Targ Patience for CITYA.M.
Will decentralised finance disrupt the global financial system, delivering untold efficiencies and eliminating unjust barriers to financial inclusion?
Or is DeFi largely a bubble – a temporary fever-dream of speculation and swindles, sold on false promises and fantasies of righteous wealth redistribution?
Despite the prevailing tendency towards binary thinking, the truth, as always, can be found in shades of grey.
On the December 3, the Bank for International Settlements (BIS) caused something of a stir with a paper, somewhat provocatively-titled ‘DeFi risks and the decentralisation illusion’.
Its authors concluded that wider adoption of DeFi, in its current form, would present unacceptable risks to the entire financial system, thanks to severe vulnerabilities arising from “high leverage, liquidity mismatches, built-in interconnectedness and lack of shock-absorbing capacity.”
The titular ‘decentralisation illusion’ is reference to an “inescapable need for centralised governance and the tendency of blockchain consensus mechanisms to concentrate power”.
Collectively, it makes for a rather bleak assessment. The message is not all bad, though: the paper’s authors anticipate that with improved scalability, wider adoption of tokenisation, and, crucially, introduction of “suitable regulation” to ensure appropriate safeguards and trust, DeFi “may yet” play an important role in the wider financial system.
The authors point to “inherent governance structures” as “the natural entry points” for authorities to interface with DeFi to contain issues before the ecosystem attains systemic importance.
Devil may care
DeFi, the purported Wild West of today’s maturing and increasingly-centralised crypto sector, remains boldly and definitively anti-authoritarian. So why should the BIS, an organisation comprised of sixty three central banks, matter to them? What self-respecting degen, in confident onion-routed isolation from authorities’ repressive reach, would give a damn about some archaic, fiat-fuddled doom-mongers?
Many won’t. Some may not even want to see wider adoption of DeFi, least of all by financial institutions, and see its rightful future as niche and arcane. I’ve spoken with plenty in the space who staunchly believe regulation, of any form, to be a de-facto devil; albeit one which is powerless to penetrate their decentralised sanctum. But I rest on the premise that wider adoption of DeFi would be a good thing.
All markets need participants to function, and require growth to prosper. Without expansion and adaptation, even the most promising of germinating revolutions will wilt and perish.
Indulging in the revolutionary motif a little, consider a phrase used by the ‘Comité de Salut Public’, led by Maximilien Robespierre, during the French Revolution:
“grande responsabilité est la suite inséparable d’un grand pouvoir”
(“great responsibility is the inseparable result of great power”)
The DeFi market has already reached considerable scale, and it continues to grow. As the value of the market expands, along with the volume and diversity of its participants, so too does its actual and potential power – both direct and indirect – over people, businesses and, ultimately, economies. A proportionate weight of responsibility is, in short, inevitable. So, what do the BIS have to say?
The macroprudential risks proposed in the BIS analysis stem from three core factors: scalability issues, leverage-driven procyclicality, and a determination that stablecoins are, inherently, unstable.
Scalability challenges for decentralised blockchains are no revelation to the industry, and have been met by a tide of innovation and enhancement. Sharding, alternative consensus algorithms, and use case-appropriate layer-2 solutions all contribute to a scalable future.
Nonetheless, the BIS are concerned that project insiders are often allocated large token holdings, which may undermine the integrity of proof-of-stake consensus. In combination with the opacity of individual wallet ownership and control, this means that fraudulent transactions could be committed to a ledger by unscrupulous validators with sufficient staking authority, which might be accrued without necessarily being detected.
Procyclicality essentially refers to characteristics that magnify any market trends; this increases risk when conditions are volatile and can potentially deepen or even trigger financial crises. The BIS observe that within DeFi, borrowed assets can be re-used as collateral in other transactions, enabling increasingly large exposures to be built up with a given amount of collateral.
The fundamental risks here are not dissimilar to those generated by rehypothecation – the re-use of collateral or client assets – in traditional markets, the effects of which were seen during the 2007-2009 global financial crisis.
On stablecoins, the BIS notes that viability broadly depends on the trust that investors have in the value of underlying assets, or the accuracy of the algorithm. An erosion of that trust could naturally lead to large numbers of token holders simultaneously trying to shed their holdings or exposure, waking the procyclical beast and potentially overwhelming DeFi funding and liquidity channels.
