DeFi’s Centralization Problem Can Be A Reason For Regulation – BIS Review

The latest issue of the Bank for International Settlement (BIS) reveals that lawmakers could use DeFi’s centralization problem as an opportunity to regulate the industry. The issue was released on December 6 through a coalition of central banks that analyzed the rising popularity of non-financial institutions but performs financial transactions and proffered some policy regulations.

Crucial Points Discussed In The Review

The review discussed five crucial points, with the first being a discussion on DeFi and its effects on the stability of the finance sector. Devi’s primary goal is proficiency in financial transactions in which financial transactions are automated through blockchains, and there would be no involvement of any third party in such transactions.

As of Friday last week, DeFi’s market cap is estimated at $163B, indicating a rise of 27% since April this year. The BIS review also proffered suggestions on how the legislature can regulate DeFi’s system even though it is currently a decentralized structure. BIS’ Hyon Song Shin stated in the report that “all transactions of any financial system can’t be automated. Hence, there would be one or two instances that would require the intervention of a centralized body.”

Salient Observations

Hyon further said, “we need to carefully observe and make our intervention when there is a clear need for a centralized guidance as it is something that would eventually be required.” The review also stated that it would be easy for a small group of stakeholders to influence significant decisions because of the concentration of power for most blockchain consensus protocols.

Hence, there can be a government-issued policy because of how the DeFi system is governed. The review argued that DeFi’s governance structure makes it almost impossible to disrupt the traditional financial landscape. But if the reverse were true, it could cause severe disruption for the finance sector. Some of the features identified in the review as causes of a massive disorder include non-third party involvement in financial transactions and interoperability among DeFi apps.

Complete DeFi Decentralization and Having Large Validators

The review stated that implementing a DeFi policy might be a struggle since DeFi is entirely decentralized. But it was quick to point out a solution: the use of DeFi’s governance tokens. Through control over governance tokens, a central authority can influence voting on modifications or proposals in the DeFi community. 

According to the review, “this seeming centralization can be the basis through which the legislature can influence the DeFi platforms.” The BIS review states that concentrating powers among a large group of stakeholders could make the blockchain non-viable. Also, these groups can influence decisions to favor them financially, for example, insider trading.

The review also stated that the current DeFi lending system is over-collateralized. That is, the collateral value is higher than the loan being requested. However, the study noted that “investors can be more exposed through a specific collateral since that collateral can be used to collect multiple loans.” Hence, creating leverage for improved asset purchase through a ‘seed’ fund.