Financial Stability Board Concerned Tokenization Boosts DeFi TradFi Links – Ledger Insights

Today The Financial Stability (FSB) published a report on Decentralized Finance (DeFi). It says that DeFi replicates traditional finance (TradFi), but it amplifies the risk. Given the FSB’s mandate, its concerns particularly encompass two areas of stability. One is the growing links between TradFi and DeFi. And the second is the potential for the stablecoin to not disrupt the money markets if the reserve funds have to be liquidated quickly.

Regarding the TradFi and DeFi links, the report states, “The FSB will examine the growth of tokenization of real assets as it may increase the links between cryptoasset/DeFi markets, TradFi and the real economy.” An example is this week’s issuance of Siemens’ €60 million bond on a public blockchain.

Improved risk from DeFi

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

On the operational vulnerability front, the FSB identifies the governance of DeFi protocols and the reliance on blockchain networks that can become overloaded or, in cases like Solana, unavailable for periods of time. It also mentions code bugs and cross-chain bridges, an area vulnerable to frequent hacks and losses over the past year.

The FSB sees leverage as having an outsized impact on DeFi. That’s because smart contracts automatically liquidate collateral that can create a spiral. In contrast, TradeFi relies on central counterparties or market makers.

Potential bank exposure to DeFi

Banks can be exposed to DeFi either directly or indirectly. For example, on the indirect front, they can lend to a DeFi counterparty or a family office. That lending can be secured with real-world assets or with crypto. Regulated institutions may offer market making, clearing services or derivatives for clients.

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

A less obvious but real exposure is DeFi lending to banks. MakerDAO is a prime example of this, as it has loaned $100 million to Huntingdon Valley Bank and $7 million to Societe Generale to refinance a senior bond.

The report states: “Should this type of interconnection grow, the risk that a shock originating in DeFi could be transmitted to the real economy would increase significantly.”

However, the FSB is not only concerned about banks. It notes the increased activity of asset managers in the sector. For example, MakerDAO invested $400 million in BlackRock ETFs. This results in more permissioned DeFi protocols being created, encouraging greater institutional participation. “Such increased linkages can increase the possibility of contagion, as investors are able to borrow in one system and invest the proceeds in the other,” the report said.

FSB DeFi plans

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

Secondly, together with standard-setting bodies, it wants the connection between DeFi, TradFi and the real economy to be measured and monitored.

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