Decentralized finance offers a mix of risks and benefits as it forms interconnections with traditional finance, the International Monetary Fund finds in a new report.
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According to the International Monetary Fund’s Global Financial Stability report released Tuesday, the war in Ukraine — following hard on the heels of the coronavirus pandemic — has led to a tightening of global financial conditions. Rapid changes in fintech and the uses and misuses of cryptocurrency play into the jumble of challenges facing the global economy.
According to the report, the pandemic and war have led to an accelerated “cryptoization” in emerging markets due to increased speculative interest during the pandemic and then attempts to evade sanctions. Given compliance within the crypto industry, the use of cryptocurrency to evade sanctions is impractical, the report found. The use of mixers, decentralized exchanges and privacy coins may allow some circumvention, but it would be restricted by limited liquidity.
A related risk is the use by sanctioned countries of excess energy — possibly built up because of sanctions — to mine proof-of-work cryptocurrencies, although financial flows from that activity would also be relatively contained. Countries concerned about coming under sanctions in the future may come to find crypto more attractive as reserve currency — and major fiat currencies less so — thanks to the greater difficulty in immobilizing crypto.
All of those issues point to the need for a coordinated regulatory approach to crypto for maintaining effective control of capital flows. Improving non-blockchain payment technologies would also help maintain that control.
The report also said regulation is not keeping up with the rapid developments in many aspects of fintech. Decentralized finance, or DeFi, is becoming steadily more interconnected with traditional finance due to its adoption by traditional financial institutions. DeFi’s lack of governance makes it a risk to financial stability and creates an environment of legal uncertainty. It is vulnerable to market, liquidity and cyber risks, but it potentially offers benefits from higher efficiency and financial inclusion.
The IMF recommended regulators concentrate on the elements of the crypto ecosystem surrounding DeFi, such as stablecoin issuers and centralized exchanges, and encourage the creation of self-regulating bodies within the industry.