DeFi stands out as crypto’s biggest regulatory challenge

At a conference hosted in Paris by the Banque de France (BdF) on September 27, there were suggestions that if the obstacles facing decentralised finance (DeFi) cannot be surmounted, then it may not be allowed to flourish within the financial system. 

DeFi removes the need for intermediaries, allowing parties to transact directly on peer-to-peer networks run on blockchains. These automated networks are typically controlled by decentralised apps that manage issues such as governance and liquidity. DeFi replicates exchanges and banks with the promise of greater speed, lower costs and anonymity.

Though central bankers are not in principle opposed to DeFi, they are clearly determined to iron out structural weaknesses before the activity becomes embedded in the traditional financial system. 

A panel of central bankers at the BdF conference agreed that DeFi poses some unique regulatory challenges, which go beyond the rest of the crypto space. 

Jay Powell, chairman of the US Federal Reserve Board, said there was a lack of transparency around DeFi. 

“DeFi is a totally different thing. There is a lot of stuff that’s unknown,” said Ravi Menon, managing director at the Monetary Authority of Singapore. He explained that the central problem with DeFi is applying rules that are designed for legal entities. 

“In a decentralised world, you can’t do that to an algorithm,” said Mr Menon. “And pinning that governance and risk management responsibility on the players that can make a difference in the DeFi world is exceedingly difficult.”

He believes it is a challenge regulators can overcome, and that DeFi does hold promise. “Otherwise, this could be a game stopper,” he warned.

Same risk, same rules

Some crypto firms seek to become regulated so they can deal with traditional institutions and have been calling to be overseen along the lines of ‘same activity, same regulation’. 

However, Agustín Carstens, general manager at the Bank for International Settlements (BIS), is wary of adopting this approach. “I think that we should have the ability to question the universal application of the same activity, same risk, same regulation,” he said. 

Other crypto operators believe their sector is different enough to deserve its own special regulatory regime, meaning simpler, lighter rules. However, Mr Carstens’ remarks suggest they have a lot of convincing to do before achieving that outcome across the board. 

The BIS has expressed considerable doubt about crypto since it burst on to the scene in a big way. It sees the sector as riddled with structural flaws and potential systemic risks.

Mr Carstens explained that the quality of a report from a DeFi operator that does not have limits on capitalisation, or liquidity or leverage rules, and where the collateral is not supervised, cannot be seen the same way as one from a regulated bank. “For me, it’s a very different animal,” he said. 

Digging deeper into the problem, he explained: “DeFi exposes intermediaries to the traditional risks that traditional financial intermediation establishes, which is liquidity risk, counterparty risk, leverage transformation and so forth.”

He went on to say that DeFi is not supported by a solid infrastructure, a situation made worse by some stablecoin arrangements greasing the wheels of this activity that have been found to be poorly designed and collateralised. 

He also lamented that governance is often not well established and the exchanges involved in DeFi are sometimes engaged in too many activities, funds are not properly segregated, and accountability is lacking.

“The good news, I suppose, is that the interaction, from a financial stability standpoint, between the DeFi ecosystem and the traditional banking system and traditional financial system is not that large at this point,” Mr Powell said. “That situation will not persist indefinitely.”

There was some discussion around the ‘crypto winter’, and it was widely agreed that rising interest rates are only partly responsible for bursting the crypto asset bubble. “Where evolution has been critically important is this search for yield, which has clearly encouraged and accelerated the process at times,” said Christine Lagarde, president of the European Central Bank (ECB). Others believe flaws in the design of crypto markets allowing the frequent theft of assets and poorly designed stablecoins are also to blame. 

Making stablecoins safe

Ms Lagarde believes the regulatory framework should distinguish between crypto assets, such as bitcoin and ether, and stablecoins backed by fiat currencies. “Crypto assets are not currencies, but are obviously pure speculative assets … and certainly not a means of payment, [and] not a very stable store of value,” she said. 

But like Mr Menon, she believes stablecoins are more promising, but currently only represent 10% of the entire crypto universe. “It is promising as long as we don’t have players that abuse the system that pretend that they have liquid assets to back the stablecoins or that it’s one for one when in fact it is not one for one,” she said. 

She explained that stablecoins have likely accelerated the desire to develop more innovative payment systems. Mr Menon sees them as having potential as a medium of exchange.

“They’re digital cash, they’re programmable and can be put on a ledger provided the value is fully backed by reserve assets,” he said.

The central bankers remarked that stablecoins are mainly used on exchanges allowing traders to switch in and out of crypto assets. However, Mr Powell said they could in time reach the general public more broadly, possibly as a means for payments. He said from a regulatory standpoint, policy should focus on the prospects for them to become more widely adopted. He said US regulators under the auspices of the US Department of the Treasury and Congress are looking into the best ways to regulate stablecoins. 

