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Decentralized finance is a growing threat to economic stability that must be contained and regulated through international cooperation.

That’s the message Federal Reserve Chairman Jerome Powell and Bank of England Governor Andrew Bailey brought to the Bank for International Settlements Innovation Summit on Wednesday, March 23.

Central bankers’ call yesterday for the creation of a single global strategy on decentralized finance (DeFi) regulation needs to happen “quickly,” Bailey said, warning, “if we try to do it in our own premises, we are going to fail because it will escape us… it will always be somewhere else.

Read more: PYMNTS DeFi Series: What is DeFi?

Controlled by self-executing smart contracts, blockchain-based decentralized finance includes projects that can create cryptocurrency and derivatives exchanges, lending and borrowing projects, manage assets, and make payments locally and across borders without any centralized human control, among other things.

See also: PYMNTS DeFi series: what is a smart contract?

They are not alone in this calling. On Thursday, the International Organization of Securities Commissions (IOSCO), a global association of regulators, released a report warning that DeFi is both misunderstood and more dangerous than meets the eye, with both obvious and hidden risks.

While acknowledging that financial innovation can bring many benefits to investors, IOSCO noted that “DeFi appears to present many similar risks to investors, market integrity and financial stability as other products do. and financial services”.

But, he added, DeFi “also poses specific and unique risks and challenges for regulators to consider.”

Chief among them, in some ways, is that “there is no generally accepted definition of ‘DeFi’ or what makes a product, service, arrangement, or activity ‘decentralized’.”

Growing pressure

Powell and Bailey are not the first to call for such global cooperation.

In January, Indian Prime Minister Narendra Modi told attendees of the World Economic Forum’s annual Davos conference that cryptocurrency is a challenge “that we face as a global family with a changing world order.”

Modi, whose government nearly banned cryptocurrency and is in the process of passing a law that would ban its use in payments and impose harsh taxes, called for a united front.

Read also: Indian PM calls for global action on crypto

“To combat this, every nation, every global agency must take collective and synchronized action,” he said.

And on March 22, the European Central Bank (ECB) doubled down on its call for a crackdown on crypto, with President Christine Lagarde citing its use to evade sanctions on Russia — despite broad consensus among US regulators that crypto is a bad way for oligarchs to move fortunes, but a good way for average consumers to protect their assets and escape authoritarian governments.

See: Crypto’s Impact on Russian Sanctions Could Lead to Tougher Regulation

ECB Executive Board Member Fabio Panetta added that crypto is a “major loophole” at the heart of the international financial system, according Bloomberg.

“These marketplaces must be held to the highest standards, including know-your-customer, anti-money laundering and disclosure requirements,” he said.

Control, not destroy

At the same time, calls for an outright ban on DeFi are few and far between, and many global banks and financial institutions are exploring ways to use smart contract and decentralized finance techniques to deliver faster, less expensive products. expensive and more efficient than is possible under the current system.

This is something proponents of softer regulation on DeFi agree on, warning that strict regulation of cryptocurrency-powered peer-to-peer financial projects run without any centralized human oversight will “simply stifle innovation” and will cause a brain drain as developers flee to friendlier jurisdictions.

Powell echoed the argument for innovation at the BRI summit, saying that “much of the progress we make down this path will depend on very high levels of international collaboration if we are to unlock the potential of assets. and digital services”.

It’s an argument he’s made before in regards to the broader cryptocurrency industry, most recently publicly disagreeing with Treasury Secretary Janet Yellen during a December Senate hearing on stablecoins. , calling “puzzling” the administration’s plan to require issuers to be FDIC-insured banks.

Read more: Powell and Yellen clash over Stablecoin regulation in Senate hearing

Need new guard dogs

According to IOSCO’s Board of Directors, the biggest challenge facing regulators is that the core mechanism of DeFi is to remove traditional financial intermediaries to create “faster, cheaper and more efficient trade execution.” “.

The problem is that “it also eliminates market participants who have traditionally acted as gatekeepers, playing a central role in ensuring investor protection and market integrity,” the report notes, citing things like helping investors understand risks, ensure the fair flow of market information, and impose structural constraints such as capital and liquidity requirements, anti-money laundering (AML) compliance and sanctions monitoring.

“These are important investor and market protections that aim to minimize fraud, reduce systemic risk and contribute to fair, efficient and equitable markets,” he said. “Without these intermediaries – and without appropriate substitution mechanisms – the risk to investors and the harm to the market can be exacerbated.

Emerging threats

The “Key Risks and Considerations” section of the reports is seven pages long with fairly brief discussions of each risk.

A number are crypto-specific, involving both structural aspects and how bad actors can game the system.

On the human side of decentralized projects, there is the ability of blockchain miners and validators to “precede” the market by seeing transactions before they enter the public ledger, the risk that “decentralized” projects can be under control de facto the control of creators or large investors holding large tokens, and the vulnerability of small blockchains to double spend via 51% attacks.

Technologically, issues include the reliance of DeFi transactions on fiat-backed stablecoins whose liquidity is not necessarily subject to regulatory oversight, the ability to evade AML using “pseudonymization,” and cryptocurrency mixing services, the inability to modify smart contracts, the reality that many blockchain and DeFi projects are indeed in beta stages of development, and concerns about the security of custodial services and of course the cybersecurity.

And, finally, there’s the growing exposure of traditional markets to DeFi: banks have been lending and investing in projects, as well as holding the multi-billion dollar funds that back stablecoin dollar pegs, and providing fiat on-and-off -ramp services.

“To date, DeFi’s interconnection with traditional financial institutions may be limited, but it is growing,” the report warned. “This activity can pose risks to traditional businesses and their operations which, if they expand, may become material to their business operations.”

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