BIS on DeFi: How far can whole financial system run purely on automated transactions?

The DeFi market is in dire need of centralised governance, per BIS. During a press briefing on Monday, Hyon Song Shin, economic adviser and head of research at BIS, said: “The point raised in the special feature is that there’s a limit to how far you can run a whole financial system purely based on those automated transactions.”

The report stated that vulnerabilities can arise from decentralised lending programs or liquidity issues in stablecoins.

The report makes a case that complete decentralisation of the DeFi market is highly improbable. “We argue that full decentralisation in DeFi is an illusion,” BIS said in the report.

According to the report, governance tokens are the actual hurdle towards complete decentralisation. Governance tokens are cryptocurrency tokens that represent voting power in a decentralised infrastructure. Those who hold governance tokens have the power to influence different DeFi projects.

Bringing centralised regulation in DeFi platforms can also help them be recognised as legal entities, the report noted.

In Monday’s briefing, Shin explained how centralisation could address issues like consumer protection, money laundering and criminal activities, and financial stability in the DeFi ecosystem.

The report stated that the decision-making power in DeFi blockchains have the risk of being controlled by only a small group of investors. “Concentration of power can facilitate collusion and limit blockchain viability. It raises the risk that a small number of large validators can gain enough power to alter the blockchain for financial gain,” it said.

Another point of vulnerability the report pointed out was the practice of lending in DeFi platforms. Often loans in a decentralised platform are over-collateralised. This means that potential loans can have a value that is smaller than the value of the asset that is used as collateral.

“Funds borrowed in one instance can be re-used to serve as collateral in other transactions, allowing investors to build increasingly large exposure for a given amount of collateral,” it noted.

The report also shed light on the vulnerabilities of stablecoins, currencies that allow transactions on a DeFi platform. Stablecoins are liable for “Risk Liquidity mismatches”, which is basically a mismatch between the market liquidity of assets and the funding liquidity of liabilities. The liability, in this case, is commercial paper, as they are, ”short-term securities with illiquid secondary markets.”

Policymakers should make moves in this sector now as the whole DeFi system has seen rapid growth in the past few years, the report stated, adding, ”Regulatory safeguards would also help to ensure that the innovative potential of DeFi brings overall benefits to finance.”