The Bank for International Settlements (BIS), often referred to as the “central bank of central banks,” has released a new report warning that the growth of cryptocurrencies and decentralized finance (DeFi) has reached a “critical mass” and could now pose systemic risks to traditional finance.

The BIS report notes that while the crypto market remains largely isolated from traditional financial institutions (TradFi), recent developments such as the approval of spot Bitcoin ETFs and the rise of real-world asset (RWA) tokenization have deepened the connection between the two sectors. The report notes that these evolving connections require greater attention and stricter oversight.

Perhaps most striking is the BIS’s analysis of how financial shocks in crypto markets can increase wealth inequality. A chart in the report shows that during periods of market stress, small individual investors tend to increase their crypto exposure, while wealthier investors exit the market. The result, according to the BIS, is a “redistribution of wealth from poorer to richer.”

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This observation echoes concerns raised by other regulators, with Ulrich Bindseil of the European Central Bank (ECB) previously arguing that Bitcoin’s structure disproportionately benefits early adopters, who are often wealthy, at the expense of latecomers.

The BIS report outlines two key developments that have accelerated the convergence of DeFi and traditional finance. The first is the decision by the U.S. Securities and Exchange Commission (SEC) to approve spot Bitcoin ETFs in January 2024. This move has significantly facilitated exposure to crypto for institutional and individual investors through traditional financial channels.

Second is the continued expansion of tokenized real-world assets. While DeFi primarily revolves around crypto-native assets, the tokenization of assets like bonds, stocks, and real estate is poised to bring mainstream financial instruments to blockchain platforms. This could lead to decentralized exchanges (DEXs) becoming more widely used by TradFi institutions.

The BIS advocates a “containment” approach to mitigate potential risks. This includes aligning DeFi protocols with regulatory frameworks currently applied to TradFi organizations. The report recommends implementing Know Your Customer (KYC) rules, enhanced disclosure requirements, and creating legal responsibilities for those operating decentralized protocols.

*This is not investment advice.

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