Regulating decentralised digital finance
Inadequate monitoring and supervision of digital assets are major risks to financial stability in a digitalising world – and G20 leaders need to focus on de-risking the system through better coordination
Trading digital financial assets on blockchains has led to the development of decentralised finance (DeFi) intermediaries and exchanges and has attracted enormous resources. The weak monitoring and supervision of DeFi assets and intermediaries favoured their growth and popularity. The benefits of DeFi are mainly associated with financial inclusion, reduced transaction costs and enhanced efficiency, while the costs depend on competition and financial stability. The growth and spread of digital finance over the past few years have caused risks to accumulate and investors have exploited the different regulations among geographical areas.
In the digitalising world, the major risks to financial stability originate in inadequate monitoring and supervision of digital assets. The collapse of Silicon Valley Bank and other DeFi intermediaries has had domino effects on other (supervised) intermediaries because the global financial market is so deeply interconnected. Among digital assets, cryptocurrencies are the most popular among all investors and have contributed to enhancing financial inclusion in developing countries and among youth.
The effective pros and cons of crypto trading directly depend on the development of the financial system, whether it includes crypto trading and whether it is efficient, especially in developing and middle-income countries, which traditionally have underdeveloped financial systems. The dominance of Bitcoin among cryptos has declined since 2017, when more efficient trading technologies were developed, which benefited Ethereum and other cryptos.
Eliminating fragmentation
The European Union recently introduced the Regulation on Markets in Crypto Assets, which will take effect in 2024. It will eliminate the regulatory fragmentation among EU members. It will create a framework for public offerings, admission to trading, transactions and services related to cryptocurrencies. It follows the Financial Stability Board’s recommendations and does not apply to non-fungible tokens or other digital assets that fall under the Markets in Financial Instruments Directive II regulation.
The popularity of crypto assets has pushed most central banks in G20 members to develop central bank digital currencies. These CBDCs are digital counterparts to legal money and are managed by the national central bank, with or without the intermediation of the domestic banking system. CBDCs are not cryptocurrencies and are designed to enhance financial inclusion, reduce costs, and limit money laundering and other illicit uses of digital money. China, the United States, the European Union and Canada already have pilot projects under way, and are preparing to introduce their CBDCs with the intermediation of the banking system.
Bahamas launched its CBDC in 2020, followed by Jamaica in 2022. The digital Bahamian dollar, called the Sand Dollar, is pegged to the US dollar, is managed by authorised intermediaries, and should contribute to enhancing financial inclusion and safeguarding stability. However, the percentage of transactions that are paid with these CBDCs in those two countries is only around 1%. The creation of a CBDC by a strong global currency, such as the euro or the US dollar, will definitely change the landscape of the monetary system.
G20 leaders at the New Delhi Summit should focus on de-risking the international financial system by coordinating the principles of financial regulation in the digital sector. In fact, financial regulation cannot be local – G20 leaders should follow the principles set by the FSB and apply them at the global level, thus limiting regulatory arbitrage. This would also facilitate the development of the digital payments’ system, especially for underdeveloped financial systems.
