Crypto Assets and Decentralized Finance: Their Functions and Impact on Financial Stability

Authors: Matteo Aquilina, Giulio Cornelli, Jon Frost and Leonardo Gambacorta

Compiled by: Yan Zilin

In April 2025, BIS published the article "Cryptocurrencies and decentralised finance: functions and financial stability implications", which explores the role of cryptocurrencies and decentralized finance (DeFi) in replicating the core economic functions of traditional finance (TradFi). It also analyzes the financial stability risks posed by its unique mechanism. The paper systematically reviews key developments such as smart contracts, decentralized exchanges (DEXs), stablecoins, and central bank digital currencies (CBDCs), and points out that while its underlying economic drivers are similar to those of traditional finance, DeFi has given rise to new issues such as information asymmetry, market failure, and "crypto" in emerging markets. The authors propose that regulation should be differentiated, such as embedding rules in smart contracts and strengthening the supervision of stablecoins, to mitigate systemic risks. At the same time, the paper constructs a prudential regulatory framework that aims to promote innovation while maintaining the stability of the financial system. The study also highlights future research directions such as the enhanced linkage between DeFi and TradFi, the macro impact of "crypto" in emerging economies, and the protection of DeFi market participants. The core part of the research has been compiled by the Institute of Financial Technology of Chinese Minmin University.

1. Introduction

Blockchain is regarded as a key innovation in the security of digital data. Although this concept has been around for decades, the first public blockchain was created in 2008 by an individual or group using the pseudonym "Satoshi Nakamoto." Its official birthday is October 31 of that year, the date the Bitcoin whitepaper was released. Two months later, the Bitcoin system officially went live, and its first block is known as the "genesis block." Since then, crypto assets have gone through several cycles of market boom and bust, with some early participants accumulating significant wealth, while most retail investors have suffered substantial losses.

Although crypto assets have not yet fully realized their original payment function, significant progress has been made since their inception. Several new blockchains have emerged, and thousands of crypto assets have been built on them. The emergence of the Ethereum blockchain in 2015 is regarded as a key technological breakthrough, enabling developers to deploy decentralized software applications, allowing users to access financial services such as trading and lending without intermediaries. This series of services is collectively referred to as decentralized finance (DeFi).

With the development of crypto assets and DeFi, regulators in various countries and international organizations are gradually beginning to address the challenges posed by them. Initially, due to the small scale of the crypto market, policy responses were mainly limited to warnings about its speculative nature. However, in recent years, as the market has expanded and its connections with the traditional financial system (TradFi) have deepened, policy interventions have gradually increased. At the international level, institutions such as the Bank for International Settlements (BIS), Financial Stability Board (FSB), International Monetary Fund (IMF), and International Organization of Securities Commissions (IOSCO) have released multiple reports and proposed regulatory recommendations. At the national level, regulators are also becoming increasingly proactive, beginning to formulate specific policies to address the growth of crypto and DeFi.

The purpose of this chapter is to explain the financial functions that cryptoassets and DeFi are trying to achieve, covering blockchain, cryptoassets, DeFi applications, stablecoins, and new central bank currencies, and to build a conceptual framework for assessing their financial stability implications, and to point out that the existing traditional financial regulatory framework can be adapted to such innovations. In addition, the need for prudential regulation of crypto assets is discussed, especially in the context of their linkage with the traditional financial system or the need to directly address DeFi risks, and a forward-looking assessment of future research directions is made.

II. Crypto Innovation and Its Financial Functions

1. The operating mechanism of blockchain and cryptocurrency assets and their usage characteristics

Blockchain aims to reduce reliance on centralized institutions for transaction verification by combining cryptography with economic incentive mechanisms. Its essence is a "write-once" distributed database that continuously records ordered data blocks, maintained collaboratively by certain network participants (such as miners or validators) to uphold data integrity. Each node holds a complete copy of the blockchain, ensuring network decentralization.

