Decentralized Finance Criticized by BIS

In its quarterly review, the Bank for International Settlements alleges that decentralized finance is unrealistic and destablizing

The tower of the headquarters of the Bank for International Settlements (BIS) is seen in Basel, Switzerland on Jan. 30, 2020. Arnd Wiegmann/Reuters

In the December edition of its quarterly review of the economy and finance, the Bank for International Settlements (BIS) took aim at decentralized finance, calling the ambitions of its proponents unrealistic and expressing concern over its potentially destabilizing effect on markets.

In a section titled “DeFi risks and the decentralisation illusion,” the BIS addresses the new movement, which seeks to overcome reliance on the traditional financial institutions that serve as mediators in most financial transactions.

“There is a ‘decentralisation illusion’ in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power,” reads the abstract of the section. “If DeFi were to become widespread, its vulnerabilities might undermine financial stability.”

The review claims that the ambitions of DeFi’s most enthusiastic advocates for these automated systems to replace central regulation is an impossible ideal.

“All DeFi platforms have central governance frameworks outlining how to set strategic and operational priorities, e.g. as regards new business lines,” says the review. “Thus, all DeFi platforms have an element of centralisation, which typically revolves around holders of ‘governance tokens’ (often platform developers) who vote on proposals, not unlike corporate shareholders.”

Decentralized finance has been a controversial feature of financial systems ever since its introduction on the heels of Satoshi Nakamoto’s blockchain whitepaper. There exist several systems for providing financial services via traditional, centralized intermediaries, but DeFi is unique in using automated algorithms to regulate financial transactions. This opens many theoretical possibilities, but this lack of oversight also makes DeFi attractive to illegal enterprises.

Concerns have also been raised about the larger economic effects of allowing DeFi to proliferate at current levels of regulation. In the recent review, the BIS alleges that economic risks of DeFi are attributable to four main concerns: “high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock-absorbing capacity.”

Proponents of DeFi argue that it will emancipate the finances of everyday people from the grips of establishment institutions. A recent column for The Washington Post summarized the aspirations of the movement, characterizing their vision as “Finance Without Financiers.”

“More than 1 billion people still don’t have access to basic banking services,” says the article. “DeFi’s supporters say it can change that by lowering transaction costs, while offering poor people the chance to earn a return on their savings, however small. They say DeFi will be the way money is democratized.”

However, these ambitions are controversial, and the BIS review indicates that established institutions are wary of the new technologies accompanying blockchain and cryptocurrency. It remains to be seen what the end result of these developments will be, but the review is a reminder that DeFi has a long way to go before its most radical aspirations to transform the financial system are realized.