Waller makes case for DeFi as complement to traditional finance

Andrew Harrer/Bloomberg

Federal Reserve Board Gov. Christopher Waller said decentralized finance works best as a complement to existing financial processes, instead of a replacement.

"Intermediation is still valuable for the average person, and we see this by the existence of trading exchanges in the crypto world," Waller said. "All these platforms involve giving custody of one's crypto-assets to an intermediary, who conducts trades on behalf of the client … reintroduc[ing] the need for trust in these platforms just as trust is needed in modern banking systems."

In the remarks, which he delivered to the Vienna Macroeconomics Workshop at the Institute of Advanced Studies on Friday, Waller contemplated the benefits and potential risks associated with DeFi technology. 

Waller said today's centralized finance comes with several flaws. Traditional transactions rely on intermediaries like banks or brokers, which not only require trust but also drive up costs with their fees for matching buyers with assets.

"Centralized finance requires a substantial amount of trust," he said. "The next wave of innovations in financial market trading could be driven by technological advances that alleviate some potential drawbacks of the centralized approach."

He said technologies like distributed ledger technology — known as DLT — tokenization of real-world assets and smart contracts can simply be used alongside existing systems to improve efficiency in centralized finance. Several financial institutions, he said, are exploring DLT for 24/7 repo trading.

"The technologies are allowing for individuals to trade assets without giving up control of those assets to an intermediary — a critical distinction with centralized finance," he said. "However, there are other uses emerging from these technologies that look more like complements to centralized finance."

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Waller also discussed the potential use cases for stablecoins, emphasizing that they allow buyers and sellers to engage in transactions using the digital asset as the settlement tool. He referred to stablecoins as a form of digital currency that can be more easily used across different jurisdictions without the need for a payment intermediary, potentially lowering global payment costs. However, the Fed official cautioned that they could pose some financial systemic risks.

"History is replete with cases in which synthetic dollars became subject to runs. Stablecoins thus face all of the same issues any substitute for genuine U.S. dollars faces," he said. "If appropriate guardrails can be erected to minimize run risk and mitigate other risks, such as their potential use in illicit finance, then stablecoins may have benefits in payments and by serving as a safe asset on a variety of new trading platforms."

He also contemplated whether DeFi technology — which often provides users anonymity — could pose compliance risks like enabling money laundering. Waller said regulators should take a look at whether new rules are needed that compel firms to identify customers involved in DeFi transactions, like those banks in traditional finance face. 

"In centralized finance, there are regulations that require banks to know who their clients are," Waller said. "Are similar rules and regulations needed around some of these new technologies? When it comes to our financial plumbing, which affects every person or business in one way or another, I think a balanced view of expeditious disruption and long-term sustainability is merited."