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    BIS Papers Discuss Risks in Crypto Markets and Decentralized Finance

    January 19, 2023

    The Bank for International Settlements (BIS) published papers on addressing the risks in crypto-asset markets and on the technology of decentralized finance.

    Paper on Risks in Crypto Markets. The paper discusses the recent high-profile failures of FTX and other crypto firms and highlights the need for appropriate policy response to address the risks in crypto, including through regulation. The paper identifies that “shadow financial” functions enabled by crypto markets share many of the vulnerabilities of traditional finance. These relate to high leverage, liquidity and maturity mismatches, and substantial information asymmetries. The paper sets out three—non-mutually exclusive—lines of actions to address the risks in crypto. The first option involves banning the crypto activities, either in their entirety or in a targeted manner. The second option is to isolate and contain crypto so that it remains a niche activity while the third option is to regulate crypto in a way similar to traditional finance. This approach would require authorities to map activities performed in crypto markets to traditional finance and then use similar guiding principles to regulate crypto, combining activity and entity-based approaches. This approach would ensure consistency in regulating financial activities—whether performed by crypto players or traditional finance—and help to promote the policy goals at the core of existing regulatory frameworks. It would allow responsible actors to innovate with regulatory compliance and oversight. The paper also outlines complementary lines of policy action to address inefficiencies in traditional finance and curb the demand for crypto, such as encouraging sound innovation with central bank digital currencies (CBDCs) and improving the quality and reducing the costs of payments. The online appendix to the paper provides a selective overview of ongoing initiatives in crypto regulation.    

    Paper on Decentralized Finance or DeFiThe paper provides a deep dive into the overall architecture, the technical primitives, and the financial functionalities of decentralized finance protocols. The paper analyzes and explains the individual components and how they interact through the lens of a decentralized finance stack reference model featuring three layers: settlement, applications, and interfaces. The settlement layer is responsible for completing financial transactions and discharging obligations. The application layer comprises applications implemented through smart contracts, thus combining crypto-assets, decentralized finance protocols, and compositions. The interface layer provides front-end interfaces that facilitate user-friendly interaction with the smart contract logic. The paper also describes financial services for the most relevant decentralized finance categories—that is, decentralized exchanges, lending protocols, derivatives protocols, and aggregators—and reviews how decentralized finance protocols can be combined into compositions. Finally, the paper outlines an interdisciplinary agenda for future research, focusing on understanding systemic risk more profoundly by analyzing token flows and protocol dependencies, both within the crypto-ecosystem and by considering the potential spillovers from and to the traditional financial system.


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    Keywords: International, Banking, Cryptoassets, Regtech, Decentralized Finance, CBDC, Central Bank Digital Currencies, Liquidity Risk, DeFi, Lending, Credit Risk, Derivatives, BIS

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