The Bank of Canada recently released a staff analytical note discussing the growth of decentralized finance (DeFi) and the potential paths for regulatory involvement in the wider market. This report, published on October 17, explores the evolution of the cryptocurrency market, its advantages, challenges faced by traditional finance, risks, and the potential impact on financial markets alongside possible regulations.
The Evolution of Crypto Assets
The note highlights that crypto assets initially started as a payment system implemented on the blockchain. However, they have since diversified into various fields within the financial services industry. To achieve decentralization, smart contracts have been utilized, eliminating the need for third-party intermediaries in settling multiple transactions. As a result, the market cap of this sector grew to reach $2.9 trillion before experiencing major platform collapses and regulatory obstacles causing a significant decline in prices.
From non-fungible tokens and decentralized stablecoins to innovative services, the emergence of this asset class has introduced a whole new niche with associated risks in today’s market. One advantage highlighted by the bank is the composability of smart contracts, enabling easier creation of services by more companies. The open-source nature of the code allows developers to collaborate and build upon existing networks.
The bank further notes that the ecosystem’s increased service offerings, enhanced competition, and transparency make it more appealing compared to traditional finance products. Additionally, DeFi aims to dismantle financial monopolies by facilitating cross-border payments and ensuring interoperability, offering users seamless experiences across multiple platforms. The transparency provided by blockchain technology also reduces frictions in financial markets, minimizing limited and opaque transactions often encountered in traditional systems. By eliminating traditional intermediaries that might be susceptible to corruption, the power is shifted to the customers.
Risks and Regulatory Considerations
While decentralized finance offers numerous benefits, it also brings certain risks to global financial markets. Key concerns include limited tokenization, high concentration, and the presence of unregulated centralized entities. Notably, despite claiming to be decentralized, certain players in the DeFi sector remain highly centralized. This poses a risk to stakeholders if not adequately regulated due to complexities in managing private keys and other services, which have contributed to the rise of centralized exchanges. The collapse of FTX in November serves as a prime example of the risks associated with unregulated centralized players in the industry.
The bank suggests the implementation of appropriate regulations across all channels to mitigate the activities of bad actors within the sector and their interaction with traditional finance. In Canada, for instance, the securities regulators’ association recently clarified stablecoin regulations to ensure proper issuance and trades without falling under the securities category.
