The European Securities and Markets Authority (ESMA), the European Union’s market regulator, published an article on October 11 about Decentralized Finance (DeFi) and its risks for the EU market.
In a 22-page report, ESMA admits the promised benefits of DeFi, such as greater financial inclusion, the development of innovative financial products and the improvement of the speed, security and costs of financial transactions.
However, the document also highlights the “significant risks” of DeFi. According to ESMA, the first is liquidity risk related to the highly speculative and volatile nature of many crypto assets. The regulator compares the 30-day volatility of Bitcoin or Ether with the Euro Stoxx 50, with the former averaging 3.6 and 4.7 times higher than the latter.
The ESMA does not believe that DeFi has managed to avoid counterparty risk, even though in theory it should be lower or even non-existent due to smart contracts and atomicity. Yet smart contracts are not immune to errors or flaws.
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DeFi is particularly vulnerable to scams and illegal activities because it has no know-your-customer (KYC) protocols. Another major source of risk for DeFi users, as specified in the report, is the lack of an identifiable responsible party and the absence of a redress mechanism.
But at this point, DeFi, and crypto in general, do not represent “meaningful risks” to financial stability, the report concludes. This is due to their relatively small size and the limited interconnection between crypto and traditional financial markets.
The ESMA is paying a lot of attention to the crypto market and will publish its second consultative paper on Markets in Crypto-Assets (MiCA) mandates on October 5. In a 307-page document, the regulator proposed allowing crypto asset providers to store transaction data in “the format they deem most appropriate,” if they can convert it to a specified format if authorities do so to ask.
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