BIS working paper: Cryptocurrencies and decentralised finance – functions and financial stability implications

Cryptocurrencies and decentralised finance (DeFi) aim to replicate many of the economic functions of traditional finance (TradFi), but their distinctive features introduce new financial stability risks. The authors of the report Cryptocurrencies and decentralised finance: functions and financial stability implications analyse these features, and examine key developments, such as smart contracts, decentralised exchanges (DEXs), stablecoins and new forms of central bank money.

„Our findings suggest that while the underlying economic drivers are not different than in TradFi, DeFi poses significant challenges, including new forms of information asymmetries, market inefficiencies and the risk of cryptoisation in emerging markets. We propose tailored regulatory interventions, such as embedding rules within smart contracts and strengthening the oversight of stablecoins, to manage financial stability risks. Finally, we provide a framework for prudential regulation that can mitigate risks while fostering innovation in the rapidly evolving crypto ecosystem.” – the authors said.

Context

Blockchains have been hailed as a pivotal innovation in securing digital data. While the concept has existed for decades, the first public blockchain was created by Satoshi Nakamoto – a pseudonym for an individual or a group of people – in 2008.

The official birthday is 31 October, the date on which the Bitcoin whitepaper was originally published (Nakamoto (2008)). Bitcoin went live two months later on 3 January 2009, with the minting of the first block of its blockchain, known as the genesis block. Since then, cryptoassets have experienced multiple boom and bust cycles.

Some early adopters amassed significant wealth, while many retail investors faced substantial losses (Cornelli et al (2022)). Although cryptoassets may not have achieved the level of success Satoshi Nakamoto envisioned, they have made considerable progress since their inception.

New blockchains have been created, together with thousands of cryptoassets built on them. A particularly important innovation was the creation of the Ethereum blockchain in 2015, which enabled developers to deploy decentralised software applications. These applications allow users to access services – such as trading, lending and borrowing – without intermediaries. Together, these services have become known as decentralised finance (DeFi).

As cryptoassets and DeFi have evolved, policymakers in national authorities and international institutions have been grappling with the challenges posed by these innovations. Initially, their reactions were marked by a mix of curiosity, scepticism and a cautious willingness to explore the underlying characteristics of these new assets.

Due to their limited size in the early years, policy actions were generally limited to issuing warnings about their speculative nature. More recently, however, as the crypto market has grown and its connections to traditional finance (TradFi) have deepened, policy interventions have increased.

Internationally, organisations such as the Bank for International Settlements (BIS), Financial Stability Board (FSB), International Monetary Fund (IMF) and International Organization of Securities Commissions (IOSCO) have produced numerous reports and, in some cases, issued recommendations or standards. At the national level, regulators have become more proactive in defining policies to respond to the growth of crypto and DeFi.

This report presents a description of the functions that crypto and DeFi innovations aim to fulfil. It covers blockchains, cryptoassets and DeFi applications, as well as other parallel developments such as stablecoins and new forms of central bank money.

Also, the report presents a conceptual framework for assessing the financial stability implications of these innovations, indicating that relatively minor adjustments to existing frameworks used in TradFi can do the job, and discusses the case for prudential regulation of cryptoassets, highlighting both their potential linkages with TradFi and instances in which regulators may need to address DeFi directly. The last section of the report provides a forward-looking assessment of potential future research.