The Financial Stability Board (the FSB) recently released its first report on Decentralized Finance (DeFi). The report identifies certain vulnerabilities within DeFi and reveals that the FSB intends to create a global surveillance system to monitor DeFi activity and applications. This article provides a concise summary of the DeFi report and describes potential implications for DeFi users.

The FSB is an international organization committed to promoting global financial stability. The FSB works with governments and financial institutions to identify and address risks to the global financial system. To be clear, the FSB has no legal authority and although the FSB drafts regulatory standards and recommendations, they are not legally binding. Rather, the FSB relies on countries to implement its policies to ensure financial stability.

Yet, since the FSB members are regulators, bankers and finance ministers from G20 countries, it’s all but certain that at least some FSB standards and recommendations will be adopted and implemented by governments. Other FSB members include representatives from the World Bank and the International Monetary Fund, so the FSB consists of the top players in global finance. Hence FSB recommendations are often strong indicators of what financial regulations G20 countries implement in the future.

And for American readers, this DeFi report may shed light on what the USA has in store for both DeFi and Crypto, because one FSB member is none other than SEC Chairman Gary Gensler. Another notable American FSB member is Lael Brainard, who was the Vice Chair of the Federal Reserve Board. I say was because she resigned on February 14 from both the Fed and the FSB to join the U.S. National Economic Council where she’ll advise President Biden on economic policy. But Brainard was the chair of the FSB’s committee on the assessment of vulnerabilities and led the research and preparation of the DeFi report. So, it’s not speculation to assume that this report reflects both Gensler and Brainard’s views on DeFi and foreshadows how the U.S. will regulate and monitor DeFi and Crypto in the near future.

Naturally, after FTX, Celsius and Terra the FSB is increasingly concerned with DeFi affecting both Traditional Finance (TradFi) and the global economy. Hence, the report identifies five vulnerabilities that the FSB believes can lead to failures within DeFi, not to mention introducing a rough sketch on how the FSB intends to monitor and track DeFi in the future. Also, the report finishes with an interesting comment about real world asset tokenization and its implications for both DeFi and TradFi.

The FSB identified the following five DeFi vulnerabilities ranked by importance:

• Liquidity

• Leverage

• Interconnectedness, concentration and complexity

• Operational fragilities

• Other vulnerabilities

The first and most pressing vulnerability according to the FSB are liquidity and maturity mismatches, which occur when liabilities (what is owed) and assets (what is owned) have different liquidity and maturity profiles, leading to possible redemption runs. Another issue occurs when DeFi lenders offer higher yields to incentivize customer deposits with lenders investing those deposits in assets that are illiquid or not easily tradeable. When more customers deposit than withdraw, the lender profits; but if market conditions change and more customers make more withdrawals than deposits, the lender may not have enough money from those investments to pay customers back, resulting in lender failures that not only affect DeFi but can spill over into TradFi and affect the global economy.

During the tumultuous period from May to June 2022, the combination of leverage and declining prices resulted in margin calls and automatic liquidations, which subsequently drove market prices lower, and intensified investor losses. Leverage concerns the FSB because in times of financial strain, automatic collateral liquidations may occur in a DeFi market with limited liquidity. This decreases collateral prices and may spark a contagion across DeFi that potentially spreads to global financial markets.

DeFi’s composability, or its ability to integrate seamlessly with other protocols like Lego blocks, is one of its greatest strengths. Yet, the interconnectedness between protocols can also lead to a greater risk of financial contagion. The FSB estimates that 75% of DeFi’s Total Value Locked (TVL) is concentrated in the four largest Decentralized Applications or DApps, and that over 60% of DeFi’s TVL is hosted on Ethereum. Therefore, disruptions to either one of these four largest DApps or Ethereum could have unforeseen implications for the DeFi market, with the failure of one protocol causing a chain reaction that triggers the collapse of other protocols within the system.

