Tobias Adrian's Speech: Cryptocurrencies and Decentralized Finance

IMF News, June 24, 2022

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Canonical URL: Tobias Adrian's Speech: Cryptocurrencies and Decentralized Finance

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Published: June 24, 2022

Overview

Remarks delivered in the context of central banking in a post-Covid world, focusing on risks and opportunities presented by crypto assets and DeFi.
Includes a recap of the collapse of the stablecoin TerraUSD (UST) as an illustrative example.

Major risks

Market risks
- Heavy reliance on crypto collateral in DeFi lending increases exposure to price volatility.
- High volatility can lead to frequent forced liquidation; liquidation volume rises when crypto prices drop and also when they increase sharply.
- Recent liquidation figures: total liquidation in May of this year was around $1.4 billion, of which $1.3 billion came from Anchor. Compared to May 2021—where we witnessed over $700 million in liquidation—in this most recent round in May 2022, liquidation from other platforms was much smaller as outstanding debt collapsed.
Liquidity risks
- High concentration of liquidity providers: only a handful of accounts make up nearly half of total liquidity of DeFi platforms.
- Borrowers can repay at any time but must meet collateral requirements; adverse price movements that push collateral below thresholds can trigger liquidations executed by liquidators who repay debt in exchange for collateral and a liquidation bonus.
Cyber risks
- Value stolen in DeFi-related cyberattacks rose substantially in 2021: from less than $100 million per quarter in 2020 to over $900 million in just the third quarter alone in 2021.
- In most cases, over 30 percent of deposits were lost entirely—either stolen or withdrawn by depositors.
- Attacks damage platform reputation, induce massive withdrawals, can trigger liquidity shortages, and in extreme cases can shut down a platform.

Opportunities and vulnerabilities of DeFi

Cost efficiency
- DeFi can reduce costs of financial intermediation by bypassing parts of the intermediation chain; marginal cost of DeFi is much lower than banks and nonbanks in both advanced and emerging market economies.
- Lower marginal costs arise because DeFi platforms automate processes via algorithms and interest rate models and do not bear labor and operational costs.
Margin and risk concerns
- DeFi margins are very small (gray margin areas in the referenced chart) and DeFi charges substantially lower margins compared to traditional institutions, offering favorable borrower prices and high deposit rates to attract users.
- Given comparable risk exposure, estimated (average) expected losses suggest DeFi margins are too low—DeFi may be underpricing their risks.
Higher upfront costs
- Smart contracts do not allow ex-post renegotiation or cancellation, requiring contracts to be completed ex-ante and thus demanding higher upfront costs to negotiate and specify terms in all possible states of the world (per Makarov and Schoar).

The collapse of TerraUSD (UST)

Design and mechanics
- UST is an algorithm-stablecoin pegged to the US dollar and maintained via arbitrage trading between UST and LUNA on the Terra blockchain.
- Protocol guarantees the ability to trade 1 UST for $1 worth of LUNA regardless of token values.
- When 1UST > $1: $1 of LUNA is burned and 1 UST is minted (increasing UST supply).
- When 1UST < $1: UST is burned and LUNA is minted (decreasing UST supply).
- Mechanism requires stable and consistent demand for both LUNA and UST.
Anchor and reserves
- Anchor, a DeFi lending protocol on Terra, attracted UST deposits with the promise of 20 percent return and held close to 75 percent of UST before the fall.
- These returns were subsidized by the Luna Foundation Guard, which held crypto assets (for example, Bitcoin, Avalanche, or others) as reserves to backstop the ecosystem.
Trigger and dynamics of the collapse
- UST collapsed on May 9 when large withdrawals from crypto exchanges and Anchor initiated a significant de-peg from $1.
- The stabilization mechanism increased LUNA supply, creating downward pressure on LUNA’s price; the plunge in LUNA depleted collateral in Anchor, triggering simultaneous liquidations.
- Panic selling of UST and the resulting “death spiral” caused total value locked in Anchor and other Terra DeFi platforms to drop in parallel.
- As of May 18, 2022, UST traded at around $0.1–0.2 and is not traded in the most major exchanges.

Spillovers and market effects

The Luna Foundation Guard released reserves to defend the peg; massive inflow of BTC to the market dragged down Bitcoin prices and aggravated the crypto sell-off.
Incident highlighted market, liquidity, and concentration risks and dealt a confidence blow to some crypto projects.
Massive liquidation and withdrawals wiped out Anchor’s liquidity pool almost entirely in the first three days of the event.
Many other DeFi platforms experienced large withdrawals in response.

Policy recommendations

Regulators should be proactive to prevent negative spillovers between DeFi, stablecoins, and traditional financial institutions given growing interconnectedness.
Address legal uncertainty
- Prepare regulatory surveillance and globally consistent regulatory frameworks.
- As a first step, address regulatory gaps in the overall crypto ecosystem by focusing on centralized entities that enable DeFi development—stablecoin issuers could be a main regulatory target.
- Discussions are ongoing in international standard-setting bodies—such as the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures, and the International Organization of Securities Commissions—regarding regulatory frameworks on stablecoin issues.
Direct regulation of DeFi functions
- Second step: regulate key functions within DeFi directly via collaboration between regulators and the private sector.
- Encourage DeFi platforms to adopt robust governance and establish self-regulatory organizations; transparent and credible governance can be an entry point for regulators.
Objective
- Closing current regulatory gaps aims to minimize DeFi risks while allowing borrowers to benefit from decentralized financial services.

Source: Tobias Adrian, "Cryptocurrencies and Decentralized Finance", Bank for International Settlements 21st Annual Conference; Tobias Adrian, IMF Financial Counsellor and Director of the Monetary and Capital Markets Department; June 24, 2022.