Cryptocurrencies and Decentralised Finance

Introduction

Blockchains have been hailed as a pivotal innovation in securing digital data. While the concept has existed for decades, the first public blockchain was created by Satoshi Nakamoto in 2008. Bitcoin went live two months later on 3 January 2009, with the minting of the first block of its blockchain, known as the genesis block.

Since then, cryptoassets have experienced multiple boom and bust cycles. Some early adopters amassed significant wealth, while many retail investors faced substantial losses. Although cryptoassets may not have achieved the level of success Satoshi Nakamoto envisioned, they have made considerable progress since their inception.

A particularly important innovation was the creation of the Ethereum blockchain in 2015, which enabled developers to deploy decentralised software applications. These applications allow users to access services – such as trading, lending and borrowing – without intermediaries. Together, these services have become known as decentralised finance (DeFi).

Crypto Innovations and Their Financial Functions

Blockchains aim to reduce reliance on centralised authorities by validating transactions through a combination of cryptography and economic incentives. Essentially, a blockchain is an append-only database that maintains a growing list of ordered records (blocks) and relies on a subset of network participants, such as miners or validators, to maintain the integrity of the records.

As implied by its name, the original goal of bitcoin and other cryptocurrencies was to provide payment services. However, this objective has largely not been achieved. Where cryptocurrencies have proven to be successful is in encouraging speculation. Over the past decade, cryptocurrency prices have been extremely volatile, but have generally trended upwards for the most successful assets.

The main innovation of Ethereum was its ability to allow developers to build software applications that could interact with its blockchain. These "smart contracts" allowed developers to add functionality beyond simple peer-to-peer transfers, enabling users to transfer funds contingent on pre-specified conditions, with the outcome of the transaction being automatically executed by the contract.

What DeFi Attempts to Do and What It Does

DeFi can be thought of as comprising multiple layers: blockchains, smart contracts, protocols and DeFi applications (Dapps). DeFi protocols are essentially combinations of smart contracts designed for specific use cases, including decentralised exchanges (DEXs), lending platforms or on-chain asset management.

Dapps provide graphical interfaces that allow users to easily interact with the underlying DeFi protocols, rather than dealing directly with the smart contracts themselves. Despite DeFi's aim to remain fully decentralised, Dapps function as de facto centralisation vectors, enabling the development of intermediaries within the DeFi ecosystem.

DeFi protocols fall into categories that largely mimic services provided by intermediaries in the traditional financial sector, based on Merton's (1995) classification of six key economic functions of financial systems:

• Clearing and settlement for payments - Blockchains, stablecoins
• Pooling funds for large-scale enterprises - Asset management protocols, crypto tokens
• Transfer of resources through time and space - Lending protocols, asset management protocols
• Management of uncertainty and risk control - DeFi insurance, derivatives, hedging strategies
• Price information for decentralized decision-making - DEXs, crypto derivatives
• Addressing incentive problems - Smart contracts, over-collateralisation

Stablecoins

Stablecoins are crypto tokens that, unlike traditional cryptocurrencies, aim to maintain a value of one dollar, providing par convertibility on demand. Due to this feature, stablecoins are considered safer than unbacked cryptocurrencies and are presented by proponents as the key medium of exchange in the crypto ecosystem.

There are three types of stablecoins:

• Fiat-backed stablecoins (e.g., Tether, USD Coin) hold fiat-denominated short-term assets to stabilize token value
• Crypto-backed stablecoins (e.g., Dai) offer par convertibility by holding crypto collateral
• Algorithmically backed stablecoins (e.g., TerraUSD) maintain value through algorithms that mint or burn tokens

Beyond serving as a medium of exchange, stablecoins are promoted as a way to facilitate cross-border payments. However, in practice, stablecoins typically play the role of gateways to access DeFi/crypto ecosystems. The widely touted role of stablecoins as a safe haven during market turbulence is far from certain, at least for now.

