The Bank for International Settlements (BIS) released a new working paper titled “The Technology of Decentralized Finance,” discussing DeFi as the new financial paradigm this week. It discusses the emergence of DeFi, which has seen rapid growth in recent years, and how it can interoperate with traditional finance.
Headquartered in Basel, Switzerland, BIS is an international financial institution that provides central banking services to its member banks and promotes global monetary and financial stability. It also acts as a clearinghouse for international payments.
According to the report, DeFi integrates technical, financial, and socio-economic complexity in an unprecedented way. It also states that this development could be neglected while DeFi was still a niche phenomenon without ties to the fiat system.
However, with the increasing integration of crypto assets with the traditional financial sector, BIS says novel methods are required to identify, investigate, and ultimately understand the risks associated with these developments. The scientific method embedded in a multi-disciplinary setting offers the most promising answer to this challenge, it says.
The BIS has been highly cautious when it comes to cryptocurrency and regularly takes part in research on central bank digital currencies (CBDCs). Recently, it imposed a 2% ceiling on crypto assets in reserves of internationally active banks, effective Jan. 1, 2025, in the face of growing interest in digital assets among banks.
Just last month, BIS published two papers in which it said while DeFi could reduce the cost of financial transactions, it doesn’t fully fix the problems of centralized intermediaries overcharging for services and can also circumvent checks.
According to the paper, the economic forces that allow intermediaries to hold market power in TradFi might still exist in the DeFi world. “The current design of DeFi applications generates formidable challenges for tax enforcement, aggravates money laundering issues and other kinds of financial malfeasance,” it read.
The paper called for proper standards to protect consumers and maintain the transparency, accountability, and stability of the system but said other jurisdictions need to cooperate in order to stop businesses from moving to the most favorable country.
Thursday’s working paper meanwhile appeared the same week as the World Economic Forum (WEF) released an overview of decentralized autonomous organizations (DAOs).
Understanding DeFi to shape the future financial ecosystem
The report, which came from the Monetary and Economic Department of BIS, identifies a range of key opportunities and challenges associated with DeFi that need to be addressed. While examining this, it highlights that DeFi could offer systemically important payment systems, promote financial stability, and include commercial banks and other financial service providers.
In addition, it could reduce credit liquidity risk, settle interbank payments more quickly and at lower cost, and improve investor protection through improved transparency. However, DeFi also faces several challenges addressed in the report, such as regulatory uncertainty and lack of adequate consumer protection regulations. The BIS report notes that DeFi may require potential intermediaries to facilitate transactions which must be carefully considered to ensure consumer protection and prevent illicit activities.
The report from BIS takes a deep dive into the overall architecture of DeFi and outlines the technical primitives or “building blocks” for DeFi systems and financial functions of the most prominent DeFi protocol families, and discusses DeFi’s risks and challenges for the traditional regulation of financial services.
“A deep understanding of DeFi is still lacking in many circles,” the authors wrote, “which calls for a specific framework for an improved working knowledge of the technology.”
DeFi’s innovation makes all the efforts worthwhile because while “it is still unclear if and to what extent DeFi will proliferate in the future,” the paper argued, “we consider DeFi a relevant development because it harnesses innovative technology that might shape the future financial ecosystem.”
The BIS report then examines how assets backing stablecoins can be managed effectively, removing intermediaries and reducing costs. As such, it emphasizes the potential for DeFi to improve settlements within the traditional financial system while managing risks appropriately.
According to the BIS, if risks from DeFi catering for crypto assets are not well managed, stablecoins are prone to runs, and possible fire sales of the assets backing stablecoins could generate funding shocks for companies and banks, feeding through to the broader financial system.
For this, the paper used a variety of tokens, blockchains, and financial services in its examples, with a particular focus on Terra/Luna for its informational value and to assess the effect of stablecoin run.
“Protocols with higher exposure to these stablecoins are also those that would be more affected by potential shocks hitting the DeFi ecosystem as a consequence of stablecoin runs,” it noted.
Introducing DeFi Stack Reference (DSR) Model
In its paper, BIS introduces the DeFi stack reference (DSR) model to conceptualize how layers and components of such systems can be designed and interconnected to facilitate the transfer of value. Through the lens of the DSR model, BIS talks about the technical aspects of three layers: settlement, applications, and interfaces.
Talking about the Settlement Layer, the author notes that this one is responsible for completing financial transactions and discharging the obligations of all involved parties. This process involves resolving potential conflicts and coming to a consensus on the current state of a system. In DeFi, this functionality is typically provided by a DLT, with the likes of Ethereum or Solana also offering an execution environment for smart contracts, which are the core components of all DeFi protocols.
