Christine Lagarde of the ECB, the Federal Reserve’s Jerome Powell, and BIS general manager Agustin Carstens attended an online panel hosted by the Bank of France on Tuesday to share their thoughts on the decentralized finance (DeFi) sector, agreeing that a broader regulation is warranted.

According to Bank for International Settlements (BIS) general manager Carstens, one of the big problems is that DeFi, in its current form, is it’s basically about “self-referencing” transactions that are not tied to real-life transactions.

“DeFi applications facilitate borrowing, lending, and trading, but the intermediaries are also exposed to traditional risks such as liquidity, counterparty risks, and leverage risk, and DeFi has no infrastructure to deal with that,” said Carstens.

According to Carstens, what DeFi applications are basically relying on is collateralized arrangements, and that’s why stablecoins are “the grease on the wheels in DeFi.” However, collateralization is often not effective, the governance of many DeFi transactions is not established well, and they, to a large extent, depend on the “exchange houses” that do too many things at the same time without appropriate segregation of activities, accountability , and appropriate governance, he stressed.

All this makes Carstens believe that DeFi has “structural problems and “intrinsic weaknesses,” so it’s not surprising that we have seen some stability issues in the sector—something that the BIS chief said concerns him the most.

The US Federal Reserve Chair Jerome Powell, meanwhile, said that monetary policy normalization that we’ve recently seen all over the world only revealed the significant structural issues in the DeFi ecosystem, but, as the tide has gone, it doesn’t seem to be a real issue now.

The real question, per Powell, is that within the DeFi ecosystem, there are bigger structural issues, including the lack of transparency.

“The good news, I suppose, is that—from the financial stability standpoint—the interaction between the DeFi ecosystem and the traditional banking system is not that large at this point. We were able to witness the DeFi movement but it didn’t have a significant impact on the broader financial stability,” said Powell.

The Fed chair, however, stressed that this situation “will not persist indefinitely” and that “we have to be very careful about how these crypto activities are taken within the regulatory perimeter.”

“In any case, wherever [these crypto activities] take place, as DeFi expands and starts to touch more and more retail customers, there’s a real need for more appropriate regulation to be in place,” said Powell.

DeFi is ‘a totally different animal’

Ravi Menon, the managing director of the Monetary Authority of Singapore (MAS), pointed out the importance of distinguishing various components of the crypto ecosystem and the kinds of risks and benefits each of them poses.

“If you look at tokenized assets, for instance, there are many banks experimenting with this. They pose lesser risk, but they are not the predominant part of the ecosystem, even though this is where the real potential lies,” said Menon.

The other component is the actual cryptocurrencies, “for which I don’t see any redeeming value,” he added.

“The speculations about these cryptocurrencies have led to price changes that have nothing to do with the underlying economic value,” said Menon.

In his view, DeFi is “a totally different animal,” though, and the biggest problem is that he doesn’t see where regulations can be applied as the protocols are decentralized.

“In a decentralized world, you can’t do that to an algorithm, […] and if this is something we can overcome, I can see some promise in DeFi. Otherwise, this could be a game-stopper,” said Menon.

Joining the discussion, Christine Lagarde, the President of the European Central Bank, described cryptocurrencies as “an enigmatic phenomenon” that went from a sort of a cultural hype pushed by libertarians and promoted by Satoshi Nakamoto to being a tool that is now accepted by PayPal , Visa, and Mastercard.

Lagarde also mentioned the collapsed Terra ecosystem, which “abused” cryptocurrencies, and its co-founder Do Kwon, who is “on the other side of this enigmatic coin,” and this, in her view, “warrants the regulation.”

“If we are not in that game, if we are not involved in experimenting, in innovating, in terms of digital central bank money, we risk losing the role of anchor that we have played for many, many decades,” said Lagarde.

No “Wild West” scenario accepted

Further discussing what tokenization might mean for the financial system, Mairead McGuinness, European Commissioner for Financial Stability, Financial Services, and the Capital Markets Union, said that tokenization started as a challenge to bypass the existing financial system, emerging from a desire to disrupt the traditional financial system.

“I think it is no coincidence that the Bitcoin network started operating in 2009 against the backdrop of the financial crisis and the distrust in financial institutions. I also think it’s no surprise that crypto markets have exploded since then,” said McGuiness, adding that despite the volatility, the global crypto market is currently valued at over $1 trillion.

McGuinness went on to say that the blockchain technology that underpins crypto protocols has a lot of potential as it cuts out the middlemen and removes the need for centralized processes and intermediaries.

“Item [the blockchain technology] can make transactions more efficient and transparent by recording key information in a non-changeable format, making it accessible to all market participants. And this could make payments cheaper, faster, and safer,” said McGuinness.

She added that this technology could also unlock “the billions of euros and dollars currently used to cover credit or settlement risk in the technology.”

Still, as McGuinness stressed, those potential benefits can’t emerge in a “Wild West” scenario; without regulation, crypto poses big risks to the financial system.

With that in mind, in 2023, the European Commission plans to propose legislation for the possible launch of a digital euro that could be granted a legal tender status just like the euro cash, said McGuinness.

Meanwhile, the European Commission is also keeping the growth of DeFi under review.

“This new ecosystem holds both opportunities and risks to firms, the financial system and the wider society, so we need to address the risks if we want to benefit from opportunities,” added McGuinness.

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