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Embedded Supervision: How to Build Regulation into Decentralised Finance

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  • Raphael A. Auer

Abstract

The emergence of so-called “decentralised finance” (DeFi) and a shadow financial system of cryptocurrency exchanges and stablecoin issuers raises the challenge of how to apply technology-neutral regulation so that similar risks are subject to the same rules. This paper makes the case for embedded supervision, ie a regulatory framework that provides for compliance in decentralised markets to be automatically monitored by reading the market’s ledger. This reduces the need for firms to actively collect, verify and deliver data. The paper explores the conditions under which distributed ledger data may be used to monitor compliance. To this end, a decentralised market is modelled that replaces today’s intermediary-based verification of legal data with blockchain-enabled credibility based on economic consensus. The key results set out the conditions under which the market’s economic consensus would be strong enough to guarantee that transactions are economically final, so that supervisors can trust the distributed ledger’s data. The paper concludes with a discussion of the legislative and operational requirements that would promote low-cost supervision and a level playing field for small and large firms.

Suggested Citation

  • Raphael A. Auer, 2022. "Embedded Supervision: How to Build Regulation into Decentralised Finance," CESifo Working Paper Series 9771, CESifo.
  • Handle: RePEc:ces:ceswps:_9771
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    File URL: https://www.cesifo.org/DocDL/cesifo1_wp9771.pdf
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    References listed on IDEAS

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    1. Auer, Raphael & Tercero-Lucas, David, 2022. "Distrust or speculation? The socioeconomic drivers of U.S. cryptocurrency investments," Journal of Financial Stability, Elsevier, vol. 62(C).
    2. Raphael Auer & Stijn Claessens, 2018. "Regulating cryptocurrencies: assessing market reactions," BIS Quarterly Review, Bank for International Settlements, September.
    3. Thomas Philippon, 2015. "Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation," American Economic Review, American Economic Association, vol. 105(4), pages 1408-1438, April.
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    9. Raphael A. Auer & Giulio Cornelli & Jon Frost, 2020. "Rise of the Central Bank Digital Currencies: Drivers, Approaches and Technologies," CESifo Working Paper Series 8655, CESifo.
    10. Cyril Monnet & Hyun Song Shin & Jon Frost & Leonardo Gambacorta & Raphael Auer & Tara Rice, 2022. "Central Bank Digital Currencies: Motives, Economic Implications, and the Research Frontier," Annual Review of Economics, Annual Reviews, vol. 14(1), pages 697-721, August.
    11. David Yermack, 2015. "Corporate Governance and Blockchains," NBER Working Papers 21802, National Bureau of Economic Research, Inc.
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    13. Douglas Arner & Raphael Auer & Jon Frost, 2020. "Stablecoins: risks, potential and regulation," Revista de Estabilidad Financiera, Banco de España, issue Autumn.
    14. Douglas Arner & Raphael Auer & Jon Frost, 2020. "Stablecoins: potential, risks and regulation," BIS Working Papers 905, Bank for International Settlements.
    15. Jon Frost & Hyun Song Shin & Peter Wierts, 2020. "An early stablecoin? The Bank of Amsterdam and the governance of money," Working Papers 696, DNB.
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    17. Iñaki Aldasoro & Torsten Ehlers & Egemen Eren, 2018. "Business models and dollar funding of global banks," BIS Working Papers 708, Bank for International Settlements.
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    Citations

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    Cited by:

    1. Tim Weingärtner & Fabian Fasser & Pedro Reis Sá da Costa & Walter Farkas, 2023. "Deciphering DeFi: A Comprehensive Analysis and Visualization of Risks in Decentralized Finance," JRFM, MDPI, vol. 16(10), pages 1-25, October.
    2. Raphael Auer & Marc Farag & Ulf Lewrick & Lovrenc Orazem & Markus Zoss, 2022. "Banking in the shadow of Bitcoin? The institutional adoption of cryptocurrencies," BIS Working Papers 1013, Bank for International Settlements.
    3. Impenna, Claudio, 2023. "The Crypto Ecosystem: Prospects and Challenges for Regulators," Economia Internazionale / International Economics, Camera di Commercio Industria Artigianato Agricoltura di Genova, vol. 76(3), pages 297-310.
    4. Guerino Ardizzi & Marco Bevilacqua & Emanuela Cerrato & Alberto Di Iorio, 2023. "Making it through the (crypto) winter: facts, figures and policy issues," Temi di discussione (Economic working papers) 38, Bank of Italy, Economic Research and International Relations Area.
    5. Nedyalko Valkanov, 2022. "Alternative Finance in the New Digital World - Some Regulatory Challenges," Izvestia Journal of the Union of Scientists - Varna. Economic Sciences Series, Union of Scientists - Varna, Economic Sciences Section, vol. 11(2), pages 29-38, August.

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    More about this item

    Keywords

    decentralised finance; DeFi; tokenisation; asset-backed tokens; stablecoins; crypto-assets; cryptocurrencies; CBDC; regtech; suptech; regulation; supervision; Basel III; proportionality; blockchain; distributed ledger technology; digital currencies; proof;
    All these keywords.

    JEL classification:

    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • D20 - Microeconomics - - Production and Organizations - - - General
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law
    • K24 - Law and Economics - - Regulation and Business Law - - - Cyber Law
    • L10 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - General
    • L50 - Industrial Organization - - Regulation and Industrial Policy - - - General
    • M40 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - General

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