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    BIS Bulletins Discuss DeFi Lending and Aspects of Crypto-Assets

    June 16, 2022

    The Bank for International Settlements (BIS) published bulletins on lending in decentralized finance (DeFi) system, on blockchain scalability and fragmentation of crypto, and on extractable value and market manipulation in crypto and decentralized finance.

    The key highlights of the aforementioned bulletins follow:

    • The bulletin on lending in decentralized finance highlights that lending platforms are a key part of the decentralized finance ecosystem; however, their institutional features mostly facilitate speculation in crypto-assets rather than in the real economy lending. Due to the anonymity of borrowers, overcollateralization is pervasive in decentralized finance lending, which generates procyclicality. A model of intermediation fully built around collateral undermines benefits for financial inclusion, as borrowers already need to own assets. Collateral-based lending only serves those with sufficient assets, excluding those with little wealth. Looking ahead, the ability of decentralized finance lending to serve the real economy appears tied to better representation of real-world assets on the blockchain (tokenization) and to improved information processing. Tokenization will be essential to overcome decentralized finance’s self-referential nature and requires both technological improvements and updated legal frameworks. Enhanced information processing hinges on identity verification that allows for credit scoring and reputation building. These advances are likely to push the system toward more centralization, blurring the distinction between decentralized finance and traditional finance.
    • The bulletin on blockchain scalability and fragmentation of crypto highlights that fragmentation arises from inherent limitations of blockchains. To maintain a system of decentralized consensus on a blockchain, self-interested validators need to be rewarded for recording transactions. Newer blockchains have higher capacity, even if these come at the cost of greater centralization and weaker security. Differences in the design also preclude blockchain interoperability. Limited scalability and lack of interoperability not only prevent network effects from taking root, but a system of parallel blockchains also adds to governance and safety risks. Despite fragmentation, cryptocurrencies on different blockchains exhibit strong price co-movements, as they often share the same investor base, and growth is sustained by speculative buying of coins.
    • The bulletin on market manipulation in crypto and decentralized finance explains “miner extractable value” and why it arises, documents the amounts involved, and draws regulatory implications for cryptocurrencies, decentralized finance, and other blockchain-based applications. Cryptocurrencies such as Ethereum, and the decentralized finance protocols built on them, rely on validators or “miners” as intermediaries to verify transactions and update the ledger. Since these intermediaries can choose which transactions they add to the ledger and in which order, they can engage in activities that would be illegal in traditional markets such as front-running and sandwich trades. The resulting profit is termed “miner extractable value,” which is an intrinsic shortcoming of pseudo-anonymous blockchains. The pseudo-anonymity of blockchains also means that credit applications rely to date on overcollateralization. This makes lending in decentralized finance systems inefficient and risky, particularly when the underlying collateral is volatile. The bulletin also highlights that addressing this form of market manipulation may call for new regulatory approaches to this new class of intermediaries.

     

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    Keywords: International, Banking, Securities, Credit Risk, Lending, DeFi, Decentralized Finance, Blockchain, Regtech, Fintech, Crypto-Assets, BIS

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