Decentralised Finance: Implications for Financial System

Srijashree Sardar, Dipak R. Chaudhari and Sangeeta Das of RBI analyses DeFi and its interlinkages with traditional financial system:

Decentralised finance (DeFi) seeks to disintermediate the traditional financial system. However, developments such as the FTX crypto exchange collapse, decline in Binance and episodes of instability in stablecoins have created trust deficit in the entire crypto system. This article assesses DeFi and its interlinkages with the traditional financial systems by employing an Exponential General Autoregressive Conditional Heteroskedastic (EGARCH) model.

Highlights:

• • Volatility in DeFi returns is far greater than traditionally higher yield providing asset classes such as equity returns.
  • Major global financial institutions have direct exposure to the crypto system, although the overall exposure to total assets under management is estimated to be low.
  • The empirical analysis indicates that DeFi returns and volatility in the returns are mainly driven by speculative motive.
  • The empirical evidence suggests increasing volatility in DeFi with respect to the volatility of foreign exchange market and stock market.
  • On account of the borderless feature of DeFi, spillover by liquidity linkages across countries is a major risk.
  • As DeFi continues to evolve and mature, and its interaction with the traditional financial system grows, its utility against risks demands further analysis.