The relationship between DeFi and monetary policy

Analysts at Bloomberg Economics have noticed that the Group of Seven (G7) countries tend to similarly tighten their monetary policies. The study found that central banks are eliminating assets and raising interest rates. In the past, the US Federal Reserve was the only central bank to lower its balance sheet; this time, however, other central banks may do the same. In order to combat growing inflation, the world's central banks had been planning to reduce the size of their balance sheets by as much as $410 billion as of 2022. However, the cryptocurrency markets may struggle to adjust to the new realities of monetary policy, which could result in a decrease in market values as a negative side effect of this decision.

The potential impact of a change in monetary policy on DeFi

Central banks are giving up on quantitative easing to fight inflation; still, the financial markets are feeling the pain of the change. "This is a major financial shock for the world," said Alicia Garcia Herrero, head economist at Natixis, adding, "You are already seeing the effects of tapering in the form of less money in the dollar market and a stronger dollar." The new moves by central banks also affect the markets for cryptocurrencies and DeFi and even though MicroStrategy and the Luna Foundation Guard bought Bitcoin (BTC), prices and other cryptocurrencies have not reacted. Is this evidence that crypto and traditional financial markets are becoming more comparable? Meanwhile, Defi Pulse has stated that “the total value locked (TVL) in DeFi projects is $75 billion, down from a high of $87 billion in February." 

Source: ethereum.org

How expansionary monetary policies affect total values locked in on Defi protocols

Expansionary monetary policy is a way for central banks to help the economy grow by raising the amount of money in circulation. The strategy is to lower interest rates and put more money into the economy and this increases the desire for goods and services, which makes the economy grow. Decentralised finance (DeFi) is a financial system built on decentralised blockchain technology and works without the involvement of banks or other controlled bodies. However, there are some DeFi platforms such as Swarm which are regulated so traditional firms are able to use DeFi products and services.

What expansionary monetary and fiscal policies entail

Expansionary fiscal policy is when the government uses budget tools to increase the money in the economy by spending more or cutting taxes. This gives consumers and businesses more money to spend which, in turn, helps the economy grow. They are macroeconomic strategies that central banks use to boost economic growth and speed up the rate of money growth in their own countries. These measures raise the amount of money in circulation, lower interest rates and boost demand - all of which also help the economy grow. Three ways the Federal Reserve in the US uses to make money more available are:

·       lowering interest rates

·       increasing the money supply 

·       decreasing reserve requirements

When an economy is contracting or in a recession, expansionary monetary policies are used to encourage people to spend more and for businesses to put more in the capital. The Federal Reserve is the United States central bank and uses various tools to adopt expansionary monetary strategies that help the economy grow, such as:

·       open market operations

·       discount rates

·       reserve requirements

Buying government bonds as part of open market operations boosts the money supply and reduces interest rates. The Federal Reserve charges the banks discount rates when they borrow money from it. By cutting these rates, banks are more likely to borrow more money which increases the amount of money in circulation. Reserve rules refer to how much money banks have to keep on hand and when these reserve rules are lowered, more money is available for loans. This, in turn, increases the amount of money in the economy and helps it grow. The main goal of expansionary monetary policies is to increase the amount of money in circulation, make it easier to borrow money and urge people to spend and invest - all of which can help the economy grow.

What are the standards for DeFi?

DeFi protocols are independent, specialised programs meant to address some of the challenges in existing financial markets such as slow transaction, high fees, counterparty risks, lack of transparency, fat finger (human) errors and the plethora for intermediaries. These methods use blockchain technology to make a financial system more inclusive without needing permission from a central authority. DeFi protocols are important because they give us an alternative and decentralised option to the centralised banking systems we are used to. Instead of depending on centralised intermediaries, DeFi protocols use smart contracts, decentralised apps (dApps) and peer-to-peer networks to make financial transactions and services such as loans, borrowing, trading and investing, clearer and safer. According to a Statista analysis chart, as of May 2022 the total value locked (TVL) in DeFi projects was about $77 billion and now currently stands at around $48 billion. DeFi protocols also make obtaining financial services easier because anyone with access to the internet can use them; this differs from traditional finance which can be limited by geography or social class. The rise of DeFi has also led to new ideas in the crypto space and is seen as a possible threat to the traditional financial industry. DeFi protocols are essential because they enable a wide range of financial services without standard financial companies. These protocols give people more power over their finances and access to financial services they might not have had before. Also, DeFi methods can help get more people involved in the global financial system even if they do not have access to regular banking services.

