Shalini Nagarajan

David Canellis

After a series of blowups in the crypto industry, the <a href="https://blockworks.co/tag/bis" target="_blank" rel="noreferrer noopener">Bank of International Settlements</a> is exploring de-risking policies for central banks, with a ban on crypto activity one potential option.



Economists Matteo Aquilina, Jon Frost and Andreas Schrimpf disparagingly wrote in a Thursday <a href="https://www.bis.org/publ/bisbull66.pdf" target="_blank" rel="noreferrer noopener">bulletin</a> that despite inefficiencies recently seen in the space, crypto proponents still believe decentralization and blockchains are solutions rather than problems.



“Recent developments underscore that the decentralization in crypto and DeFi markets is illusory,” they said, reiterating the bank’s <a href="https://blockworks.co/news/decentralization-proves-to-be-an-illusion-bis-says" target="_blank" rel="noreferrer noopener">stance</a> from last year.&nbsp;



“The vision of crypto proponents is to do away with financial intermediaries, yet to function and achieve a meaningful scale, crypto markets rely heavily on centralized entities for several reasons.”



The economists pitched three potential options to tackle crypto risk in the wild. “A crucial element to be considered when selecting which options to pursue is the ability to enforce any rule that is introduced, including ensuring that the resources needed to do so are on hand,” the report states.



<h3>Ban specific crypto activities</h3>



This is the “extreme option,” per the authors, involving either an entire ban or a targeted one that eliminates potential harm to the financial system. This would mean investors wouldn’t be exposed to the misconduct of crypto service providers, the economists said.



They admitted that implementing a ban would be difficult in terms of enforcement. Decentralized crypto activities are borderless, so the ban would work better if focused on centralized intermediaries (an apparent reference to exchanges or payment providers). 



&#8220;But the activity could move to jurisdictions that do not impose the ban and investors may find ways to evade it,&#8221; BIS researchers wrote. “The main downside is that any useful innovation from crypto would be lost or delayed.&#8221;



<h3>Isolate crypto from TradFi and the real economy</h3>



This course of action would see crypto become more of a niche activity — a good thing as it wouldn’t be interconnected with TradFi (traditional finance), according to the economists.&nbsp;



How would that work?&nbsp;



“By limiting the flow of funds into and out of it and by limiting other connections with TradFi.” The authors then acknowledged this firewall-like approach wouldn’t be effective, again due to the borderless world of crypto.&nbsp;



<h3>Regulate the sector just like TradFi</h3>



The third option would seek to fit digital assets into existing regulations at all costs.



Authorities would be encouraged to map activities in the crypto industry to their counterparts in TradFi, then apply variants of existing regulations for those sectors to regulate crypto.



“This approach would ensure consistency in regulating financial activities — whether performed by crypto players or TradFi — and help to promote the policy goals at the core of existing regulatory frameworks,” the report states.



<figure class="wp-block-image size-large"><img decoding="async" loading="lazy" width="1024" height="532" src="https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png" alt="" class="wp-image-44078" srcset="https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=1024 1024w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=300 300w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=768 768w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=1536 1536w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=428 428w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=470 470w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=389 389w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=80 80w, https://blockworks-co.imgix.net/wp-content/uploads/2023/01/Screen-Shot-2023-01-13-at-14.38.10-1024x532.png?w=1952 1952w" sizes="(max-width: 1024px) 100vw, 1024px" /><figcaption class="wp-element-caption">At least BIS admits a ban on crypto &#8220;could conflict with founding principles of society&#8221;</figcaption></figure>



The authors reasoned that the crypto sector hasn&#8217;t yet &#8220;grown large enough or sufficiently interconnected with TradFi to threaten financial stability,&#8221; but all that could purportedly change if retail or institutional interest in the sector doesn&#8217;t stop growing. 



&#8220;Interconnections with the real economy and TradFi could also increase should crypto become less self-referential, in particular if asset tokenisation makes inroads. Discussions on the appropriate policy response to crypto are therefore timely,&#8221; they said.



<h3>Analysis by David Canellis</h3>



We’ve already seen some of the latter approach: the SEC <a href="https://blockworks.co/news/sec-under-gensler-crypto-power-grab-effective-protection" target="_blank" rel="noreferrer noopener">forcing digital assets</a> through the 77-year-old Howey Test to determine securities status, and the FATF’s strict (and <a href="https://www.coincenter.org/the-long-awaited-fatf-crypto-guidance-is-not-as-bad-as-it-could-have-been-but-still-flawed/" target="_blank" rel="noreferrer noopener">controversial</a>) recommendations on a “<a href="https://blockworks.co/news/eu-to-require-exchanges-identify-most-crypto-transactions" target="_blank" rel="noreferrer noopener">travel rule</a>” for crypto.



