A staff analytical note published by the Bank of Canada explores the development of decentralized finance (DeFi) and potential pathways for broader market regulations.

The note, released on Oct 17, discusses the stages of development in the cryptocurrency market, its advantages, the challenges faced by traditional finance, risks, potential impacts on financial markets, and regulatory measures.

According to the report, crypto assets originally served as a blockchain-based payment system before expanding into new areas of financial services.

To achieve decentralization, smart contracts are employed to eliminate the need for intermediaries in multiple transactions. This innovation led to a market cap of $2.9 trillion before major platform collapses and regulatory obstacles caused a decline in prices.

A new niche has emerged within the asset class, including non-fungible tokens, decentralized stablecoins, and leading services, accompanied by new risks in the current market.

Benefits highlighted by the Bank of Canada

One advantage of the ecosystem, as emphasized by the bank, is the composability of smart contracts, allowing for easier creation of services by more companies. This is made possible by the open-source nature of their code, enabling collaboration and building on top of other networks.

The bank also identifies increased service offerings, competition, and transparency as factors that make the ecosystem more attractive compared to traditional financial products.

In its pursuit to dismantle financial monopolies, cross-border payments in most services facilitate transactions between countries, while interoperability provides users with seamless experiences across multiple platforms.

DeFi can also reduce friction in financial markets by offering new utilities through various chains, thereby increasing transparency by leveraging blockchain technology and eliminating corrupt traditional intermediaries, empowering customers.

Market risks and regulations

Despite the numerous benefits of decentralized finance, it presents several risks to global financial markets, including limited tokenization, high concentration, and unregulated centralized entities.

“Only tokenized assets can be recorded on the blockchain and interact with smart contracts. However, few real-world assets have been tokenized thus far, resulting in a self-referential system mainly focused on speculative crypto trades. The contribution to the real-world economy remains minimal.”

Regarding the presence of centralized systems in the space, certain players, although claiming to be decentralized, remain heavily centralized, posing risks to stakeholders if not properly regulated.

This is primarily due to the complexities associated with managing private keys and other services, which has led to the popularity of centralized exchanges. The collapse of FTX in November serves as a typical example of unregulated centralized players introducing risks to the sector.

The bank suggests implementing adequate regulations across all channels to prevent the activities of bad actors in the industry, including their interactions with traditional finance.

Recently, the association of Canada’s securities regulators clarified its approach to stablecoin regulation, outlining the processes for issuance and trading without falling under securities regulations.


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