The link between Defi and monetary measures

This new, open financial system offered by DeFi aims to give people more control over their money and reduce the reliance on big financial companies. Protocols such as Aave, Maker and Compound are some of the most popular DeFi protocols and allow one to stake/lock up, grow and mine. Holding a

cryptocurrency in a wallet is called "staking” and is a way to support the running of a blockchain network, with the ‘staker’ being able to earn benefits. For lockups to work, users have to put their cryptocurrency away for a certain amount of time; farming is a way to provide liquidity to DeFi platforms and earn rewards whilst mining is a way to earn rewards by helping to verify transactions on a blockchain network. Expanding the money supply means there are more assets and stake holders to share rewards which could reduce the value of  a unit of capital and total value locked (TVLs) of DeFi systems.

Source: europa.eu

Meanwhile, lower interest rates make DeFi users less likely to give assets to the protocols. Instead, they might buy money at a lower cost, leading to a drop in capital and TVLs. If interest rates go down, the value of stablecoins (often used in DeFi systems) may rise. Stablecoins are typically pegged to a single asset e.g. $, gold or a group of assets, and the stablecoin value is intended to be linked to the assets it is pegged to. But, when interest rates decrease, investors may be more tempted to hold this no income producing asset class because stablecoins typically do not pay any interest when held. In the past, measures that made money easier to borrow have had different effects on DeFi systems. For example, during the COVID-19 pandemic the US Federal Reserve cut interest rates to almost zero which caused DeFi's TVLs to rise as users looked for better yields. But as the pandemic progressed, inflation increased. This made stablecoins less valuable and resulted in people being less interested in borrowing and using DeFi platforms. But it is important to remember that monetary policies that make money easier to borrow are not the only thing that can change DeFi standards. Regulations and changes in the market are two other things that could also affect DeFi protocol capital and TVLs. The instability of the cryptocurrency market is a big part of how the capital and TVLs of DeFi systems are set. For example, if the price of Bitcoin or Ethereum goes down significantly, the value of DeFi systems built on those blockchains could also decrease. In May 2021, there was a big crash in the cryptocurrency market which caused the TVLs of many DeFi systems to drop sharply. Changes in regulations can also affect DeFi systems; an example being in September 2020 when the US Commodity Futures Trading Commission (CFTC) stated that BitMEX, a large DeFi exchange, had broken anti-money laundering and other rules, so causing its TVL to drop significantly. A year later, in September 2021, the US Securities and Exchange Commission (SEC) was looking into Uniswap (a well-known DeFi platform) which caused the value of the Uniswap governance token to fall.

How expansionary monetary policies affect DeFi protocols rests on several things, such as the protocol itself, its assets and the state of the economy. Investors may be more likely to look for better returns in riskier investments such as DeFi protocols if interest rates are lower and this could lead to more investment and liquidity in the DeFi area. Also, a rise in the money supply could lead to inflation, making people keen to invest in alternative asset classes such as DeFi even more - and vice versa. Unexpected changes can cause the price of cryptocurrencies (which historically has been the assets used in DeFi platforms) to be volatile. Investors and users of DeFi must stay informed and learn about DeFi protocols to make more informed investment decisions and minimise risks. It would seem, despite some of the esoteric products and services and outlandish yields that are promoted by some DeFi platforms, that traditional financial services companies are beginning to realise the attractions and benefits that DeFi offers.