New Forms of Central Bank Money

Beyond stablecoins, but potentially with some similar functions, are new forms of central bank money, such as central bank digital currencies (CBDCs). CBDCs are defined as digital payment instruments that are denominated in the national unit of account and are a direct liability of the central bank.

There are two types of CBDCs:

• Wholesale CBDCs used exclusively for transactions between financial institutions
• Retail CBDCs available to the general public, ie households and businesses

At the time of writing, there are three live retail CBDCs in the world – in The Bahamas, Nigeria and Jamaica. At least 25 jurisdictions have reached a pilot stage for retail CBDC and nearly as many have conducted wholesale CBDC pilots.

Retail CBDC projects are characterized by different design features, including architecture (direct, hybrid, intermediated), infrastructure (centralized database vs DLT), access (account-based vs token-based), and cross-border functionality.

The Rationale for Prudential Regulation of Crypto and DeFi

The textbook rationale for the economic regulation of markets in general and financial markets in particular is the presence of market failures. The same rationale can be applied to the innovative ways of intermediating markets that characterise DeFi.

Externalities: In financial markets, negative externalities can be severe, with the potential for cascade of defaults where one party defaulting causes losses to counterparties that are then unable to meet their obligations. In DeFi, the presence of smart contracts and atomic settlement makes some of these externalities less likely, but there are systemic players (e.g., stablecoins and their issuers) which give rise to similar issues.

Information Problems: Market participants may not have relevant information necessary to make rational decisions. Many of these issues are clearly present in crypto and DeFi. For instance, a smart contract will behave in different ways as the underlying economic situation evolves, and consumers may have a hard time predicting how the behavior will change.

In the presence of information asymmetry, markets lead to suboptimal outcomes. Given the novelty of crypto and DeFi, it is complex for consumers to differentiate across products on the basis of their quality. Low-quality products can therefore remain in the market for very long periods, and outright scams can persist.

A Conceptual Framework for Financial Stability Implications

The rationale for the regulation of TradFi applies to DeFi. However, there is an active debate on how to tackle the challenges brought about by crypto. Aquilina, Frost and Schrimpf (2024b) summarise the ongoing debate by highlighting three high-level strategies: "ban", "contain" and "regulate".

This report focuses on the "contain" and "regulate" strategies, as a ban would not be desirable (due to useful innovations in crypto and DeFi) nor feasible (given its global nature).

Links with TradFi and the Real Economy: The links between crypto and DeFi on one side and TradFi and the real economy on the other are currently still very limited but have grown in recent years. A clear example is the approval by the US SEC of exchange-traded funds (ETFs) with underlying assets of bitcoin or ether.

The Risk of Cryptoisation: In EMDEs there is a further rationale for regulation: the risk that cryptocurrencies could displace the local currency in real and financial transactions. This is similar to the existing phenomena of dollarisation and euroisation. In practice, several EMDEs already have higher crypto adoption than advanced economies.

Safeguarding Market Participants: As the number of investors and the amount of money they invest reached a critical mass, investor protection elements have become a significant concern for regulators. A potential approach is to base new rules on two main pillars: rules requiring information not easily available on-chain, and regulation embedded in smart contracts.

Conclusions

This chapter has analysed the economic functions of cryptocurrencies and DeFi, comparing them with TradFi. It showed that the underlying economic drivers are not different in DeFi than in TradFi, but that the distinctive features of DeFi – such as smart contracts and composability – introduce new challenges and the need for proactive regulatory interventions to safeguard financial stability, while fostering innovation.

As the DeFi ecosystem continues to evolve, several areas warrant deeper exploration:

• The interaction between DeFi and TradFi needs more attention
• The role of stablecoins in supporting DeFi's growth and the risks posed by their instability require further analysis
• The regulatory implications of fully decentralised protocols and DAOs is an open area of research
• The potential macroeconomic implications of cryptoisation in EMDEs must be fully understood

These areas of research are key to shaping a safe and inclusive financial landscape.