FSB (Financial Stability Board) to Asses DeFi’s Potential Stability Risks and Vulnerabilities
On February 16, 2023, the Financial Stability Board announced its plans to assess and potentially minimize the financial stability risks associated with Decentralized Finance (DeFi). These services aim to replicate some functions of the traditional financial system by eliminating intermediaries and decentralizing governance.
DeFi utilizes self-executing code, known as smart contracts, to replace the roles of financial institutions and market infrastructures to varying degrees. Essentially, DeFi is a crypto-based alternative and competitive marketplace of financial services, including trading, borrowing, and lending, mainly within the crypto-asset space.
Potential Risks Caused by DeFi
At present, the ability to oversee this type of activity is hindered by several factors, including a lack of dependable data on the industry, non-adherence to reporting regulations, and the tendency for companies within the industry to operate in a non-transparent manner, making it difficult to gather accurate data for analysis.
Prior to the sudden drop in Bitcoin prices and the FTX market failure, authorities had primarily directed their attention toward regulating cryptocurrency assets rather than the underlying technology.
Additionally, the FSB has expressed intentions to investigate the tokenization of tangible assets, whereby they are converted into digital representations. This could potentially create stronger connections between decentralized finance (DeFi) and crypto markets with the broader financial system and economy.
How FSB Will Monitor and Regulate DeFi?
Given these difficulties, the report recommends that the FSB take a more proactive approach to analyze the financial risks associated with the rapidly expanding DeFi ecosystem, as part of its routine monitoring of the cryptoasset markets. Additionally, the FSB should closely monitor the growing links between DeFi and the conventional financial system.
To achieve these goals, the FSB intends to collaborate with regulators and standard-setters to explore strategies for measuring and monitoring this interconnectivity. In the meantime, it recommends that authorities increase their data collection and sharing efforts to strengthen their supervision of this sector.
Moreover, the FSB has declared its intent to broaden its suggested policy measures for the global regulation of cryptocurrency assets to encompass the distinct hazards presented by DeFi. These may include:
- Smart contract-triggered automatic liquidations
- Mismatches in liquidity from different maturities in liabilities and assets
- Opaque administration arrangements
- Implementation of procedures vulnerable to market exploitation and cyber-attacks
Such measures are necessary to ensure sufficient supervision and enforcement, as well as to tackle the stability threats that arise from deepening links to conventional markets.
According to the paper, they would need to adopt policies that produce adequate regulatory outcomes for activities posing equivalent risks in places where DeFi falls outside the regulatory perimeter like Switzerland.