In traditional banking systems, fund transfers rely on intermediaries to complete account verification and fund allocation; whereas in blockchain systems, transactions are submitted by users to a pending transaction pool and broadcast to the entire network. Network participants compete to add new blocks by solving computationally intensive cryptographic puzzles. Once a node successfully validates and writes a new block, other nodes can quickly verify and update their local ledgers, achieving network consensus. The new block contains the cryptographic hash of the previous block, forming a chain structure that ensures any tampering requires consensus from the entire network, thus guaranteeing data irreversibility and resistance to tampering. To incentivize nodes to participate in this resource-intensive process, the system offers newly issued cryptocurrencies or transaction fees paid by users as rewards.

Although the initial goal of cryptocurrency was to serve as a means of payment, its payment function has not yet been widely realized. In reality, very few households use cryptocurrency for goods or services payments. In contrast, the role of cryptocurrency in speculative activities is more significant. The dramatic price fluctuations attract a large number of investors seeking high returns, especially during price increases, where the frequency and number of users using cryptocurrency trading platforms significantly increase, showing a strong correlation between price trends and investor activity. Overall, crypto assets have primarily been used for high-risk investments rather than daily payments.

2. The Structure and Function of Decentralized Finance

After the birth of the Bitcoin blockchain, the crypto ecosystem rapidly expanded. The initial significant advancement was the rise of cryptocurrency exchanges, allowing users to exchange Bitcoin for fiat currency, attracting a large number of new users and driving price volatility. Subsequently, Ethereum was launched in 2015, with its core innovation being the introduction of "smart contracts," enabling developers to deploy decentralized applications on the chain and achieve automated trade execution triggered by conditions. This mechanism facilitated the formation of the decentralized finance (DeFi) ecosystem.

The technical architecture of DeFi can be divided into four levels: blockchain, smart contracts, protocols, and decentralized applications (Dapps). Among them, protocols are composed of multiple smart contracts, serving specific purposes such as decentralized trading, lending, asset management, etc.; while Dapps provide users with an intuitive interface, simplifying interaction with protocols, and serve as the actual access point in the DeFi system.

DeFi systems attempt to replicate six core functions of traditional finance: payment settlement, capital aggregation, intertemporal resource allocation, risk management, price discovery and information integration, and mitigating incentive asymmetry issues. For example, decentralized exchanges (DEXs) support asset trading without intermediaries, simulating the price discovery function of markets; lending protocols provide capital allocation through over-collateralization; asset management platforms and yield farming enable users to invest collectively and arbitrage across multiple platforms, replicating the fundraising and asset allocation mechanisms of traditional finance; in addition, derivatives and insurance protocols correspond to risk management functions.

However, despite DeFi structurally mimicking traditional finance, its role in the real economy remains very limited. Currently, DeFi almost entirely serves the internal needs of the crypto ecosystem and has not effectively supported financing for the real economy, risk hedging, or the commercialization of innovative products. At the same time, DeFi activities are highly speculative, with users primarily participating in trades with the goal of profiting from token appreciation. This characteristic of "self-circulation" restricts its functional extension and highlights the gap between it and traditional finance in terms of actual efficacy and economic connections.

3. Evaluation of Types and Functions of Stablecoins

Stablecoins are a class of cryptocurrencies designed to achieve a 1:1 exchange rate with fiat currencies such as the US dollar, aiming to provide redeemability on demand. Due to their price stability, stablecoins are often viewed as safer than unsecured cryptocurrencies and are widely promoted as a key medium of exchange within the crypto ecosystem.

According to the different mechanisms for maintaining parity, stablecoins can be divided into three categories:

The first category is fiat-backed stablecoins, such as Tether and USD Coin, which dominate the market. These stablecoins use short-term dollar-denominated assets (such as U.S. Treasury bonds, high-grade commercial paper, repurchase agreements, and bank deposits) as reserves, and their asset structure is highly similar to that of money market funds (MMFs).

The second type is crypto-asset-backed stablecoins, such as Dai, which use cryptocurrencies rather than fiat currencies as collateral to maintain their pegged value. Among them, "decentralized stablecoins" rely on smart contracts to automatically manage crypto collateral.