The authors do suggest a potential fourth alternative: increase quality and reduce costs of payments through “sound innovation in TradFi,” harnessing crypto transformation and applying it to existing financial rails.



As for the sweeping ban: totally outlandish, bordering on trolling. Not to mention, practically unrealistic due to the decentralized resiliency of blockchains such as Bitcoin and Ethereum (which the authors do appear to realize).



The BIS’ crypto stance shouldn’t surprise, considering it serves as a bank for central banks. This positions it as a natural-borne antagonist for crypto-cypherpunks.



After all, Bitcoin was <a href="https://en.bitcoin.it/wiki/Genesis_block" target="_blank" rel="noreferrer noopener">born</a> sporting a middle finger to all things central bank. The BIS is simply blowing raspberries right back.



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Bank for Central Banks Floats Ways to Contain Crypto, Including Ban

Jocelyn Yang

<div id="highlights-block_62b0ea456e0f3" class="highlights">
 <ul>
 <li>The institution said the future monetary system should be built on the trusted division of roles between the central bank and private sector entities</li>
 <li>In another bulletin issued in June, BIS economists said “decentralization proves to be an illusion”</li>
 </ul>
 
</div>



As <a href="https://cms.blockworks.co/how-cryptoasset-markets-have-changed-since-terra-crash/" target="_blank" rel="noreferrer noopener">Terra’s stablecoin implosion</a> and recent <a href="https://cms.blockworks.co/crypto-total-market-capitalization-under-1t-after-10-fall/" target="_blank" rel="noreferrer noopener">market turmoil</a> have demonstrated crypto&#8217;s volatility, central bank digital currencies, or CBDCs, offer a more stable solution for a future monetary system, according to the Bank of International Settlements (BIS).&nbsp;



Crypto’s security risks, high fees and scalability issues, as well as its “unregulated intermediaries that pose financial risks,” are growing concerns in today’s monetary system, BIS said in its annual report, released Tuesday.



“The crypto universe lacks a nominal anchor, which it tries to import, imperfectly, through stablecoins,” the report said. “​​These structural shortcomings are unlikely to be amenable to technical fixes alone. This is because they reflect the inherent limitations of a [decentralized] system built on permissionless blockchains.”&nbsp;



“The crypto sector provides a glimpse of promising technological possibilities, but it cannot [fulfill] all the high-level goals of a digital monetary system,” it added.&nbsp;



BIS argues that a future monetary system should contain both the “retail CBDC level” — which is predominantly used by individuals to pay each other or businesses — and “the wholesale CBDC level” — which is used by financial institutions to settle trades in markets.



The monetary system should be built on the division of roles between the central bank and private sector entities, the institution said in its report.



“The metaphor for the future monetary system is that of a tree, whose solid trunk is the central bank,” Hyun Song Shin, BIS’ economic adviser and head of research, said in a statement. “This tree boasts a rich and vibrant ecosystem of private sector service providers serving users to [fulfill] their economic needs. The ecosystem is rooted, figuratively speaking, in settlement on the central bank’s balance sheet.”&nbsp;



Earlier this month, Israel&#8217;s central bank announced a partnership with the Hong Kong Monetary Authority and BIS’ Innovation Hub to test the feasibility of a retail CBDC, <a href="https://www.reuters.com/markets/currencies/bank-israel-bis-hong-kong-cenbank-test-retail-cbdc-feasibility-2022-06-16/" target="_blank" rel="noreferrer noopener">Reuters</a> reported.&nbsp;



China <a href="https://cms.blockworks.co/china-debuts-digital-yuan-at-winter-olympics-amid-warnings-from-us-senator/" target="_blank" rel="noreferrer noopener">rolled out</a> the pilot for its own CBDC, or eCNY, at the Beijing Winter Olympics in February this year, and Jamaica’s Jam-Dex earlier this month became the world’s first CBDC to be recognized as <a href="https://cms.blockworks.co/in-historic-move-jamaica-makes-cbdc-akin-to-cash/" target="_blank" rel="noreferrer noopener">legal tender</a> — it will officially launch for public use later this month. Several countries, including <a href="https://cms.blockworks.co/kenya-seeks-public-opinion-on-potential-cbdc/" target="_blank" rel="noreferrer noopener">Kenya</a>, Brazil and Haiti, are also <a href="https://cms.blockworks.co/why-emerging-markets-are-leading-the-charge-on-cbdcs/" target="_blank" rel="noreferrer noopener">exploring</a> the technology.



