Full Decentralisation in DeFi is Illusory: BIS Report

In its latest quarterly review, the Bank for International Settlements (BIS) has claimed that decentralization in decentralized finance (DeFi) is an illusion and argues that policymakers should leverage this to regulate the sector.

BIS Report Calls DeFis Main Proposition “Illusory”

The Bank for International Settlements (BIS), an international financial institution owned by central banks of different countries, published a research paper on Monday containing a special feature on DeFi and its implications for financial stability.

In the feature, the BIS argues that full decentralization in DeFi is an illusion, citing the inescapable need for some form of centralized governance to exist and the tendency of blockchain consensus mechanisms to concentrate power.

According to the report, all DeFi platforms “have central governance frameworks outlining how to set strategic and operational priorities,” thereby necessarily containing “an element of centralisation.” On this point, the BIS specifically highlighted holders of governance tokens and stakeholders that exercise “managerial or ownership benefits” as typical examples for points of centralization.

“These groups, and the governance protocols on which their interactions are based,” the report said, “are the natural entry points for policymakers.” Interestingly, the BIS did not make any specific policy recommendations for lawmakers, but rather only highlighted the need to regulate DeFi before the ecosystem attained “systemic importance.”

Despite its impressive growth, the BIS described DeFi as “largely self-contained” and its potential to disturb the larger financial system as limited. However, the report acknowledges that if DeFis exponential growth continues, its “severe” vulnerabilities could spill over and undermine the financial stability of the real economy.

The BIS specifically highlighted high leverage, liquidity mismatches, built-in interconnectedness, and the lack of shock-absorbing capacity as DeFis main vulnerabilities. High leverage and the built-in interconnectedness exacerbate procyclicality, while liquidity mismatches and the absence of shock-absorbing entities like banks on the market raise the possibilities of investor runs on stablecoin issuers, said the report.

The report also touched on DeFi‘s permissionless nature, claiming that transaction anonymity and the lack of anti-money laundering and know-your-customer provisions “exposes DeFi to illegal activities and market manipulation.” Finally, the BIS said that DeFi’s main proposition of reducing the rents that accrue to centralized intermediaries is “yet to be realized.”

According to the report, regulatory safeguards are necessary, as they might also help “ensure that the innovative potential of DeFi brings overall benefits to finance.”

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