The third category is algorithmic stablecoins, such as the now-collapsed TerraUSD, which achieve price anchoring by algorithmically adjusting the token supply. However, in practice, this mechanism is vulnerable to shocks from fluctuations in market confidence, posing significant systemic risks.

Although stablecoins are often promoted as tools to facilitate cross-border payments and avoid high fees in traditional systems, in reality, they serve more as entry tools into the DeFi and crypto markets. Furthermore, there is no conclusive evidence to support their "safe-haven asset" function. Recent studies have shown that over 90% of fiat-backed stablecoins also experience capital outflows when faced with shocks in the crypto market and U.S. monetary policy, indicating that they cannot provide effective risk mitigation during market turbulence.

4. The Development and Design of New Central Bank Digital Currencies

In addition to stablecoins, central bank digital currencies (CBDCs) are also being rapidly promoted globally as a new type of digital payment tool. CBDCs are denominated in the national currency and constitute a direct liability of the central bank, and can be viewed as a digital form of physical cash or commercial bank reserves.

CBDC is mainly divided into two categories: the first is wholesale CBDC, used for transactions between financial institutions, some of which adopt distributed ledger technology (DLT) and tokenization, and can be seen as "tokenized central bank reserves"; the second is retail CBDC, aimed at the public (households and businesses), functionally similar to electronic cash. Unlike existing electronic money, retail CBDC is directly backed by the central bank, providing a higher level of credit security.

Currently, only three countries, the Bahamas, Nigeria, and Jamaica, have officially launched retail CBDCs, while over 25 countries have entered the pilot stage. Research has found that economies with high mobile technology penetration and strong innovative capabilities tend to advance their CBDCs further; retail CBDCs are more likely to be implemented in countries with a large informal economy, while wholesale CBDCs are positively correlated with the overall level of financial development.

In terms of design, CBDC reflects diversity. First, in terms of system architecture, most countries tend to prefer a "hybrid" or "dual-layer architecture" model, where the central bank issues and maintains the ledger, while private institutions are responsible for customer interface services; a few countries are exploring a "direct" architecture, suitable for inclusive finance goals. Second, the infrastructure can adopt traditional centralized databases or distributed ledger technology, with most central banks leaning towards solutions that balance efficiency and fault tolerance. Third, in terms of access mechanisms, central banks weigh between "account-based" and "token-based" systems, with most exploring account-based or hybrid models: small transactions can be used anonymously, while larger ones require identity verification. Finally, the design for cross-border use is also receiving increasing attention, with more and more projects beginning to consider scenarios involving non-residents and cross-border payments.

Overall, the development of CBDCs demonstrates that regulatory agencies are actively positioning themselves to improve payment efficiency, enhance monetary sovereignty, and adapt to digital trends. The design choices also reflect a comprehensive consideration of technicality, flexibility, and policy objectives.

III. The Theoretical Basis for Prudent Regulation of Cryptocurrencies and Decentralized Finance

The classic basis for market regulation in economic theory lies in the existence of "market failure", which means that the market's own operating mechanism cannot achieve optimal resource allocation and requires policy intervention to enhance overall efficiency. This is especially true for financial markets, as they heavily depend on information symmetry, trust mechanisms, and system stability. Once these conditions are undermined, the market may produce severe externalities, which can in turn impact the entire economy.

This regulatory logic also applies to emerging financial intermediaries such as DeFi. Although DeFi systems adopt innovative architectures, they still face various potential market failures during operation, including but not limited to information asymmetry, distorted incentive mechanisms, and systemic externalities. For this reason, the cryptocurrency finance sector also needs to implement corresponding prudent regulation to mitigate the risks brought about by these failures, prevent individual behaviors from evolving into systemic shocks, and maintain the stability of the entire financial system.

1. Externality

Externalities refer to the costs or benefits generated by a transaction that affect third parties not involved in the transaction. In financial markets, negative externalities can be extremely severe, even leading to a complete failure of the financial intermediation mechanism. Information issues are an important source of externalities, manifested in the insufficient information held by market participants to support rational decision-making, or the asymmetry of information held by one party before and after the transaction compared to the other party.

