Decentralized finance (DeFi) could be an illusion with a centralized problem that could make it susceptible to regulation, according to a quarterly review by the Bank of International Settlements (BIS).
DeFi is an umbrella term for a financial system that functions without third-party intermediaries like banks — one that is geared toward disrupting the traditional finance world. Inspired by blockchain technology, DeFi seeks to improve the efficiency of financial transactions by replacing middlemen like banks and exchanges.
BIS, the central banks’ liaison and coordination organization, analyzes developments in global non-bank financial intermediaries and offers policy perspectives. The current swipe at DeFi is the first of its five special features to discuss the system’s implications on global financial stability.
The quarterly report said while DeFi tries to build a system without regulating intermediaries, it has an “inescapable need” for centralized governance.
“DeFi supporters stress its potential efficiency gains, such as reducing high costs and slow speeds within traditional finance systems. For now, these gains are difficult to detect: DeFi appears to be operating largely within its own ecosystem, with little in the way of financial intermediation services being provided to the real economy,” wrote the institution known as the central bank of central banks.
“At the same time, besides giving rise to first-order money laundering and investor protection concerns, DeFi displays substantial financial vulnerabilities.”
BIS said there is the “illusion” that DeFi is decentralized and “some of its features, notably the consensus mechanism, favor a concentration of power.” This makes it easy for a small number of stakeholders to make big decisions.
These vulnerabilities can arise from intermediary-free lending programs, or from liquidity issues in stablecoins. Other vulnerabilities include interconnectedness among DeFi applications and a lack of banks to absorb potential shocks, the report said.
One element that could break this illusion is DeFi’s governance tokens, which are cryptocurrencies that represent voting power in decentralized systems, according to the report.
Governance-token holders – known as decentralized autonomous organizations (DAO), can influence a DeFi project by voting on proposals or changes to the governance system.