BIS highlights DeFi’s role in liquidity; Malaysia eyes CBDC

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The global finance landscape is gradually changing with the advent of a peer-to-peer financial system and the rise of central bank digital currencies (CBDCs), which will be pivotal in transforming the payments and investments sectors.

As decentralized finance (DeFi) continues its ascent to the mainstream, a new report suggests that sophisticated players are receiving a larger share of profits than the majority of retail investors.

The Bank for International Settlements (BIS) undertook the study to examine the state of liquidity providers in decentralized exchanges. According to its 52-page report, the biggest liquidity providers are a small group of market participants with above-average resources.

Liquidity providers provide digital assets to a liquidity pool, earning rewards for their key services on the platform. These market participants can earn rewards from trading fees, native tokens, and a range of incentives to encourage their contribution to the liquidity pool.

In traditional finance, intermediaries in the form of market makers provide the bulk of liquidity, but DeFi democratizes the process, allowing retail investors to play the role of liquidity providers. While retail traders have fulfilled this function to the best of their abilities, the BIS report notes that “sophisticated players” are running the show.

Using data from Uniswap V3, the BIS noted that sophisticated participants provide as much as 85% of liquidity, while retail investors capture less than 20% of the market share.

The report notes that despite the democratization provided by exchanges, certain economic factors require the rise of sophisticated players. Variations in skill levels, specialization, and economies of scale contribute to the dominance of an experienced minority in providing liquidity within the DeFi space.

Sophisticated participants typically post orders in a price range close to the current market price while actively managing their positions. Conversely, retail liquidity providers normally adopt a laid-back approach toward their positions, interacting with them less often.

“These participants submit orders that mimic bids and asks and are able to extract significantly higher profits compared to their unsophisticated counterparts,” read the BIS report. “They also exhibit considerable skill, extracting higher profits during periods of high volatility by capturing a higher share of trading without incurring additional adverse selection.”

A range of differences

According to the report, sophisticated liquidity providers are more likely to target high-volume pools with daily averages above $10 million. On the other hand, retail providers thrive in low-volume pools of $100,000 per day while operating in volatile trading pairs.

The report notes that the latest iteration of Uniswap swung the balance in favor of sophisticated players. Before May 2021, sophisticated liquidity providers contributed only 50% of the action, but by the tail end of 2023, the figure had risen to 85%.

Malaysia tries its hand at CBDC

Malaysia is keen on exploring the pros and cons of rolling out a CBDC for its financial system while ruling out the possibilities of a retail offering.

Bank Negara Malaysia (BNM) is focusing on the potential upsides of a wholesale CBDC for its payment ecosystem as it seeks to catch up with its peers. The banking regulator keeps its eyes peeled on utilities involving interbank settlements and cross-border transactions.

The central bank shared its ambitions at a media briefing on the sidelines of the Digital Payments Media Workshop, drawing attendance from key payment sector stakeholders.

“The key reason for pursuing the initiatives is to generate greater payment efficiency gains, not just in the domestic space but also for cross-border transactions, and to advance greater financial inclusion for Malaysians,” said a spokesperson. 

The focus on a wholesale CBDC for the Southeast Asian country is not far-fetched, with the central bank identifying “greater efficiency gains” in payments. The BNM said that a wholesale CBDC may offer a range of positives, particularly around eliminating the bottlenecks associated with cross-border payments.

The BNM has been testing the waters for a CBDC since 2017, and in the seven years since its exploration, the local ecosystem has been bustling with activities. In 2021, the BNM entered into a high-level collaboration with the central banks of Australia, Singapore, and South Africa to explore wholesale CBDCs.

After several Proof of Concepts (PoCs), the Malaysian central bank says it will adopt a cautious approach to a wholesale CBDC to avoid disrupting its payment ecosystem. Central bank officials say this approach will be key to avoiding logistical and technological concerns associated with rolling out a CBDC offering.

Despite the cautious approach, the bank has plans to carry out high-level research on distributed ledger technology (DLT) for central bank digital money. On the cross-border side, the BNM is partnering with central banks from Singapore, Thailand, and India for Project Nexus to enable instant international payments.

Not legal tender

According to the Malaysian central bank, digital assets are not legal tender. Experts note that this stance may create numerous problems for the BNM in the future. Despite its hard stance, the banking regulator hints at changing its position if issuers meet the right conditions.

“Any stablecoin arrangement must comply with BNM’s requirements to ensure monetary and financial stability and financial integrity,” said the central bank.

Since 2017, several central banks have galloped toward the launch of a wholesale CBDC to complement existing systems to improve settlements between local and international financial institutions.

Watch: Finding ways to use CBDC outside of digital currencies