The turmoil in cryptoasset markets and in DeFi in 2022 exposed a number of vulnerabilities in relation to DeFi, including operational fragilities and liquidity and maturity mismatches, as well as issues relating to leverage and interconnectedness
Decentralised finance (DeFi) has emerged as a fast-growing segment within the cryptoasset ecosystem. DeFi is an umbrella term commonly used to describe a variety of services in cryptoasset markets that aim to replicate some functions of the traditional financial (TradFi) system, purportedly by disintermediating their provision and decentralising their governance. In DeFi, the role of financial institutions and market infrastructures is replaced to varying degrees by self-executing code, or so-called smart contracts.1
The turmoil in cryptoasset markets and in DeFi in 2022 exposed a number of vulnerabilities in relation to DeFi, including operational fragilities and liquidity and maturity mismatches, as well as issues relating to leverage and interconnectedness. So far, these vulnerabilities have not affected the traditional financial system due to DeFi's relatively small size and limited interconnectedness with traditional markets. However, the scale of DeFi and/or its links with TradFi may grow over time, raising the potential for contagion and threats to financial stability.
Against this background, the Financial Stability Board (FSB) published a report in 2023 entitled The Financial Stability Risks of Decentralised Finance to provide an overview of the main features and vulnerabilities of DeFi, assess potential financial stability threats and draw policy implications.
Background of DeFi
DeFi services are built in a multi-layered architecture that includes permissionless blockchains,2 smart contracts, DeFi protocols3 and purportedly decentralised applications (DApps). DApps can replicate some functions of the traditional financial system. These include decentralised exchanges (DEXs), decentralised forms of lending, derivatives issued and traded in a decentralised system, initial forms of decentralised insurance and asset management.
The DeFi ecosystem is a complex web of interconnections involving multiple players with varying interrelationships and interests. They include protocol creators and developers, so-called decentralised autonomous organisations (DAOs),4 funders (eg venture capital and private equity funds) and institutional and retail end users, among others. DApps purport to have decentralised ownership and governance structures if they have such structures at all. However, in some DeFi applications, decision-making is centralised and, in practical terms, the actual degree of decentralisation among underlying DeFi organisational structures varies broadly.
The DeFi market is driven largely by institutional participants in advanced economies. In contrast, there is relatively little direct participation from retail investors and emerging or low-income economies. To date, DeFi is mainly self-referential, in the sense that DeFi products and services interact mainly with other DeFi products and services rather than with TradFi and the real economy....
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