Bank for International Settlements headquarters in Basel, Switzerland (Gianluca Colla/Bloomberg via Getty Images)

Decentralized finance (DeFi) has a centralization problem and policy makers should use it to regulate the sector, the Bank for International Settlements (BIS) said in its latest quarterly review.

The review, published Monday by the central banks’ liaison and coordination organization, examines developments in global non-bank financial intermediaries and offers policy perspectives. The review dedicated the first of its five special features to discussing DeFi and implications for financial stability.

DeFi seeks to improve the efficiency of financial transactions by replacing traditional middlemen like banks and exchanges with automated contracts built on blockchains. As of Dec. 3, DeFi is a $162 billion market, up 26% from April.

Although there is much debate about how a system without intermediaries can be regulated, according to the BIS report policymakers have a way in. DeFi has an “inescapable need” for centralized governance, the report says.

“The point raised in the special feature is that there’s a limit to how far you can run a whole financial system purely based on those automated transactions,” said Hyon Song Shin, economic adviser and head of research at BIS during a press briefing on Monday.

There will be occasions when DeFi projects will be in need of reorganization or judgment, Shin said. “I think it’s an open question how far this project can be pushed without that kind of centralized guidance. I think that’s something that we will clearly need to watch very carefully.”

According to the report, the tendency for blockchain consensus mechanisms to concentrate power also makes it easy for a small number of stakeholders to make big decisions.

“DeFi’s inherent governance structures are the natural entry points for public policy,” the report says.

Despite its fast growth, DeFi is “self-contained” and its potential for disrupting the larger financial system remains low, according to the review. If, however, DeFi were to become widespread, its “severe” vulnerabilities could undermine financial stability.

According to the 16-page feature, those vulnerabilities can arise from intermediary-free lending programs, or from liquidity issues in stablecoins – which are the asset-pegged cryptocurrencies that typically facilitate transactions in DeFi applications. Other vulnerabilities include interconnectedness among DeFi applications and a lack of banks to absorb potential shocks, the report says.

“The decentralized nature of DeFi raises the question of how to implement any policy provisions,” the report says. “We argue that full decentralization in DeFi is an illusion.”

One element that could break this illusion is DeFi’s governance tokens, which are cryptocurrencies that represent voting power in decentralized systems, according to the report. Governance-token holders can influence a DeFi project by voting on proposals or changes to the governance system. These governing bodies are called decentralized autonomous organizations (DAO) and each one can oversee multiple DeFi projects.

“This element of centralization can serve as the basis for recognizing DeFi platforms as legal entities similar to corporations,” the report says. It gave an example of how DAOs can register as limited liability companies in the state of Wyoming.

“These groups, and the governance protocols on which their interactions are based, are the natural entry points for policymakers,” the report says.

During Monday’s briefing, Shin explained that there are three areas regulators could address through these centralized organizational bodies. These include consumer protection, guarding against money laundering and criminal activities, and financial stability – to what extent the DeFi ecosystem will overlap with the conventional financial system.

“Then there is the issue of how we think about these new institutions, these new arrangements as part of the financial market infrastructure,” Shin said.