Cryptocurrencies and decentralized finance (DeFi) have ushered in a new era of financial innovation, promising to transform how we transact, invest, and manage resources. Built on blockchain technology, these systems aim to replicate the core functions of traditional finance (TradFi)—from payments to lending—without relying on centralized intermediaries like banks. However, as outlined in the Bank for International Settlements’ (BIS) April 2025 study, these innovations carry significant risks to financial stability, necessitating carefully crafted regulatory strategies.
This blog delves into the dual nature of cryptocurrencies and DeFi as groundbreaking yet perilous systems, exploring how regulators can mitigate risks while preserving their transformative potential.
A New Financial Frontier
The journey of cryptocurrencies began with Bitcoin in 2008, a decentralized digital currency powered by a blockchain—a distributed ledger that validates transactions through cryptography and economic incentives, such as proof-of-work. Bitcoin’s vision was to revolutionize payments, but its volatility shifted its role toward speculation, attracting investors chasing high returns. The introduction of Ethereum in 2015 marked a turning point, enabling smart contracts—self-executing code that automates transactions based on predefined conditions. This innovation birthed DeFi, a sprawling ecosystem of protocols like decentralized exchanges (DEXs), lending platforms, and yield farming apps that mimic TradFi services. Additionally, stablecoins, such as Tether, peg their value to fiat currencies to facilitate DeFi transactions, while central bank digital currencies (CBDCs) offer a digital form of central bank money, potentially bridging TradFi and DeFi. These advancements promise efficiency, accessibility, and financial inclusion, particularly in regions with limited banking infrastructure, by allowing anyone with internet access to participate in global financial markets.
The Shadow of Risk
Composability Risk
Despite their promise, cryptocurrencies and DeFi pose substantial risks to financial stability, as the BIS study highlights. The interconnectedness of DeFi, known as composability , creates fragile networks where a single failure—like the 2022 collapse of the algorithmic stablecoin TerraUSD—can trigger widespread disruption. DeFi loans, often over-collateralized with volatile crypto assets, amplify this fragility: a price drop can spark mass liquidations, further depressing token values and propagating systemic risk.
Anonymity and Risk
The anonymity of blockchains exacerbates these issues by reducing reputational constraints, encouraging riskier behavior among participants. Information challenges further compound the problem. While blockchains are transparent, smart contracts are complex, and their behavior under varying conditions is difficult for consumers to predict. Oracles, which feed real-world data into DeFi, introduce additional vulnerabilities.
Asymmeric Information and Investor Protection
Moreover, investors often lack insight into developers’ identities or intentions, leaving them exposed to scams like rug pulls, where developers abscond with funds. In emerging market and developing economies (EMDEs), the risk of cryptoisation—where cryptocurrencies displace local currencies—looms large, threatening monetary policy effectiveness and macroeconomic stability, much like dollarisation. Retail investors, drawn by the allure of quick profits, are particularly vulnerable, often losing out to wealthier investors during market downturns, challenging the narrative of crypto as a tool for inclusive growth.
Bridging TradFi and DeFi
The boundaries between DeFi and TradFi are increasingly porous, amplifying both opportunities and risks. The 2024 approval of Bitcoin and Ether exchange-traded funds (ETFs) in the United States and other jurisdictions has made crypto accessible to mainstream investors, while asset tokenization—representing real-world assets like bonds or real estate on blockchains—further integrates DeFi with traditional markets. These developments promise to expand the scope of DeFi beyond its self-referential ecosystem, but they also heighten the potential for systemic spillovers. The BIS study notes that the 2023 U.S. banking stress was partly linked to crypto-related depositor exposures, an unexpected connection that underscored the need for robust risk management :
” For instance, the drivers of the March 2023 banking stress are difficult to pinpoint exactly. But the indirect exposure of US banks to depositors with large stakes in crypto markets was a contributing factor which took many policymakers and supervisors by surprise.” ( BIS, April 2025, page 19 )
As these linkages grow, regulators must ensure that shocks originating in the crypto ecosystem do not destabilize critical TradFi infrastructure or the broader economy.