A typical form of externality in financial markets is the "contagion of defaults": when one party defaults, its counterpart may also become unable to fulfill its obligations due to incurred losses, leading to systemic instability. Due to the central role of the financial system in resource allocation, such chain defaults may spread to the real economy, for example, causing a sharp reduction in credit supply, which in turn suppresses economic growth. More importantly, this damage often affects entities that are originally unrelated to the initial default event, causing them to bear external costs. It is precisely because default costs can be externalized that financial institutions often face misaligned incentives, tending to take on higher risks.

Recent volatility events in the financial markets indicate that chain defaults are not the only channel generated by externalities. A large number of non-bank financial intermediaries may also become sources of instability, especially during the deleveraging process, where their asset liquidation may trigger a downward price spiral, creating what is known as "monetary externalities."

Systemic externalities are widely present in various functions of the financial system, especially in payment clearing and cross-period resource allocation functions. If the former fails, it will have a chain reaction on other links in the financial system; the latter is more likely to trigger contagion effects during defaults due to the high interconnectivity of credit relationship networks. Although DeFi has introduced smart contracts and atomic settlement mechanisms, which have reduced certain types of externality risks to some extent, important participants in the system (such as stablecoins and their issuers) may still become transmission nodes of systemic risk, warranting regulatory attention.

2. Information Issues

Information issues are widespread in financial markets, primarily reflected in two situations: insufficient information and information asymmetry. These problems are particularly prominent in the fields of crypto assets and decentralized finance (DeFi), severely hindering the effective operation of the market and the rational allocation of resources.

2.1. Insufficient information

Insufficient information refers to the lack of key information necessary for market participants to make rational decisions, which may stem from companies lacking disclosure motivation or from the complexity of financial products themselves. Many financial products have multidimensional attributes, and their true quality often takes a long time to manifest. In DeFi, similar issues are particularly evident. For example, the operation of smart contracts relies on specific input conditions, and their behavior undergoes dynamic adjustments as economic environments change, making it difficult for users to predict their future performance. At the same time, investors know almost nothing about the background, technical capabilities, or behavioral motivations of the development teams behind Dapps. Even if information is disclosed, its authenticity and verifiability are hard to assess.

Another information challenge arises from the use of "oracles". Oracles are responsible for bringing off-chain real-world data onto the blockchain for smart contracts to use. However, whether or not oracles truly adhere to the principles of decentralization is still a matter of debate. A fully decentralized oracle system may introduce lengthy and complex consensus mechanisms, which could reduce transaction efficiency and increase the computational burden on the system, ultimately harming overall performance.

2.2. Information Asymmetry

Information asymmetry can lead to a decline in market efficiency, such as reduced output, decreased product quality, and even market crashes. In the DeFi ecosystem, product innovation is rapid and structures are complex, making it difficult for users to effectively distinguish between various service providers based on quality, resulting in the prolonged existence of low-quality products and even fraudulent projects. Although prices and transaction data on the blockchain are transparent, consumers still face challenges such as a lack of historical information, difficulty in tracking developer reputations, a lack of systematic disclosure documents, and insufficient means for effective product comparison.

In addition, many DeFi applications are governed by decentralized autonomous organizations (DAOs), whose internal structures are complex and responsibilities are unclear, making it difficult for external users to identify who holds substantial decision-making power, who is accountable for governance outcomes, or who possesses information advantages beyond those of regular users. This further exacerbates the problem of information asymmetry, undermines the foundation of market trust, and increases systemic risk.

3. Mechanisms for Mitigating Market Failure

The existence of market failure does not necessarily imply the necessity of regulatory intervention. In certain situations, the market mechanism itself can mitigate the impact of failure through technological innovation or structural adjustments, or the failure itself may have a minimal impact, making systematic intervention unnecessary. Therefore, the necessity for regulatory intervention should be comprehensively judged in conjunction with market functions, types of failure, and existing mitigation measures.