Responding to a question regarding whether stablecoins are like money market funds (MMFs), Mr Powell said they have similarities with MMFs, but also bank deposits. He remarked that redemption issues that had afflicted some stablecoin operators recently had echoes of runs on MMFs during the 2007–9 global financial crisis.

“Both of those are very substantially regulated, and appropriately so,” he said. “[The public] will assume that it’s money … [that] has the central bank’s backing so that they can trust it.” He said stablecoin reserves need to be publicly transparent and consist of credit assets that will always be there when there is a need to fund withdrawals. 

Programmable CBDCs

Mr Carstens was probably the most sceptical of the panel’s participants about the role of stablecoins. “Who establishes the rules of the algorithms? Who takes the decisions about stablecoins?” he asked, adding that there is an illusion of decentralisation. “At the end of the day, they are quite well identified central players that can be regulated.”

Furthermore, he thinks central bank digital currencies (CBDCs) can perform any function a stablecoin can. “I think that the nimbleness that stablecoins bring to the table should be provided by CBDCs,” he said, explaining that CBDCs can be programmable and could participate in DeFi-like activities. “If we already have trusted money, why do we need to export the value to another currency [stablecoins]?” he asked. 

However, eurosystem central bankers appear to be steering away from designing a programmable CBDC or digital euro, preferring smart contracts to provide that functionality instead. No final decision has been taken on launching a digital euro nor on its precise design features. 

However, creating programmable central bank money could be deeply controversial in some jurisdictions due to fears citizens could be restricted over how they can spend their money. 

Some industry sources believe programmability is best left to privately operated stablecoins, which would be less controversial.  

These could be specialist stablecoins designed for a particular capital markets function or retail setting, or for a supply chain application. 

Mr Menon noted that stablecoins are only one of several routes to digitisation, which include CBDCs and tokenising bank deposits so they can run on digital ledgers and benefit from existing regulatory protections.  

The panel’s central bankers took different positions on CBDCs. Mr Powell was non-committal on the topic, pointing out that the Fed is looking at the issue very carefully. “We have not decided to proceed and we don’t see ourselves as making that decision for some time,” he said. He added that any go-ahead would depend on the Biden administration’s position and that of Congress.

The ECB, meanwhile, appears more enthusiastic and is exploring designing a retail CBDC, which the general public could use. 

Ms Lagarde stressed the need to experiment with digital central bank money or central banks could lose the role of monetary anchor that they have played for many decades. She suggested that losing that role would pose systemic risks to the financial system. 

She acknowledged that if a digital euro became too successful it could disintermediate deposit-taking banks. The ECB is looking at safeguards that could include limiting digital euro holdings or introducing a sophisticated remuneration tearing system. Meanwhile, Ms Lagarde said the eurozone settlements system needs to be upgraded to reflect digital developments and could involve the use of digital ledger technologies. 

Wholesale CBDCs

Elsewhere in the eurozone, the BdF has been pioneering the exploration of a wholesale CBDC, seeing it as potentially revolutionising financial markets. These would only be used in capital markets transactions involving regulated financial institutions and the central bank. They would be a lot less disruptive than a retail CBDC. 

“Not offering the market wholesale CBDCs could open the market up to so-called stablecoins, which would pose a systemic risk,” said BdF governor François Villeroy de Galhau in his opening speech to the event. 

Mr Villeroy de Galhau, who also chaired the panel, said wholesale CBDCs pose relatively less complex legal issues and have two strong business cases: they could significantly improve cross-border payments, and complement the tokenisation of securities as a safe and liquid settlement asset on blockchain technology.

According to Mr Villeroy de Galhau, the BdF has conducted nine experiments since 2020 involving wholesale CBDCs and announced the launch of three new ones. 

“I’m a bigger fan of wholesale CBDCs than retail CBDCs,” said Mr Menon. He explained that the critical problems policy-makers face can be solved via programmable money in the form of private stablecoins, tokenised deposits or wholesale CBDCs. “I think in the future landscape we’ll have all three in play,” he said. 

Mr Menon believes that retail CBDCs are a public choice and that they are not necessary to tackle issues in trade finance, cross-border payments, settlements post- or pre-trade, or capital market activities. “Wholesale CBDCs, stablecoins and tokenised deposits can do it,” he said. 

The debate reflected nuanced differences regarding digital money among the central bankers. No doubt individual jurisdictions will pursue initiatives that suit their circumstances. Where central bankers do agree is that global systems for international transactions and regulatory oversight are needed for crypto, which by its nature does not recognise borders. 

This article first appeared in Global Risk Regulator, a service from The Banker.