BIS Study Urges Vigilance as DeFi and Crypto Approach "Critical Mass"

Well, our friends at the Bank for International Settlements (BIS) just published an interesting long read. It looks at potential financial stability risks resulting from the crypto ecosystem’s growing links to the traditional financial system, including banks and nonbank financial companies. The study further underscores the immediate need for proactive regulatory approaches. As digital assets continue to expand, many of them are approaching what Ulrich Bindseil of the European Central Bank (ECB) terms “critical mass.”

The BIS paper identifies two main channels where the crypto and TradFi ecosystems are becoming more connected. Besides the impact on the crypto market, the first is the increasing participation of traditional finance (TradFi) asset managers and broker-dealers in the crypto market. The second is the rise of the real-world assets (RWAs) tokenization.

With TradFi, participation in the space is on the rise as well DeFi, which is, admittedly, largely built upon crypto rails. Decentralized exchanges (DEXs) are likely next to lure in TradFi firms. In fact, they might just find themselves to be an integral component of the financial services ecosystem writ large.

The BIS warns that this deeper interconnectedness has its dangers. The paper stresses the need for additional research into the financial stability implications of RWA tokenization. This means tackling the systemic risks that may result from closer interconnections between DeFi and TradFi.

The report’s most significant and alarming finding is the current regulatory approach to permissionless, open-source blockchains. Yet, as per the Basel banking crypto rules, these blockchains are classified as high-risk. To the authors, as DeFi has come to be regarded as a more mainstream financial service, the same regulatory obligations must be levied on TradFi institutions.

In terms of policy approaches to crypto, the paper outlines three potential paths: ban, contain, or regulate, implying that an outright ban would be an undesirable outcome. In their conclusion, the authors urge an immediate adoption of a “containment” strategy. This method will better equip TradFi firms to measure and manage the risks associated with crypto assets.

The authors assert that a “containment” approach is warranted to ensure that TradFi firms properly assess the risks. - BIS Paper

And while dApps can be seen as technically challenging to regulate, the report underscores their ability to act as regulatory touchpoints. The International Monetary Fund (IMF) has been unequivocal in its warning of the dangers of cryptoisation. This issue presents grave risks, particularly for EMEs.

The crypto market is quick to play up its connections to traditional finance as insignificant. Yet, according to the BIS study, the picture is much different. Meanwhile, TradFi players are becoming more engaged than ever. At the same time, RWA tokenization is skyrocketing, deepening the nexus between the traditional finance world and the digital one.