These DLT platforms have native tokens like ETH representing and transferring value. These native tokens called crypto assets, lie at the intersection of the settlement and the DLT application layer, it states.
As for the Application Layer, the paper states it comprises applications implemented through smart contracts, which are further divided into crypto assets, DeFi protocol, and DeFi Compositions.
Crypto assets are defined as DLT applications that facilitate the transfer of value across the DeFi ecosystem. They are created by implementing specific “token contracts,” which can either be fungible by maintaining a registry of account addresses and balances or be non-fungible by recording token ownership.
A DeFi Protocol, meanwhile, is defined as a DLT application implemented by a set of smart contracts, utilizing crypto assets and providing some financial service functionality. The functionality is realized through financial functions such as the supply of collateral. Decentralized exchanges (DEXs), lending protocols, and derivatives protocols were identified as the main categories that describe well most of the existing relevant DeFi protocols.
DeFi Compositions are defined as a specific type of DeFi protocol that allows for implementing new financial services using the services of other DeFi protocols, such as DEX Aggregators and Yield Aggregators.
At last, the Interface Layer, which is not covered by the paper in detail, is DLT applications implemented as smart contracts and provide programmatic interfaces to developers. They do not offer any interactive graphical tool to the end-users.
These DeFi applications provide front-end interfaces to facilitate the interaction with the smart contract logic, typically achieved via non-blockchain applications, such as Web or mobile device apps. This layer acts mainly as a framework to provide input parameters to the DLT application layer.
“Each of these DeFi stack layers is associated with real-world entities in a broader ecosystem,” states the paper.
The author further notes that validators are economically incentivized to process transactions and execute programs on the lowest layer. And end-users can participate in the governance of a protocol as a stakeholder or interact with a DeFi application via user interfaces.
Areas of Interest Besides Crypto Markets
The paper discusses the integration of DLT with existing financial infrastructure, as well as new working papers that outline how such systems could function. It further highlights blockchain scalability and large-scale tokenization as important technology components that allow companies, banks, and other traditional financial institutions to participate in DeFi. Tokenization is also seen as a suitable regulatory framework for generating funding shocks in the broader financial system.
The report outlines how new financial paradigms could escape some of the existing financial regulations and how indices, algorithmic stablecoins, coins backed by fixed-income assets, and other innovations can support DeFi.
It then examines how DeFi can provide access to a wide range of financial services by utilizing primitives like smart contracts and distributed ledgers to enable financial functions that are not possible with traditional finance, such as creating new markets, decentralized lending and investing, tokenized assets, derivatives trading, providing liquidity, and automated market-making.
In their paper, the authors further said that algorithmic automation, transparency, and competitive financial engineering are topics of interest that go well beyond just crypto markets. Competitive engineering, in particular, was regarded as composability, combining smart contracts to create complex and original financial products.
The paper states that recent episodes of market turmoil have also led to a discussion on whether and how the DeFi industry should be regulated. It notes that the rise of DeFi has been accompanied by many incidents with an accumulated total loss exceeding $3 billion, highlighting the risks of technical vulnerabilities and their amplification caused by the intertwined nature of DeFi protocols.
It then explores the regulatory challenges associated with DeFi, such as the decentralization opaqueness of certain protocols, the risks posed by distributed leverages, and the need to disentangle actual regulatory gaps between DeFi and current financial legislation.
While examining how DeFi could be regulated in order to achieve regulatory objectives while still facilitating innovation, it looks at the potential of regulatory technology (RegTech), such as smart contracts, to connect DeFi with existing financial services value chain infrastructure.
This can enable embedded regulatory requirements while also helping control risk through embedding systems to monitor activity. The report also outlines policy considerations that need to be addressed to ensure context-specific outcomes and a reconcentrated portion of risks associated with DeFi use cases.
It looks at how technological evolutions have moved DeFi from its underlying utopian ideal to a more pragmatic practical evolution as well as how cryptocurrencies, financial technology (fintech), and regulatory technology (regtech) are allowing the technology to be used in global finance, traditional finance, and financial centers.
The insights also cover advances in fintech, regtech, and cryptocurrencies and provide a more streamlined approach to regulatory compliance, risk management, and capital formation.
Ultimately, this report provides a comprehensive overview of the technology behind decentralized finance (DeFi) and its potential impact on the future of finance.
The paper, in the end, calls for future research to focus on understanding systemic risk more profoundly, including token flows and protocol dependencies within the crypto-ecosystem, as well as considering the potential spillovers from and to the traditional financial system. In particular, future research should focus on whether and how to further integrate DeFi in Fintech and the traditional financial ecosystem.