From the perspective of economic function, DeFi and traditional finance (TradFi) face similar regulatory motivations in many aspects, such as systemic externalities, insufficient information and asymmetry, but there are significant differences in the coping mechanisms between the two. In terms of payment and clearing, TradFi mitigates risks through prudential supervision, deposit insurance, and the role of the central bank lender of last resort, while DeFi can achieve instantaneous liquidation, but it lacks an effective protection mechanism for systemic assets such as stablecoins. In terms of capital aggregation and allocation, TradFi relies on mandatory information disclosure and fiduciary intermediaries to protect investors' rights and interests, while DeFi mainly relies on smart contracts and voluntary disclosure (such as white papers), and the quality and transparency of information are generally low. In terms of credit function and risk management, TradFi focuses on prudential supervision, regulatory reporting and central guarantee mechanisms, while DeFi relies on over-collateralization and on-chain mechanisms for risk control, but lacks systematic credit assessment and legal enforcement mechanisms. In terms of price information aggregation and incentive constraints, although DeFi can achieve a certain degree of information integration through on-chain contracts, in practice, the selective disclosure of information is serious and the quality control mechanism is lacking.

3.1. Externalities and Systemic Risk

Market mechanisms have limited ability to correct externalities, especially when private and social incentives are misaligned. Therefore, TradFi relies on public authority intervention to stabilize the system through prudent regulation, risk management requirements, deposit insurance, and central bank intervention. In DeFi, the mechanisms of stablecoins (especially algorithmic stablecoins) are weak, leading to multiple instances of crashes that pose a risk of contagion to the system.

Moreover, the high level of anonymity in DeFi reduces the reputational constraints on participants, enhancing the motivation for high-risk behavior. Lending relationships rely on highly volatile collateral, lacking a credit mechanism for borrowers. Once the market declines, it triggers automatic liquidation, leading to synchronous depreciation of collateral assets on other platforms, creating "price externalities" and a systemic feedback loop. The high composability among DeFi protocols further exacerbates network fragility, where the failure of localized nodes can produce amplifying effects across multiple networks, causing broader systemic shocks.

3.2. Information Issues and Disclosure Mechanism

Although blockchain itself has a certain degree of information transparency, DeFi systems still have significant shortcomings in alleviating information issues. First, accessible information does not mean it is understandable or usable. Information disclosure needs to be structured and standardized to help users make rational judgments. However, the form of disclosure in DeFi is often voluntary and non-standardized "white papers," which are mostly marketing materials, lacking authenticity guarantees and comparability. Moreover, the information on project websites often severely contradicts the terms actually accepted by users.

Secondly, there are significant gaps in off-chain information in DeFi, such as developer identities, technical backgrounds, and compliance records, which are often concealed, making it difficult for users to assess their credibility or behavioral motivations. In more extreme cases, such as "rug pulls," developers abscond with funds after issuing tokens. While such incidents also exist in TradFi, at least users can pursue legal recourse; however, in DeFi, due to anonymity and cross-border characteristics, accountability is nearly impossible, significantly amplifying the risks of information asymmetry.

In summary, although the DeFi system introduces new risk mitigation mechanisms in certain aspects (such as atomic settlements, smart contract execution, etc.), it still falls short in areas such as information disclosure, risk sharing, governance structure, and externality control, necessitating the urgent design of a regulatory intervention framework that adapts to its structural characteristics.

4. Conceptual Framework of Financial Stability Impact

As pointed out earlier, the regulatory logic of traditional finance (TradFi) also applies to decentralized finance (DeFi). However, there is an active debate in academia and among regulators regarding the challenges posed by crypto assets, with the core issue being how to correct market failures without stifling potential innovation while effectively reducing the risks for market participants and the entire financial system. Aquilina, Frost, and Schrimpf (2024b) summarize the current response strategies into three high-level pathways: "prohibition," "isolation," and "regulation."