The report also identifies certain technical vulnerabilities that could lead to widespread losses or liquidations such as oracle failures, smart contract code errors, bridge hacks or failures and blockchain disruptions. While the DeFi space is making progress addressing these issues, high-profile occurrences have the potential to erode investor and user confidence in DeFi and its DApps.

Lastly, the FSB considers insider trading and the dissemination of false or inaccurate information as potential threats to DeFi market integrity and investor confidence. Also, bad actors who exploit the lack of uniform regulations to perpetrate scams or engage in illicit activity without facing repercussions may also lead to a decrease in investor confidence.

The bad news for DeFi is that the FSB wants to create an extensive surveillance system to monitor DeFi’s vulnerabilities and track its growth. Although the FSB admits that they currently don’t know how to collect DeFi data, they are moving to develop standards and methods for obtaining and analyzing on-chain information.

Although surveillance standards aren’t ready yet, the report indicates what the FSB has in mind. The FSB envisions that regulators or authorities will perform both frequent and occasional monitoring, with frequent data checks to ensure DeFi market conditions remain stable and occasional monitoring to detect structural changes and potential risks associated with DeFi protocols.

In terms of what information will be tracked, at a macro level the FSB wants to monitor DeFi transactions and know the identities of DApp owners and users. Yet, at the micro level the FSB intends to track areas within the five vulnerabilities discussed above. Although nothing is official, the FSB gives the following examples of what they’ll be looking at:

• Analyze indicators of collateralization such as the amount of assets that are re-hypothecated and the degree to which cash is directed into DApps, in order to evaluate the amount of debt in DeFi and crypto-asset markets.

• Monitor and examine the interconnectedness and concentration of blockchains, protocols, oracles, bridges and stablecoins to determine how linked different DeFi elements are and discover which components are used more often than others.

• Tracking and gathering data on oracles or cross-bridges to keep track of the services that depend on them.

• Collecting information on the concentration of governance token ownership to understand the power that developers in a protocol have; also, tracking; information on DAO proposal voting percentages and token holders to identify who has veto power.

• Tracking stablecoin originators, applications and investments

Lastly, FSB’s surveillance system intends to track DeFi’s growth using the following four metrics:

• DeFi’s Total Value Locked (TVL) measured in US Dollars

• The number of active DeFi applications (DApps)

• Stablecoin market capitalization

• The number of DApp users or daily active wallet addresses.

Additionally, the report contains three potential future scenarios for DeFi; one having DeFi incorporated (or swallowed) by TradFi and ceasing to exist; and another has DeFi remaining a small niche space existing only for a small user group. But the FSB’s final and most likely scenario is real world asset (RWA) tokenization propelling DeFi’s growth and leading to an increased collaboration with Tradfi.

Tradfi is already embracing RWA tokenization with Goldman Sachs tokenizing bonds and multiple major banks around the world also beginning to tokenize bonds and credit notes. And it’s safe to assume that TradFi and banks will soon move on from bonds and credit notes and begin tokenizing real estate, stocks and mutual funds.

But the more TradFi embraces RWA tokenization the more exposed it is to crypto. And it’s only a matter of time before tokenized assets find their way on both centralized and decentralized exchanges, leading to scenarios where TradFi asset tokens are owned by DeFi protocols to provide liquidity and even used as collateral for DeFi lending. Naturally, the more that RWA tokens travel between TradFi and DeFi the stronger the links are between the two markets, leading to a greater concentration risk for the entire financial system, as one system component failure may trigger a contagion that causes failure across both markets.

But the FSB’s emphasis on RWA tokenization in the DeFi report indicates that the FSB anticipates RWA tokenization to be a major digital asset class in the future. And one should expect more RWA tokenization offerings and projects from TradFi over the rest of 2023, along with increased regulatory scrutiny.

To conclude, the DeFi report shows that the FSB and its members are moving to develop a surveillance system to collect and share DeFi data with governments and financial authorities around the world, making it all but certain that the FSB will develop DeFi surveillance standards and regulatory guidelines for governments to implement in the near future.