DeFi business is built on smart contracts
Decentralized finance (DeFi) aims to decentralize many of the financial activities we typically associate with the financial system. In the traditional financial system, much of the activity is built around intermediaries and central hubs in the form of various technical systems. For example, banks are financial intermediaries in that they take deposits and then lend money to other customers.
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In DeFi, the idea is instead that there should be no intermediaries or central entities. Instead, services provided through decentralized apps called dApps are built on top of a blockchain, primarily the Ethereum blockchain. To perform various activities on the blockchain, programmable, self-executing contracts – known as smart contracts – are written that describe what should happen, such as what transactions should be performed, and the conditions under which this should happen. The contracts cannot be changed afterward once they are placed on the blockchain. Stablecoins and other crypto-assets are used in DeFi to make transactions. A common activity in DeFi is the provision of credit using various crypto-assets as collateral.
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The DeFi market has grown rapidly in 2021 and 2022. In total, just under USD 110 billion worth of crypto assets were being used in DeFi in mid-May 2022. However, this is a decrease since early December 2021, when about USD 250 billion worth of crypto assets were being used in DeFi.
DeFi is currently unregulated while growing rapidly. Because stablecoins and other crypto assets are used within DeFi, the same risks exist with the various DeFi activities as with crypto assets in general. There is a very low level of transparency and minimal consumer and investor protection. If DeFi continues to grow at the same pace, the interconnectedness with the rest of the financial system may increase, including the link between stablecoins and the traditional financial system. As a result, the risks within DeFi could spread there. It is therefore relevant for authorities to monitor the development of DeFi.
Financial system is changing to the decentralized version
Fintech, including crypto-assets, has been associated with high growth in recent years and there is now a greater awareness of crypto-assets in society. The use of new technologies for various financial services can increase the efficiency of the financial system, as development and innovation can lead to new services that are cheaper, easier, and faster for individuals to use, for example. However, this also poses some challenges for governments and others.
This is particularly true for crypto-assets, which are largely unregulated in many parts of the world, and it is difficult to monitor how the risks associated with them evolve. This is due to the low availability of data on them. Crypto assets are also associated with low, or non-existent, consumer and investor protection, making it risky for individuals to invest in them.
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There is no precise figure on how many European households are exposed to crypto-assets. However, from a global perspective, exposure to crypto assets among Europeans is likely to be relatively low. Even European banks and institutional investors seem to have limited exposure to them at present. Therefore, the risk of disruptions in the crypto-asset market affecting the European market and the traditional financial system is likely to be low so far.
In addition, various international assessors, such as the International Monetary Fund and the FSB, have stated that crypto-assets do not pose a systemic risk at present. However, they may affect financial stability in the future if the risks associated with them are not addressed. In line with this, many central banks, authorities, and international standard-setting bodies are therefore continuing to focus on monitoring the development of the crypto-asset market and taking action where possible and necessary, for example by issuing standards related to crypto-assets. In parallel, regulatory work is underway in many jurisdictions, including to reduce the risks associated with crypto-assets and enhance consumer and investor protection.
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