FSB calls for action on DeFi

The fledging decentralised finance (DeFi) sector faces many of the same stability risks as the traditional financial system, and a host of added crypto risks as well, according to a new report from the Financial Stability Board (FSB), which calls on policymakers, regulators, and standards setters to take action to monitor and tackle those risks.

The report examines the development of DeFi — supposedly decentralized, disintermediated versions of traditional financial services — alongside the larger crypto sector.

Among other things, it finds that, while DeFi involves novel processes, it largely performs the same functions as the traditional financial sector, and carries many of the same risks as a result.

“In attempting to replicate some of the functions of the traditional financial system, DeFi inherits and may amplify the vulnerabilities of that system. This includes well-known vulnerabilities such as operational fragilities, liquidity and maturity mismatches, leverage, and interconnectedness,” the FSB said.

On top of these risks, the DeFi sector carries an array of added concerns, the report noted — including the prevalence of extensive connections between DeFi firms, the fact that the reality of DeFi structures often deviates significantly from its original intent, and an overall lack of compliance with established regulation.

Ultimately, the report concludes that the growing threat of these risks spilling over to the broader financial system and the real economy demands “careful monitoring as the ecosystem grows and evolves.”

Currently, this kind of oversight is hampered by a lack of reliable data on the sector, non-compliance with reporting requirements, and the fact that firms in the sector tend to operate in “opaque and non-transparent ways that create challenges for accurate data collection and analysis.”

In the face of this challenge, the report calls for the FSB to step up its efforts to analyze financial vulnerabilities in the growing DeFi ecosystem as part of its regular monitoring of the cryptoasset markets, and to more closely watch for growing connections between DeFi and the traditional financial system.

To that end, the FSB said that it will work with regulators and standards setters to explore ways to measure and monitor this interconnectedness; and, in the meantime, that the authorities should increase data sharing and data collection to beef up their oversight of this area.

Additionally, the FSB said that it will look at expanding its proposed policy recommendations for the international regulation of the crypto sector asset to address the specific risks posed by DeFi — including automatic liquidations by smart contracts, opaque governance arrangements, and the use of processes that remain susceptible to market manipulation and cyber thefts — to ensure adequate oversight and enforcement, and to address the stability risks posed by growing connections to the traditional markets.

“Potential policy responses may include, for example, regulatory and supervisory requirements concerning traditional financial institutions’ direct exposures to DeFi,” it said, along with possible measures to address vulnerabilities within DeFi itself — if it remains separate from the traditional sector.

Specifically, the FSB said that it may also consider whether to subject crypto trading platforms and stablecoins to additional prudential requirements, and investor protection requirements, or stepping up the enforcement of existing requirements.

“If DeFi activities and entities are deemed to fall within the regulatory perimeter, the enforcement of compliance with applicable regulations is warranted,” it said, adding that enforcement actions should proceed too.

And, in areas where DeFi falls outside the regulatory perimeter, “the challenge would be to develop policies that achieve appropriate regulatory outcomes for activities giving rise to similar risks,” it concluded.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.