Decentralized finance (DeFi) does not yet pose a significant risk to overall financial stability, but does require supervision, the European Union’s financial markets and securities regulator said.
On October 11, the European Securities and Markets Authority (ESMA) released a report entitled Decentralized finance in the EU: developments and risks. In addition to discussing the benefits and risks of the emerging ecosystem, the regulator concluded that it does not yet pose a significant risk to financial stability.
“Cryptoasset markets, including DeFi, do not currently pose significant risks to financial stability, primarily due to their relatively small size and limited contagion channels between crypto and traditional financial markets.”
The total crypto market cap is just over $1 trillion, and the total value of DeFi is just $40 billion, according to DefiLlama. By comparison, according to the European Commission, the total assets of financial institutions in the EU amounted to around $90 trillion in 2021.
DeFi TVL by protocol type. Source: ESMA
The report states that the total crypto market is approximately the size of the EU’s twelfth largest bank, or 3.2% of the total assets of EU banks.
The ESMA also looked at several crypto contagions of 2022, including the collapse of the Terra ecosystem and FTX, noting that this crypto ‘Lehman moment’ still had ‘no meaningful impact on traditional markets’.
Nevertheless, the regulator noted that DeFi has similar characteristics and vulnerabilities to traditional financial markets, such as liquidity and maturity mismatches, leverage and interconnectedness.
It also highlighted that while investor exposure to DeFi remains low, serious risks to investor protection still exist due to the “highly speculative nature of many DeFi schemes, significant operational and security vulnerabilities, and the lack of a clearly identified responsible party.”
It warned that this “could translate into systemic risks if the phenomenon were to gain significant attention and/or if connections to traditional financial markets became material.”
Additionally, the report identified a “concentration risk” associated with DeFi activities.
“DeFi activity is concentrated in a small number of protocols,” it noted, adding that the three largest represent 30% of TVL.
TVL’s Top Ten DeFi Protocols. Source: ESMA
“The failure of any of these major protocols or blockchains could reverberate throughout the system,” the report said.
The regulator is paying much more attention to the DeFi and crypto markets following the publication of its second consultative paper on the Markets in Crypto Assets (MiCA) regulations earlier this month.