IMF warns governments to regulate DeFi or risk a financial crisis

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

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Crypto ecosystems may allow individuals or entities to circumvent sanctions, the report said. And Bitcoin mining could help countries evade sanctions, allowing them to “monetise energy resources.” Russia and Iran may be capturing a combined 15% of global mining revenue, which hit $1.4bn last year, according to the report.

The Treasury Department this week placed 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 news release.

More broadly, the IMF sees growing risks to stability in decentralised finance. DeFi platforms consist of “smart contracts” that are essentially software code setting the conditions for a transaction. They are entirely automated and don’t rely on centralised entities for market making, liquidity, settlement, or custody services.

Typically, users borrow a stablecoin — a token designed to maintain a fixed value — and provide a volatile crypto like ether or Bitcoin as collateral for the loan. The stablecoins are then used for trading, often as collateral for a long or short bet on another crypto. Lenders get compensated with a yield on the tokens they provide to a “liquidity pool,” 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 arising from shortfalls in collateral or when a loan-to-value ratio falls below a preset threshold.

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

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

DeFi is also working its way into the institutional world as platforms develop ways to bring in large investors, creating more links and mechanisms with the potential to affect traditional finance. And DeFi may “accelerate the ongoing trend toward cryptoisation” in some economies,” the IMF warns, potentially displacing traditional currencies and undermining state monetary policies.

The solution, in the IMF’s view, is to crack down on the enablers of DeFi: centralised exchanges, wallet providers, and stablecoin issuers. Authorities could also review and audit the software governing smart contracts; require disclosures from DeFi platforms; and establish more governance of the industry, potentially through a self-regulatory organisation. Another option would be to restrict exposure to DeFi platforms by regulated entities such as crypto exchanges, aiming to “slow the pace of growth,” it said.

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

DeFi has been dubbed the “Wild West” by US regulators. The IMF didn’t describe it that way, but it is one of several financial watchdogs now calling for sheriffs to ride in.

Write to Daren Fonda at daren.fonda@barrons.com

This article was published by Barron’s, part of the Dow Jones