New research from the U.S. Federal Reserve offers two scenarios that could lead to the widespread adoption of crypto and decentalized finance (DeFi).
In a new report, the Fed says there are two paths forward – one where blockchain finance intertwines with traditional finance, and one where they are separate but parallel.
“Broadly speaking, there are two conceptual scenarios (not necessarily mutually exclusive) that could lead to a breakthrough in which blockchain finance may become an important provider of the services currently provided by off-chain financial markets and institutions.
In one scenario, these blockchain services gain greater interoperability with the existing payments and financial system (for example, evolving to link real assets to public blockchains).
A second scenario may see crypto assets evolving to become a separate, parallel financial system that provides services for the real economy.”
According to the Fed study, financial stability risks loom in either scenario as both the decentralized finance and centralized finance (CeFi) subsectors are largely unregulated.
“In either scenario, both CeFi and DeFi may pose financial stability risks that are exacerbated by the fact that both are currently largely outside the prudential regulatory perimeter.
Remedying many of these potential weaknesses is conceptually relatively easy for a large class of CeFi providers but could prove more challenging for DeFi providers.
The existence of a centralized intermediary in the case of CeFi provides an entity that is potentially subject to regulation and with which the supervisors may be able to discuss their concerns.
However, DeFi products and services may not be so easily brought into the current supervisory and regulatory perimeter.”
The Fed also looks at the wild price swings in crypto and suggests two ways to improve the stability of the digital asset markets.
“An additional way to reduce the volatility of cryptocurrency prices might be for various aspects of DeFi to be more closely integrated to the existing financial system.
This approach could take the form of the [2021] proposal that stablecoins should only be issued by insured depositories backed by deposit insurance and central bank liquidity facilities (such as the Federal Reserve’s discount window).
Finally, the creation of a central bank digital currency (CBDC) that becomes available on public, permissionless blockchains such as Ethereum may also serve to reduce volatility.”
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