DeFi Can Exacerbate Volatility Without Even Avoiding Middlemen, BIS Reports Say

Decentralized finance (DeFi) could lead to bumpier financial markets and may not even fix problems of large intermediaries dominating, two papers published Friday by the Bank for International Settlements (BIS) said.

The papers put a damper on plans for trading to become fully automated – and for proposals to use new technology to cut out the middleman, including one proposed by FTX’s Sam Bankman-Fried before his crypto exchange collapsed.

Regulators want to see financial markets that cushion shocks – for example, offering a form of insurance if there’s a spike in energy prices. But, a paper by Alfred Leharof the University of Calgary and Christine Parlour of the University of California Berkeley said, DeFi could have the opposite effect because liquidated loans depress collateral prices further.

“This contagion to other exchanges leads to negative feedback loops,” Leharof and Parlour said, after studying behavior on Aave and Compound, two major DeFi protocols. “Our findings illustrate a new form of systemic fragility arising from collateralised lending under DeFi architecture.”

While those platforms are different from the FTX plan, which was withdrawn on the day the exchange filed for bankruptcy protection, Bankman-Fried’s proposal “would immediately liquidate collateral through limit orders,” the authors said.

A separate BIS study also published Friday found DeFi could reduce the cost of financial transactions – but doesn’t fully fix the problems of centralized intermediaries overcharging for services, and can also circumvent checks.

“The current design of DeFi applications generates formidable challenges for tax enforcement, aggravates money laundering issues and other kinds of financial malfeasance,” said Igor Makarov of the London School of Economics and Antoinette Schoar of MIT's Sloan School of Management in a paper produced for the BIS.

“The economic forces that allow intermediaries to hold market power in traditional finance might still exist in the DeFi world,” added Makarov and Schoar, citing the examples of oracles – the links between smart contracts and the real world, which might be persuaded to collude and falsify data without the proper incentives.

It’s in the U.S. interest to “set standards that protect consumers and maintain the transparency, accountability and stability of the system,” but other jurisdictions need to play ball to stop business moving to the most favorable country, Makarov and Schoar said.

Without proper rules, regulators will be left depending on “goodwill and voluntary cooperation,” they added, or countries might each run their own versions of the blockchain.

Officials from BIS, a grouping of the world’s central banks, have previously dismissed DeFi as an “illusion” in which individuals in reality can exert significant control. It also overturns traditional regulatory norms in which obligations are placed on a centralized actor like a broker or bank.

Read more: International Regulators Struggle With How to Oversee DeFi