OFR Researcher Says DeFi Could Threaten Financial Stability
Commentary by Steven Lofchie
A researcher from the Office of Financial Research ("OFR") analyzed the potential threats that decentralized finance ("DeFi") poses to financial stability if its growth continues without the guardrails of traditional finance.
Effects of Digital Asset Price Declines on Traditional Financial Institutions
In the OFR Risk Spotlight, the researcher opined that if traditional financial market participants accumulate significant exposure to digital assets, future price declines or disruptions in the digital asset market could have spillover effects in traditional financial markets and the real economy. He said the majority of the world's largest banks have invested in companies operating in the digital asset or blockchain space, but the coinciding regulatory data on their exposures to crypto assets are "scarce," which made it difficult to monitor the interconnectedness of crypto assets and traditional financial markets.
Rapid Withdrawals from Digital Assets
The OFR researcher said that DeFi could create financial stability risks if it is directly integrated with the real economy. He explained that if stablecoins continue to grow, rapid withdrawals from stablecoins backed by commercial paper could potentially disrupt commercial paper markets and create losses for traditional financial institutions. According to his analysis, losses could increase further if traditional borrowers have obtained funding through stablecoins or crypto asset lenders.
Disruptions from Digital Assets as Payment
Citing OFR's 2022 "Annual Report to Congress" (see related coverage), the researcher found that digital assets and DeFi remain small parts of the financial system and have limited linkages to other financial markets and the real economy. However, the OFR researcher cautioned that digital assets could pose a threat to financial stability if they are widely adopted as a means of payment. He said that, under the right conditions, a shift from low to high risk from DeFi could happen very quickly. Given past periods of rapid growth, he called for close monitoring of developments in the DeFi market to identify emerging risks.
Commentary
Apparently, the researcher is saying that digital assets do not pose a risk to traditional financial markets, but if things were totally different, maybe they would. That is hard to dispute. That said, it is hard to give credence to the worry that any investment by banks in the "digital-asset space" poses a risk to the bank system, given that U.S. banks cannot buy digital assets for investment or speculative purposes. Further, the U.S. government already monitors bank involvement in digital assets and will certainly continue to do so. Likewise, it is odd the article refers to commercial paper that "purportedly" backs some stablecoins. Presumably, these are stablecoins not broadly traded in the United States as the issuer would likely be regarded as an "investment company," and one would think OFR would be able to sufficiently research to confirm or deny this rumor, rather than fall back on the use of the word "purportedly."
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In its 2022 Annual Report to Congress, the Office of Financial Research warned that threats to U.S. financial stability are elevated compared to previous years because of rising inflation, tight credit conditions and geopolitical uncertainty.
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In a 2019 Annual Report to Congress, the Treasury Department's Office of Financial Research concluded that risk remains moderate to U.S. financial stability.