With interoperability between DeFi platforms and products, complex value dependence is interwoven between assets, adding further potential fuel to negative trends. As the value of assets placed as collateral falls, positions must either be re-collateralised or will be liquidated.
The rapid sale of various assets in response to these events – by liquidators and position holders alike – can lead to unpredictable price volatility, spreading contagion across assets, markets and protocols.
The BIS caution that, once these DeFi dominoes start falling, there are no shock-absorbing mechanisms to limit them; meaning that banks or other institutions with significant exposures to affected markets could transmit the shockwaves into the wider financial system.
In the absence of comparable data, reporting and risk pricing standards to those mandated in traditional markets, there is no reliable way to estimate the probability, timing or impact of such an event.
This all begs some important questions:
Firstly, do the three authors of this paper, with academic pedigrees in traditional finance and economics, actually understand DeFi? Or have they simply made distorted observations of DeFi’s kaleidoscopic terrain through an obscured lens of legacy market concepts?
Secondly, is it even possible to regulate DeFi; and if so, should it be regulated, what might “suitable regulation” look like, and how does that compare to the various proposals and developments currently emerging from certain regulatory authorities?
The first of these questions is by far the easiest to answer. Whilst summary dismissal of such sobering analysis may appeal to some, it would be hard to justify.
Notwithstanding the respective backgrounds of its co-authors, the paper cites sixteen additional contributors, with diverse and often clearly relevant credentials. This includes Mike Alonso, currently Principal Architect at the BIS, previously Lead Solution Architect at DeFi colossus Consensys; plus Raphael Auer and Jon Frost, Principal and Senior Economists, respectively, of Innovation and the Digital Economy at the BIS; and Benedicte Nolens and Asad Khan, Head and Digital Technology Adviser, respectively, at the BIS Innovation Hub. In summary, this ain’t their first rodeo.
‘DeFi risks and the decentralisation illusion’ was, in fact, only the latest of several DeFi research papers published by the BIS over the past year, which indicates two things: both a surprising depth of understanding about this highly novel sector, and a weight of significance it has attained in the eyes of the planet’s most powerful monetary authorities, who collectively oversee the major economies of Europe, Asia, North and South America, Oceania, and Africa.
But irrespective of all else, from our present vantage point, the BIS analysis seems to have been almost prophetic. Since its publication, many of the described dynamics have played out in spectacular fashion across certain swathes of DeFi, sharpening minds and accelerating its momentum towards an uncertain future.
The second question is neither easy, nor brief to answer. In subsequent articles, I will take a closer look at the evolving DeFi landscape, its major players, components and risks, and the varied regulatory approaches and proposed solutions that loom – for better or worse – on their horizon. By exploring these topics from opposing perspectives, and the vast space between them, I will seek to unravel clear answers.
Accompanied, no doubt, by many new questions.
-  https://www.bis.org/publ/qtrpdf/r_qt2112b.pdf
-  https://www.bitcoin.com/satoshi-archive/emails/cryptography/12/
-  https://www.activism.net/cypherpunk/crypto-anarchy.html
-  https://www.barrons.com/articles/what-is-defi-wild-west-crypto-51635526163
-  https://dyor-crypto.fandom.com/wiki/Degen
-  https://www.onion-router.net/
-  https://books.google.ca/books?id=D55aAAAAcAAJ&pg=PA72&redir_esc=y#v=onepage&q&f=false
-  https://www.nansen.ai/post/nansens-state-of-the-crypto-industry-report-2021
-  https://fc16.ifca.ai/bitcoin/papers/CDE+16.pdf
-  https://vitalik.ca/general/2021/04/07/sharding.html
-  https://101blockchains.com/wp-content/uploads/2018/08/Different_Consensus_Algorithms.png
-  https://github.com/Awesome-Layer-2/awesome-layer-2
-  https://www.fsb.org/2017/01/re-hypothecation-and-collateral-re-use-potential-financial-stability-issues-market-evolution-and-regulatory-approaches/
-  BIS DeFi publications
-  https://www.bis.org/about/member_cb.htm?m=1%7C2%7C601