“This architecture is assumed to have several benefits: less financial risk for the customer, more liquidity, lower costs, increased competition, and wider access,” the Bank of Israel said.



The BIS said retail CBDCs could play a similarly beneficial role in developing fast payment systems, citing the technical feasibility of a CBDC architecture — also known as <a href="https://news.mit.edu/2022/digital-currency-fed-boston-0203" target="_blank" rel="noreferrer noopener">Project Hamilton</a> — that can process 1.7 million transactions per second, which is “far more than major card networks or blockchains,” according to the report.&nbsp;



“These new capabilities not only permit the expansion of the types of transactions, but also enable transactions between a much wider range of financial intermediaries — not just commercial banks. Wholesale CBDCs also work together across borders, through multi-CBDC arrangements involving multiple central banks and currencies,” the report said.&nbsp;



In another bulletin issued in June, BIS economists said “decentralization proves to be an illusion” and <a href="https://cms.blockworks.co/decentralization-proves-to-be-an-illusion-bis-says/" target="_blank" rel="noreferrer noopener">suggested</a> decentralized lending systems would “gravitate towards greater centralization.”



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CBDCs the Core of Future Monetary System: BIS Report

<div id="highlights-block_62ac9d8ecaed5" class="highlights">
 <ul>
 <li>Bank of International Settlements’ economists said current DeFi loans don’t finance real economy activities</li>
 <li>Total value locked in DeFi lending protocols reached $50 billion in early 2022, up from nearly zero at the end of 2020, according to BIS data</li>
 </ul>
 
</div>



The recent Terra LUNA collapse and <a href="https://cms.blockworks.co/celsius-withdrawal-halt-reveals-run-risks-on-other-crypto-banks/" target="_blank" rel="noreferrer noopener">Celsius’ restrictions on withdrawals</a> have sparked fears of a crisis in crypto lending. Economists at the <a href="https://www.bis.org/publ/bisbull57.pdf" target="_blank" rel="noreferrer noopener">Bank of International Settlements</a> (BIS) said while on-chain collateral in DeFi lending overcomes asymmetric information, it doesn’t make the space immune from boom-bust episodes, compounded by liquidation spirals. 



Cryptocurrency lending platforms — where borrowers can deposit cryptoassets as collateral to secure a loan from the lenders — are critical to the DeFi (decentralized finance) ecosystem, according to the institution’s bulletin released this week. However, BIS economists found these platforms’ institutional features mostly “facilitate speculation in cryptoassets” rather than “real-economy lending.”&nbsp;



“Smart contracts assign each collateral type a haircut, or margin, that determines the minimum collateral borrowers must pledge to receive a loan of a given amount. The high price volatility of cryptoassets means that there is overcollateralization: the collateral required tends to be much higher than the loan size,” the bulletin read.&nbsp;



“As DeFi loans are disbursed in cryptoassets and secured by crypto collateral, they do not currently finance real economy activities,” it added.&nbsp;



Meanwhile, BIS economists believe that the need for collateral blocks the fundamental goal of DeFi: “democratizing finance.” Those not so asset-rich are often excluded when it comes to accessing financial services.&nbsp;



“Due to the anonymity of borrowers, overcollateralization is pervasive in DeFi lending,” the report read. “Reliance on collateral also limits access to credit to borrowers who are already asset-rich, negating financial inclusion benefits.”



As high returns attract investors, the total value locked in DeFi lending protocols reached $50 billion in early 2022, up from nearly zero at the end of 2020, according to BIS.&nbsp;



Now that trend has reversed — total value locked <a href="https://defillama.com/chains" target="_blank" rel="noreferrer noopener">has plummeted</a> along with asset prices.



<h3>Is it collateral or opaqueness that’s the problem?</h3>



It’s not surprising that a champion of central banks would dismiss the concept of decentralization. But Chase Devens, research analyst at Messari, argues centralization is largely responsible for the current mess, noting that it was poor risk-management mixed with a lack of understanding of asset and protocol functions — such as Terra and stETH — that left large centralized players such as Celsius searching for liquidity.&nbsp;



“The falling dominoes have been fueled by a lack of transparency as to how much leverage was built up within the system,” Devens said.



