IMF Wants Authorities to Crack Down Crypto ‘DeFi’

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Decentralized finance, or DeFi, has been compared to the Wild West.

The time of dreams

The International Monetary Fund has a message for governments: find ways to regulate DeFi platforms for trading and lending cryptocurrencies before the risk to the global financial system spirals out of control.

The IMF made that call in its latest Global Financial Stability Report, released this week. The document outlines a litany of risks to the global financial system, including “shockwaves from the war in Ukraine” and a dangerous mixture inflation, debt and monetary policies.

Crypto also has a place on the wall of worries. “More widespread use of crypto assets in emerging markets could undermine domestic policy objectives,” IMF financial adviser Tobias Adrian said in the report’s summary.

Crypto ecosystems can allow individuals or entities to circumvent sanctions, according to the report. And bitcoin mining could help countries evade sanctions, allowing them to “monetize energy resources.” Russia and Iran could grab 15% of global mining revenues, which reached $1.4 billion last year, according to the report.

The Treasury Department this week put a Russian miner, Bitriver, on its list of sanctioned entities. “Russia has a comparative advantage in crypto mining due to energy resources and a cold climate,” Treasury said in a press release.

More broadly, the IMF sees growing risks to the stability of decentralized finance. DeFi platforms consist of “smart contracts” which are essentially software code defining the terms of a transaction. They are fully automated and do not depend on centralized entities for market making, liquidity, settlement or custody services.

Typically, users borrow a stablecoin – a token designed to hold a fixed value – and provide volatile crypto like


ether

or


Bitcoin

as collateral for the loan. Stablecoins are then used for trading, often as collateral for a long or short bet on another crypto. Lenders are compensated by a return on the tokens they provide to a “pool of liquidity”, with rates set by supply and demand in the market.

The systems aim to build in protections for lenders through collateral requirements and automatic liquidations resulting from a lack of collateral or when a loan-to-value ratio falls below a predefined threshold.

DeFi has exploded with more than $215 billion in ‘locked value’ on platforms, up from less than $1 billion two years ago, according to the site. DeFi Llama. This very success is why DeFi has become another risk to the stability of the financial system, the IMF warns.

“DeFi often involves the accumulation of leverage and is particularly vulnerable to market, liquidity, and cyber risk,” the IMF says.

DeFi is also making its way into the institutional world as platforms develop ways to attract large investors, creating more connections and mechanisms that may affect traditional finance. And DeFi could “accelerate the current crypto trend” in some economies,” the IMF warns, potentially displacing traditional currencies and undermining state monetary policies.

The solution, according to the IMF, is to crack down on the enablers of DeFi: centralized exchanges, wallet providers, and stablecoin issuers. Authorities could also review and audit the software governing smart contracts; require disclosures from DeFi platforms; and establish better industry governance, possibly through a self-regulatory body. Another option would be to restrict exposure to DeFi platforms by regulated entities such as crypto exchanges, in an effort to “slow the pace of growth”, he said.

Some of these proposals have already been launched in Washington. The Biden administration has ordered federal agencies to come up with crypto regulatory frameworks by the fall. The European Union is developing rules to combat illicit transfers on crypto networks and recently adopted a broad draft regulatory framework covering the industry.

DeFi has been dubbed the “Wild West” by US regulators. The IMF didn’t portray it that way, but it’s one of many financial watchdogs now calling on sheriffs to step up.

Write to Daren Fonda at [email protected]

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