latest BIS paper mentions four “transmission channels” from DeFi to the real economy as identified by the Financial Stability Board, namely (i) exposure of TradFi institutions to crypto and crypto-linked products, (ii) confidence effects, (iii) wealth effects from price fluctuations and (iv) the use of crypto in payment and settlement. The paper further stated three other relevant concerns. In addition to the expansion of crypto, TradFi might start using DeFi smart contracts. Emerging market and developing economies are also at risk of cryptoization, where residents avoid local fiat currencies and instead seek refuge in risky cryptoassets. Besides, even if crypto currently does not have significant spillover into TradFi and the real economy, there is still a need to protect the interests of market participants in DeFi.
As the links between TradFi and crypto continue to grow, applying “containment” strategies is ever more important to ensure that TradFi firms properly assess the risks they are exposed to. In January 2024, the US SEC approved ETFs with underlying assets of Bitcoin or ether, and such products have become available in many jurisdictions, making it much easier for retail customers to gain exposure to crypto. The tokenization of real-world assets is another area that is driving increased connections between TradFi and DeFi. Tokenization broadens the range of assets that could potentially be traded in the DeFi ecosystem, which would likely increase participation from financial institutions and possibly bring DeFi-specific infrastructures, such as DEXs, to the mainstream.
It appears that the question now is not about whether DeFi will enter the mainstream, but when. As such, it will be prudent to introduce requirements on DeFi, similar to those that exist for TradFi. This would include KYC and other disclosures, adequate training, as well as qualifications for industry professionals.