The "ban" strategy is mainly advocated by those who believe that crypto assets and DeFi have almost no practical value and pose significant risks to the financial system and consumers. However, this section focuses on the two strategies of "isolation" and "regulation" because a comprehensive ban is neither feasible nor aligned with interest considerations. The ban strategy is difficult to implement, partly because the global nature of crypto assets allows the industry to easily move to jurisdictions without bans; at the same time, some crypto technologies and DeFi applications do indeed contain beneficial innovative potential and have future application value.

The "isolation" strategy aims to separate the risks of the traditional financial system from those in the cryptocurrency space. Some supporters argue that regulators should "let crypto assets live or die on their own," avoiding granting legitimacy through regulation (Cecchetti and Schoenholtz, 2022a); while the Basel Committee on Banking Supervision (BCBS, 2022), which is under the Bank for International Settlements, is more concerned with preventing spillover risks from the crypto ecosystem to the traditional financial system.

The "regulatory" strategy advocates for the adoption of a regulatory framework similar to traditional finance to address the aforementioned market failures (Makarov and Schär, 2022). To explore how to deploy the "isolation" and "regulatory" strategies, we can start from the four transmission channels of DeFi to the real economy identified by the Financial Stability Board (FSB, 2023a): (1) the exposure of financial institutions to crypto assets, related financial products, and the real economy affected by crypto assets; (2) confidence effects; (3) the wealth effect brought about by the volatility of crypto asset market capitalization; (4) the degree of use of crypto assets in payment and settlement.

In addition, it is worth noting the potential applications of smart contracts in traditional finance, the risks of cryptoisation for emerging markets and developing economies (EMDEs), and how to protect the interests of DeFi market participants even in the absence of significant spillover effects. These factors jointly constitute the key issues in building an effective regulatory and risk isolation framework.

1. The relationship between crypto assets and traditional finance and the real economy

Currently, the connection between crypto assets and decentralized finance (DeFi) with traditional finance (TradFi) and the real economy is relatively limited, but it has increased in recent years and may continue to expand in the future. In 2024, the U.S. Securities and Exchange Commission approved Bitcoin and Ethereum-related ETFs, facilitating investor participation and deepening the relationship between banks, brokers, and the crypto market.

The tokenization of real assets will also promote the development of this connection, allowing more assets to be digitized and traded in DeFi, while traditional financial institutions and infrastructures, such as decentralized exchanges, may gradually integrate into the mainstream financial system. This will not only expand the existing connections but may also create new risks and transmission channels. For example, the 2023 U.S. banking sector stress event was partly due to the banks' indirect exposure to large players in the crypto market.

In terms of prudent regulation, an "isolation" strategy should be adopted to prevent the risks of crypto assets from spreading to traditional finance and the real economy. Financial institutions, especially banks, need to establish a sound risk management mechanism, paying attention to price volatility and potential liability risks. In addition, blockchain applications in non-financial areas such as supply chain management should also have the capability to respond to system interruptions and cybersecurity risks.

As the integration of crypto assets with traditional finance and the real economy deepens, the relevant regulatory rules should align with traditional finance, including information disclosure, customer identification, and professional qualification requirements. Regulatory agencies need to obtain sufficient resources and legal authority. Ensuring that the traditional financial system and the real economy can effectively respond to the shocks brought by crypto assets is key to reducing overall economic risks.

2. The risks of cryptocurrency assets replacing fiat currency

In emerging markets and developing economies (EMDEs), cryptocurrencies may replace local currencies for real and financial transactions, a phenomenon known as "cryptoisation," similar to dollarization and euroization. Due to high inflation or a lack of trust in local currency in some regions, residents and businesses tend to hold more stable currency assets or borrow in foreign currency to enjoy lower interest rates. However, this may lead to macroeconomic issues, such as a weakened transmission mechanism of monetary policy, economic growth and inflation being constrained by foreign monetary policy, and the risk of surging foreign currency liabilities due to local currency depreciation.

