OFR blog post highlights 3 ways ‘DeFi’ growth could threaten financial stability

The risk to financial stability should decentralized finance (DeFi) continue to grow in size and scope – and without the guardrails that are in place for traditional finance – is discussed in a blog post Tuesday by Treasury’s Office of Financial Research (OFR).

The post, which the office said reflects the views of the authors and not the OFR, summarizes three channels through which threats could emerge in the DeFi market, and ways those threats could negatively affect traditional finance.

Here are excerpts from the post:

  1. Effects from Price Declines of Digital Assets Could Spill Over into Traditional Financial Markets: If traditional financial market participants and institutions accumulate significant exposure to digital assets, then future price declines in or disruptions of the digital-assets market could have spillover effects in traditional financial markets and the real economy. (The post goes on to note current challenges in monitoring traditional institutions’ exposure.)
  2. Rapid Withdrawals of Digital Assets Could Create Losses for Traditional Financial Institutions: Decentralized finance could create financial-stability risks through its direct integration with the real economy. Currently, most activity in decentralized finance supports trading and speculation in digital assets. However, an important exception involves non-crypto assets, including commercial paper, that purportedly back some stablecoins. Especially if stablecoins continue to grow, rapid withdrawals from stablecoins backed by commercial paper could potentially disrupt commercial-paper markets.
  3. Disruptions Would Have Immediate Consequences If Digital Assets Were Widely Used as Payment: Digital assets could become a threat to financial stability if they were widely adopted as a means of payment. While volatile crypto assets like Bitcoin are unlikely to become a means of payment, stablecoins are expressly designed to serve this purpose for blockchain-based transactions.

“Digital assets and decentralized finance generally remain small parts of the overall financial system, with limited linkages to other financial markets and the real economy. For these reasons, the current risks to financial stability from these new financial arrangements remain modest,” the authors wrote. “However, past periods of rapid growth suggest that, under the right conditions, a shift from low to high risk from DeFi could happen quickly. Therefore, developments in this market should continue to be monitored to identify emerging risks.”

Risk Spotlight: OFR Identifies Three Ways DeFi Growth Could Threaten Financial Stability