Decentralised finance (DeFi) activity expanded significantly last year, but the phenomenon currently poses little risk to the mainstream financial system, says Fitch Ratings.
In a new report, the rating agency said that the total value of DeFi grew from US$22 billion at the start of 2021 to about US$180 billion by the end of the year.
However, the sector’s growth is slowing on a month-over-month basis, it said — and contagion risks remain low.
“DeFi presents limited risks to the mainstream financial system as, barring stablecoins, it is largely separate and not yet systemic in size,” the report said.
That could change, however, and the rating agency indicated that its view on the sector will likely evolve, alongside legal and regulatory considerations.
Currently, the lack of regulatory oversight in the sector is one of its key features, as the absence of regulatory constraints combined with the inherent flexibility of the technology “facilitates product innovation” in the sector, the report noted.
“Users can execute complex multi-legged and leveraged transactions which settle simultaneously,” it said.
And while DeFi can theoretically reduce some of the risks of traditional centralized financial systems, it also carries risks of its own, including a high risk of fraud, along with market and liquidity risks.
The report noted that “Rug pull scams, where developers abandon projects and take users funds, are prevalent, alongside phishing and code bugs. The manipulation of token prices is another threat.”
These risks aren’t likely to dissipate on their own.
“The immaturity of the sector is likely to lead to further exploits and risks,” the report said.
Indeed, Fitch suggested that policymakers’ differing approaches to these sorts of risks may effectively split the sector over time.
“China has, in effect, banned the use of DeFi and private digital assets, and Russia may take a similar approach. However, we expect many jurisdictions to view DeFi more favourably, allowing it to evolve but with increasing regulation,” it said.
“This is likely to divide the sector, leading to a regulated strand gaining market acceptance and an innovative but unregulated segment,” the report suggested.
As the more regulated branch of DeFi evolves, Fitch said that its links with the mainstream financial system will likely increase.
“Over time, this would lead to increased contagion risk from DeFi to the mainstream system,” it said.