Crafting Nuanced Regulation
The BIS study dismisses outright bans on cryptocurrencies and DeFi as both impractical, given their global reach, and undesirable, due to their innovative potential. Instead, it advocates for a dual approach of containment and regulation. Containment focuses on shielding TradFi from crypto risks by requiring financial institutions, particularly banks, to rigorously assess exposures, including indirect risks like liquidity demands or collateral calls. The Basel Committee’s 2022 standards on crypto capital requirements provide a foundation for this approach. Beyond finance, firms using blockchains for non-financial purposes, such as supply chain management, must ensure resilience against outages or cyber threats. Regulation, meanwhile, involves tailoring TradFi principles to DeFi’s decentralized structure. By mapping DeFi protocols to their economic functions—such as lending or trading—regulators can apply equivalent rules, including mandatory disclosures and know-your-customer (KYC) requirements. Embedding regulations directly into smart contracts could enforce compliance, ensuring transactions align with ledger status or meet best execution standards. Stablecoin issuers, critical to DeFi’s value transfer, require specific oversight to maintain parity through high-quality reserves and operational resilience. In EMDEs, regulators can counter cryptoisation through capital controls, taxation, and the development of CBDCs as stable alternatives to volatile cryptocurrencies or foreign stablecoins. Protecting retail investors is also paramount, with measures like minimum standards for DeFi products and developers, and enhanced transparency around Dapps, which serve as entry points for most users.
Looking Ahead
The BIS paper notes that Cryptocurrencies and DeFi are more than speculative phenomena—they represent a bold reimagining of finance with the potential to streamline processes, enhance efficiency, and expand access. Smart contracts could optimize TradFi operations, while CBDCs might revolutionize payments. Yet, their risks demand proactive regulation to prevent systemic crises and safeguard consumers, particularly in vulnerable economies. The BIS study calls for deeper research into cryptoisation, refined CBDC designs, and frameworks that balance innovation with stability. By navigating this delicate balance, policymakers can harness the transformative power of crypto and DeFi while ensuring they evolve into tools for resilient, inclusive finance. The path forward is complex, but with thoughtful regulation, this new financial frontier can deliver on its promise without compromising stability.
Reference: Aquilina, M., Cornelli, G., Frost, J., & Gambacorta, L. (2025). Cryptocurrencies and decentralised finance: functions and financial stability implications. BIS Papers No. 156. Bank for International Settlements.
Appendix: Glossary
Asset Tokenization: The process of creating a digital representation of a real-world asset (e.g., real estate, bonds) on a blockchain, enabling its trading or management in a digital ecosystem.
Bitcoin: The first cryptocurrency, launched in 2008, operating on a decentralized blockchain to enable peer-to-peer transactions without intermediaries.
Blockchain: A distributed ledger technology that records transactions in a secure, transparent, and immutable manner using cryptography and consensus mechanisms like proof-of-work or proof-of-stake.
Central Bank Digital Currency (CBDC): A digital payment instrument issued by a central bank, denominated in the national currency, functioning as digital cash (retail CBDC) or tokenized reserves for interbank transactions (wholesale CBDC).
Composability: The ability of DeFi protocols to interoperate, allowing components to be combined to create complex financial services, increasing efficiency but also systemic fragility.
Cryptoisation: The phenomenon where cryptocurrencies or stablecoins displace local currencies in transactions or as a store of value, particularly in emerging markets, similar to dollarisation.
Decentralized Exchange (DEX): A blockchain-based platform that enables users to trade cryptoassets directly without intermediaries, using smart contracts to facilitate transactions.
Decentralized Finance (DeFi): A financial ecosystem built on blockchains, using smart contracts and protocols to provide services like trading, lending, and asset management without centralized intermediaries.
Ethereum: A blockchain platform launched in 2015 that supports smart contracts, enabling the development of decentralized applications and DeFi protocols.
Know-Your-Customer (KYC): Regulatory requirements for financial service providers to verify the identity of their clients to prevent fraud, money laundering, and other illicit activities.
Oracle: A system that imports real-world data into blockchain environments for use in smart contracts, bridging on-chain and off-chain information but introducing potential vulnerabilities.
Proof-of-Work/Proof-of-Stake: Consensus mechanisms used by blockchains to validate transactions. Proof-of-work requires computational effort, while proof-of-stake involves validators locking up cryptocurrency.
Rug Pull: A scam in DeFi where developers promote a project, collect investor funds, and then disappear, leaving investors with worthless tokens.
Smart Contract: Self-executing code on a blockchain that automatically enforces the terms of an agreement when predefined conditions are met.
Stablecoin: A cryptocurrency pegged to a stable asset, like a fiat currency, to maintain a consistent value, used as a medium of exchange in DeFi (e.g., Tether, USD Coin).
Traditional Finance (TradFi): The conventional financial system, including banks, stock exchanges, and other centralized institutions that facilitate financial services.
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