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Bank of Canada Assesses DeFi’s Innovation and Challenges on Financial Markets

The Bank of Canada has published a staff analytical note that explores the evolution of decentralized finance (DeFi) and potential pathways for broader market regulations.

The note, released on October 17, outlines the developmental stages of the cryptocurrency market, highlighting its benefits, challenges to traditional finance, risks, and potential impacts on financial markets, including regulatory considerations.

According to the report, crypto assets initially emerged as a payment system on the blockchain before expanding into various financial services. The report notes the decentralized nature of cryptocurrencies, facilitated by smart contracts that eliminate the need for intermediaries in multiple transactions. This evolution led to a market capitalization of $2.9 trillion before major platform collapses and regulatory challenges triggered a decline in prices.

The report also highlights the emergence of new elements within the crypto space, such as non-fungible tokens (NFTs), decentralized stablecoins, and other leading services. These developments have given rise to a new market niche within the asset class, introducing additional risks in the present market landscape.

Bank of Canada points to benefits

The Bank of Canada’s report underscores one of the advantages of the cryptocurrency ecosystem, particularly decentralized finance (DeFi): the composability of smart contracts. This feature makes it easier for companies to create new services within the ecosystem. The open-source nature of smart contract code enables developers to collaborate and build on top of existing networks, fostering innovation and the rapid development of new financial products and services.

The report also identifies increased service offerings, heightened competition, and enhanced transparency as factors that make the cryptocurrency ecosystem, particularly DeFi, more appealing than traditional financial products. These characteristics contribute to the dynamic and evolving nature of the crypto space, presenting opportunities for a diverse range of financial services to emerge.

Driven by the goal of dismantling financial monopolies, decentralized finance (DeFi) facilitates cross-border payments across various services, enabling transactions between countries. With the growing emphasis on interoperability, users can enjoy seamless experiences without the need to navigate multiple platforms.

DeFi has the potential to alleviate frictions in financial markets, addressing issues related to limited and opaque transactions. Various blockchain chains offer new utilities, providing innovative solutions to longstanding challenges in traditional financial systems.

Moreover, DeFi introduces increased transparency to the financial landscape by leveraging blockchain technology. By eliminating traditional intermediaries that may be susceptible to corruption, DeFi places actual power in the hands of customers, fostering a more transparent and user-centric financial ecosystem.

Market risks and regulations

Despite the myriad benefits associated with decentralized finance (DeFi), it also presents several risks to global financial markets, including limited tokenization, high concentration, and the presence of unregulated centralized entities.

The report notes that only tokenized assets can be recorded on the blockchain and interact with smart contracts. However, the tokenization of real-world assets has been limited, resulting in a system that is predominantly self-referential and focused on speculative crypto trades. This has led to a minimal contribution to the real-world economy.

Another risk highlighted is the potential for certain players within the DeFi sector to remain heavily centralized, despite claims of decentralization. This poses a risk to stakeholders if not properly regulated, as it contradicts the core principles of decentralization that underpin the DeFi movement.

The challenges in managing private keys and other services contribute to the popularity of centralized exchanges, as highlighted in the report. The collapse of FTX in November serves as a notable example of the risks associated with unregulated centralized players in the decentralized finance (DeFi) sector.

The report emphasizes the need for adequate regulations across all channels to mitigate the activities of bad actors in the industry, including how they interact with traditional finance. Regulatory measures are crucial to addressing potential risks and ensuring the integrity and stability of the financial ecosystem.

Furthermore, the report mentions recent efforts by the association of Canada’s securities regulators to clarify regulations related to stablecoins. These clarifications aim to delineate the processes involved in their issuance and trades, avoiding entanglement with securities regulations. This reflects a broader trend of regulatory bodies seeking to provide clearer guidelines in the evolving landscape of decentralized finance.

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What we write about

I want to save money. Will cryptocurrency work?

Cryptocurrency is essentially virtual money that operates in a decentralized manner, not through a bank but directly on multiple independent computers.

Every cryptocurrency has two main components: the units of digital exchange called “coins” and the network within which the exchange takes place. These units can be transferred between wallets and exchanged on exchanges. The networks in which these coins exist are called blockchains, which translates to “chains of blocks.”

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