Today, The Financial Stability (FSB) published a report on decentralized finance (DeFi). He says that DeFi replicates traditional finance (TradFi), but amplifies the risks. Given the FSB’s mandate, his concerns include two areas of stability in particular. One is the growing links between TradFi and DeFi. And the second is the possibility of a stablecoin failing to disrupt money markets if reserve assets have to be liquidated quickly.

Regarding the links of TradFi and DeFi, the report states that “the FSB will explore the growth of real asset tokenization as it could increase the links between the crypto/DeFi markets, TradFi and the real economy.” One example is this week’s issuance of Siemens’ €60 million bond on a public blockchain.

Enhanced DeFi Risks

DeFi vulnerabilities include operational fragility, liquidity and maturity mismatches, leverage, and interconnectedness.

On the operational fragility front, the FSB identifies governance of DeFi protocols and reliance on blockchain networks that could become congested or, in cases like Solana, unavailable for periods. It also mentions coding errors and cross-chain bridging, an area vulnerable to attacks and frequent leaks over the past year.

The FSB considers that leverage has a huge impact on DeFi. This is because smart contracts automatically liquidate collateral which can create a spiral. Rather, TradeFi relies on central counterparties or market breakers.

Potential bank exposure to DeFi

Banks could be exposed to DeFi directly or indirectly. For example, on the indirect front, they could lend to a DeFi counterparty or a family office. That loan could be collateralized by real world assets or by crypto. Regulated institutions may provide market making, clearing or derivative services for clients.

A direct bank exposure will materialize if they issue a bank deposit or settlement token used in DeFi. Or if the real world assets are tokenized. There are numerous examples of tokenized bonds, some of which are issued on public blockchains, such as those of the European Investment Bank.

A less obvious but real exposure is DeFi lending to banks. MakerDAO is a prime example of this, having lent $100 million to Huntingdon Valley Bank and $7 million to Societe Generale to refinance a covered bond.

The report states: “If interlinkages of this type were to grow, the risk that a shock originating from DeFi could be transmitted to the real economy would increase materially.”

However, the FSB does not only care about banks. The increase in the activity of asset managers in the sector is confirmed. For example, MakerDAO invested $400 million in BlackRock ETFs. This is resulting in the creation of more licensed DeFi protocols, which encourages greater institutional participation. “This increased linkage may increase the possibility of contagion, as investors can borrow in one system and invest the proceeds in the other,” the report says.

FSB DeFi Plans

The report includes a number of recommendations. First of all, the FSB plans to analyze the vulnerabilities of the DeFi ecosystem, as mentioned, including the potential of tokenization to increase TradFi-DeFi connectivity.

Second, together with regulatory bodies, it wants the interconnectedness between DeFi, TradFi and the real economy to be measured and monitored.

Third, the proposed policy recommendations may need to be expanded to take into account the specific risks of DeFi. In particular, it wants to explore the regulatory perimeter, focusing on entry points that include stablecoins and centralized cryptocurrency exchanges.