Bank for International Settlements (BIS) says DeFi’s Governance Structure Is A Natural Entry Point for Public Policy

In its report on decentralized finance titled “DeFi risks and the decentralization illusion” published this week, the Bank for International Settlements talked about the new sector of the crypto industry.

It covered how the DeFi ecosystem revolves around stablecoin and novel protocols for trading, lending, and investing, with its main vision being intermediation without centralized entities. BIS argues that some form of centralization is inevitable; as such, it is a “decentralization illusion.”

Centralized governance is needed to take strategic and operational decisions and the consensus mechanism in DeFi protocols already “favor a concentration of power,” it said, adding: the inherent governance structures of DeFi are the natural entry points for public policy.

The agency wants to use these entry points — the groups of stakeholders that make and implement decisions and the governance protocols on which their interactions are based — to contain DeFi-related issues “before this ecosystem attains systemic importance.”

And while DeFi has the “potential to complement traditional financial activities,” BIS says, at its current stage, it has few real-economy uses and is primarily supporting speculation and arbitrage.

According to BIS, DeFi poses financial stability concerns due to high leverage, liquidity mismatches, and the lack of shock-absorbing capacity, which make vulnerabilities severe. As for stablecoins, they are prone to runs if risks are not well managed, and there’s potential for funding shocks for corporates and banks in case of fire sales by a stablecoin of its reserve assets.

While the early development of novel technologies comes with bubbles, down the road innovations could potentially be of broader use, it said.

“Given this self-contained nature, the potential for DeFi-driven disruptions in the broader financial system and the real economy seems limited for now,” said the agency.

To be used widely in financial intermediation, the still-developing DeFi ecosystem would need to satisfy a number of conditions such as improved scalability and proper regulation, the BIS said. As such, it calls for “same risks, same rules” as in traditional finance.

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