![]() In addition, the crypto ecosystem lacks internal shock absorbers, such as banks, that can provide liquidity at times of stress. As a key attribute of crypto markets, leverage amplifies their volatility and procyclicality. This special feature examines DeFi mainly from a financial stability perspective, drawing attention to vulnerabilities that stem from leverage and liquidity mismatches. ![]() Public authorities would need to interface with DeFi's inherent governance structures, so as to ensure sufficient financial stability safeguards as well as to enhance trust by addressing investor protection issues and illegal activities. No less importantly, DeFi will need to be properly regulated. For one, blockchain scalability and large-scale tokenisation of traditional securities would need to be improved. DeFi's vulnerabilities are severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock-absorbing capacity.ĭeFi would need to satisfy a number of conditions if it is to become a widely used form of financial intermediation.DeFi's inherent governance structures are the natural entry points for public policy. There is a "decentralisation illusion" in DeFi due to the inescapable need for centralised governance and the tendency of blockchain consensus mechanisms to concentrate power.Decentralised finance (DeFi) aims to provide financial services without intermediaries, using automated protocols on blockchains and stablecoins to facilitate fund transfers.Given this self-contained nature, the potential for DeFi-driven disruptions in the broader financial system and the real economy seems limited for now. At present, however, it has few real-economy uses and, for the most part, supports speculation and arbitrage across multiple cryptoassets. In principle, DeFi has the potential to complement traditional financial activities. ![]() ![]() In addition, some features in DeFi, notably the consensus mechanism, favour a concentration of power. First and foremost, centralised governance is needed to take strategic and operational decisions. As such, there is a "decentralisation illusion". While the main vision of DeFi's proponents is intermediation without centralised entities, we argue that some form of centralisation is inevitable. The DeFi ecosystem revolves around two elements: (i) novel protocols for trading, lending and investing, and (ii) stablecoins, which are cryptoassets that facilitate fund transfers and aim to maintain a fixed face value vis-à-vis fiat currencies, mainly the US dollar. DeFi provides financial services without centralised intermediaries, by operating through automated protocols on blockchains. While some forms of crypto intermediation have direct analogues in traditional finance, others – known as decentralised finance, or "DeFi" – are fundamentally new and have recently gained more traction. 1Ĭrypto markets are underpinned by various forms of intermediation. Existing governance mechanisms in DeFi would provide natural reference points for authorities in addressing issues related to financial stability, investor protection and illicit activities. These can be severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers such as banks. If DeFi were to become widespread, its vulnerabilities might undermine financial stability. There is a "decentralisation illusion" in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power. The key elements of this ecosystem are novel automated protocols on blockchains – to support trading, lending and investment of cryptoassets – and stablecoins that facilitate fund transfers. Decentralised finance (DeFi) is touted as a new form of intermediation in crypto markets.
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