<blockquote class="wp-block-quote">“As we know, the state of DeFi is publicly verifiable and allows the health of the system to be assessed in real time. However, [over-the-counter] deals and off-chain leverage can build up beyond this ecosystem and trigger surprise liquidation cascades as they are unraveled.” </blockquote>



If DeFi lending wants to make it into the real-world economy, BIS economists suggested it must engage in “large-scale tokenisation of real-world assets” and rely less on crypto collateral. However, “developing its ability to gather information about borrowers,” would eventually lead the system to “gravitate towards greater centralization.”&nbsp;&nbsp;



“The similarities between DeFi and legacy intermediaries are increasing, which has two important implications,” the report read. “The first is that elements of DeFi, mainly smart contracts and composability, could find their way into traditional finance. The second implication is that, once more, decentralization proves to be an illusion.”&nbsp;



Devens agreed that large-scale tokenization has always been a goal for DeFi. Yet, he thought abandoning anonymity and relying on centralization might not be the best strategy over the long term because “centralized entities have proven to be opaque and create bottlenecks of their own,” he said, pointing once more at Celsius.&nbsp;



“Although the identities of the borrowers are (mostly) unknown, we know exactly what price levels will trigger liquidations from on-chain lending protocols such as Maker or Aave,” he said.&nbsp;



<blockquote class="wp-block-quote">“As zero-knowledge technology continues to improve in the coming years, identity and reputation-based lending systems will have room to flourish.”</blockquote>



Protocols such as MakerDAO are <a href="https://forum.makerdao.com/t/aggressive-growth-strategy/13958" target="_blank" rel="noreferrer noopener">specifically focusing</a> on onboarding real-world assets to expand the collateral base of DAI and, by extension, all of DeFi.



“The evolution of crypto will continue to play out for many years to come and ultimately result in an antifragile system that is anchored on decentralization at its core,” he added.



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‘Decentralization Proves To Be an Illusion,’ BIS Says

Sebastian Sinclair

<div id="highlights-block_61e0f18032350" class="highlights">
 <ul>
 <li>Switzerland&#8217;s central bank, the Bank for International Settlements and the SIX stock exchange have successfully conducted interbank transfers using a wholesale central bank digital currency</li>
 <li>The effort also involved five prominent banks including Citi, UBS, Goldman Sachs, Hypothekarbank Lenzburg and Credit Suisse</li>
 </ul>
 
</div>



The Swiss National Bank, the Bank for International Settlements&#8217; Innovation&nbsp;Hub Swiss Centre and the country’s stock exchange, SIX, have completed a joint experiment to integrate a wholesale central bank digital currency (CBDC) for interbank transactions.



Dubbed Project Helvetia, the second phase of the experiment, conducted in Q4, 2021, explored the settlement of interbank, monetary policy and cross-border transactions, according to a <a href="https://www.snb.ch/en/mmr/reference/pre_20220113/source/pre_20220113.en.pdf" target="_blank" rel="noreferrer noopener">statement</a> Thursday.



The project was conducted using the test systems of SIX, the central bank&#8217;s real-time gross settlement system, SIX Interbank Clearing as well as core banking systems. The effort also involved five prominent banks including Citi, UBS, Goldman Sachs, Hypothekarbank Lenzburg and Credit Suisse.



The move marks a turning point in CBDC infrastructure development, demonstrating to the rest of the world that such use of distributed ledger technology may yet prove useful to the traditional banking and financial sector.



In its test, the banks and stock exchange experimented on six use cases for its wholesale CBDC including issuance, redemption, delivery-versus-payment, transfers, booking and settlement as well as intraday control and monitoring, according to a <a href="https://www.snb.ch/en/mmr/reference/project_helvetia_phase_II_report/source/project_helvetia_phase_II_report.en.pdf" target="_blank" rel="noreferrer noopener">joint report</a>.



Phase I, conducted in 2020, involved testing two approaches for settling tokenized assets in central bank money by issuing a wholesale CBDC on a tokenized platform and then linking the existing payment system to a digital ledger.



A wholesale CBDC relates to the settlement of interbank transfers and&nbsp;wholesale&nbsp;transactions. It differs from retail CBDCs that aim to digitize a nation&#8217;s currency like the one seen in China with its digital yuan.



The second phase of Project Helvetia successfully demonstrates that such integration is &#8220;operationally possible,&#8221; the central bank said in its statement. Though it emphasized the project was an experiment of &#8220;exploratory nature&#8221; and was not to be interpreted as a move by the central bank to implement a wholesale CBDC.



“We have demonstrated that innovation can be harnessed to preserve the best elements of the current financial system, including settlement in central bank money, while also potentially unlocking new benefits,” said Benoit Coeure, Head of the BIS Innovation Hub.