The risks of assetization of cryptocurrencies may even exceed those of dollarization and euroization. The widespread use of cryptocurrencies as a means of payment or store of value could lead to macroeconomic instability and inefficiencies. In extreme cases, such as Venezuela and Zimbabwe, hyperinflation has prompted users to view cryptocurrencies as an alternative to local currencies. The price volatility of crypto assets can be severe; if a large number of everyday transactions are conducted using cryptocurrencies, it may lead to drastic fluctuations in price levels and inflation, with economic performance influenced by global market speculative demand rather than domestic fundamentals. The case of El Salvador attempting to adopt Bitcoin as legal tender in 2021 illustrates that there are significant challenges associated with such practices (Alvarez et al., 2022).

In fact, cryptocurrency adoption in some emerging markets has surpassed that of developed countries. Chainalysis (2024) data shows that India, Nigeria, and Indonesia have the highest rates of cryptocurrency usage. Local users may engage in actual transactions to hedge against the existing financial system and local currency risks, or they may speculate. Most of the stablecoins used are denominated in US dollars or euros, which has created a new channel for dollarization and euroization. Once cryptocurrencies or stablecoins are widely used for real-world transactions, fluctuations in any underlying asset can have a pass-through effect on the overall economy. As a result, regulators may restrict the use of cryptocurrencies through regulations, capital controls, and tax measures to reduce risk.

3. Protecting market participants in the decentralized finance (DeFi) ecosystem

With the rapid growth of the number of DeFi investors and the scale of funds, regulatory agencies are increasingly focused on investor protection. Regulation should be based on the economic functions achieved by DeFi protocols, identifying specific activities and entities, formulating corresponding rules, and taking into account the decentralized characteristics of DeFi. The focus should be on the entities that actually control DeFi protocols and the decentralized applications (Dapps) that retail users mainly interact with.

Regulation can rely on two pillars: first, rules similar to traditional finance, requiring the disclosure of off-chain information, setting minimum standards for products and services, and professional qualification requirements for practitioners (such as developers and management teams); The second is to use the automatic execution function of on-chain information and smart contracts to directly embed some regulatory rules into smart contracts to achieve automatic compliance, such as ensuring the "best execution" of transaction prices, information disclosure, etc.

In addition, regulators should focus on the overall stability of the crypto ecosystem, particularly the role of stablecoins. As the core of value transfer in the crypto market, the ability of stablecoins to maintain their peg to the US dollar is crucial, which requires strict regulation on the types of assets backing stablecoins and their operational mechanisms, ensuring that redemption can be achieved even under market pressure.

Consumer protection is equally important. Data shows that retail investors often chase short-term gains during market volatility, and trading activity actually increased during the price crash in 2022, while large holders ("whales") were selling, and ordinary retail investors ("krill") were buying, reflecting a trend of wealth shifting from small investors to large investors, revealing that the crypto market is not entirely inclusive and stable, but may actually exacerbate wealth inequality.

5. Conclusion

This chapter analyzes the economic functions of cryptocurrencies and decentralized finance (DeFi), and compares them with traditional finance (TradFi). The results indicate that the fundamental economic drivers of DeFi are no different from those of traditional finance, but its unique features—such as smart contracts and composability—bring new challenges that require proactive regulatory intervention to maintain financial stability while promoting innovative development.

As the DeFi ecosystem continues to evolve, the following areas deserve in-depth study. First of all, the interaction between DeFi and traditional finance needs to be paid more attention, especially in the context of the tokenization of real assets, the application of smart contracts in traditional finance and the emergence of new forms of digital intermediation. Second, the role of stablecoins in supporting DeFi growth and the risks posed by their instability also need to be analyzed in depth, including the assessment of the stability of the DeFi ecosystem itself and its potential spillovers to traditional finance, and it is particularly important to establish a robust evaluation framework. Third, the regulatory implications of fully decentralized protocols and decentralized autonomous organizations (DAOs) are still open issues, and it is necessary to study how DAO governance structures affect financial stability and how regulators respond to truly decentralized systems. Finally, it is necessary to fully understand the macroeconomic impact of cryptocurrency in emerging market and developing economies (EMDEs), and explore how to prevent the risks of widespread adoption of cryptocurrencies through central bank digital currencies, capital controls, and tax policies, while promoting technological innovation.

These research directions are of great significance for building a secure and inclusive future financial system.