FSB highlights risks of DeFi to financial stability

The Financial Stability Board (FSB) has warned that the expansion of crypto-based decentralized finance (DeFi) may have wide-ranging implications for traditional finance markets, as connections between the two ecosystems increase.

The FSB, created by the G20 following the Global Financial Crisis, noted in The Financial Stability Risks of Decentralised Finance that, to-date, DeFi has largely remained “self-referential”, as products and services interact only with others within the crypto-asset ecosystem. However, traditional financial (TradFi) entities are increasingly entering the market.

DeFi services aim to replicate the functions available in traditional financial markets in cypto-asset markets, while disintermediating these services and decentralizing governance. But as these functions are very similar, they also present similar risks.

DeFi services can also transmit risk among different crypto-asset markets, through connections to centralized platforms for crypto-asset trading, lending and borrowing.

The FSB states in a release: “In attempting to replicate some of the functions of the traditional financial system, DeFi inherits and may amplify the vulnerabilities of that system. This includes well-known vulnerabilities such as operational fragilities, liquidity and maturity mismatches, leverage, and interconnectedness.”

The FSB notes that the risks to financial stability depend on the interlinkages and transmission channels between DeFi, TradFi and the real economy.

While major crypto events, such as the collapse of FTX in November 2022, had only minor implications for traditional markets, it warns that the scope for spillovers would increase with the emergence of real-world use cases and greater interlinkages.

As defi services present new risks while seeking to replicate traditional financial services that themselves present risks, the FSB warns that the growth of Defi has the potential to amplify the vulnerabilities of the financial system.