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Swiss Central Bank, BIS, SIX Complete Test of Wholesale CBDC Trial Labelling it ‘Operationally Possible’

Macauley Peterson

<div id="highlights-block_61a624760da75" class="highlights">
 <ul>
 <li>CBDCs are inevitable, but institutions should ensure they can be designed and implemented in a manner that maximizes benefits while minimizing risks</li>
 <li>Crypto assets and DeFi must be regulated to prevent disintermediation and maintain stability of the payment system</li>
 </ul>
 
</div>



Denis Beau, First Deputy Governor of the Bank of France, thinks that innovation in digital currencies can lead to greater efficiency in payments and reduced costs&nbsp; — an unquestionable public good — but only when the health of the existing commercial banking industry is maintained.



In remarks made to attendees at a conference titled, &#8220;The new challenges of financial regulation,&#8221; in Paris on November 19, 2021, but <a href="https://www.bis.org/review/r211128f.htm" target="_blank" rel="noreferrer noopener">released in English on Sunday</a> by the Bank for International Settlements, Beau characterized the risks facing central banks as they attempt to navigate the digitalization of global economies.



His view, which is largely representative of global central bankers, puts digital asset payment and settlement rails based on geopolitically neutral cryptography — i.e. DeFi — on a collision course with the global banking elites.



<h3>Innovations have potential, but&#8230;</h3>



New technologies, notably distributed ledgers, new settlement assets (crypto-assets), Beau said, are likely “to profoundly alter our euro payments ecosystem.”



<blockquote class="wp-block-quote">“These innovations have the significant potential to improve the functioning of our payment system, in particular by making payment means simpler, easier and cheaper to use, and faster if not instantaneous.”</blockquote>



However, the benefits from these innovations can only be realized if policymakers proceed with “caution and confidence.”



<h3>What are the risks?</h3>



Beau called “the dominance of currencies linked by a legally binding rule of convertibility at par” as the first of three “organisational principles of our payment system.” This, combined with the principle that only central bank money can be accepted as legal tender is what allows the dominant central bank currencies to play, what he terms “complementary roles” of money that “fulfills an integrating and anchoring function [and] guarantees the efficiency and stability of our payment system.”



However, Beau says, “these foundations are threatened by the diffusion of innovations across the payments field, which has been sped up by the health crisis and social distancing, if no measures are taken to preserve them.”



The negative normative slant evoked by reference to a “foundational threat” seems rather at odds with the concept of being “technology-neutral”, one goal expressed by, among others, <a href="https://www.bis.org/publ/work951.pdf" target="_blank" rel="noreferrer noopener">BIS economists</a> Raphael Auer and David Tercero-Lucas in July 2021.



However, much of the ideological and political heft behind the momentum of digital assets is indeed explicitly aimed at questioning Beau’s premises. What are the ontological underpinnings of central bank money? How can we ensure the enforcement of their dominance serves the public interest?



<h3>Please don’t hurt the banks</h3>



“The introduction of a CBDC raises complex issues that need to be resolved without penalising banks,” Beau asserts.



In a section titled, “Avoiding disruptive effects for financial intermediaries,” Beau warned that a failure to do just that, “would conflict with our mandate to safeguard monetary and financial stability.”



He outlines the “risk of fragmentation” of the payment system — which is aimed simultaneously at decentralized finance and stablecoins, as well as Big Tech initiatives like the Diem project of <a href="https://cms.blockworks.co/zuckerberg-says-facebooks-new-name-will-be-meta/" target="_blank" rel="noreferrer noopener">Meta Platforms</a> — and also the “risk of concentration,” targeted squarely at the latter.



Beau is also concerned with ways in which CBDCs may interfere with the conduct of monetary policy by central banks.



<blockquote class="wp-block-quote">“The introduction of an unremunerated retail CBDC with no holding limit could make it difficult for central banks to pursue a negative interest rate policy, as market participants would prefer to hold the CBDC instead of assets remunerated at negative rates.”</blockquote>



The positive yields widely available in DeFi would face the same objection, and Beau hinted at the tightening of the regulatory noose around this aspect of the digital asset market, while providing no concrete prescription and acknowledging the practical challenges regulators face.



“I’m referring in particular to the supervision of the development of decentralised finance, where the usual regulatory frameworks are constrained by the fact that issuers and service providers are not easily identifiable in an environment where protocols are automatically executed without intermediaries, and there is no fixed jurisdiction for the services offered.”



The BIS has said that nine out of ten central banks report having, at a minimum, undertaken research and development programs towards a CBDC. Although, to date, Beau noted, only two retail CBDCs have been introduced: the Bahamas&#8217; Sand Dollar and DCash for the Organisation of Eastern Caribbean States. Over twenty pilot projects are underway around the world, he said.



As for the European Union, banks evidently have nothing to fear. Beau concludes that, “given the way in which investigations are being conducted into a digital euro&#8230;it is unlikely that banks will be erased from a future payments landscape in which stablecoins and central bank digital currency dominate.”



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