The European Securities and Markets Authority (ESMA), the EU’s top financial regulator, has published a new report assessing the potential advantages and notable risks associated with the DeFi (Decentralized Finance) ecosystem.
In the 22-page analysis, ESMA acknowledges the innovative aspects of DeFi in terms of financial accessibility, product diversity, and transaction efficiency. However, it emphasizes the substantial risks accompanying these innovations, including liquidity issues due to the inherent volatility of cryptocurrencies and vulnerabilities in smart contract development.
ESMA compared 30-day volatility for Bitcoin and Ether against the Euro Stoxx 50 stock index to explain that crypto assets were, on average, 3.6 and 4.7 times more volatile than the equities benchmark.
The report underscores that despite its promise, DeFi doesn’t fully mitigate counterparty risk since smart contracts remain susceptible to vulnerabilities. It further warns that weak identity controls within the DeFi space expose it to elevated risks of fraud and illicit activities. The absence of responsible overseeing entities or recourse mechanisms leaves users vulnerable in case of adverse events.
ESMA’s conclusion is that, as of now, these emerging technologies do not present systemic threats to the broader financial stability of the EU, primarily due to their limited adoption and interconnectedness. However, the regulator strongly advocates the need to regulate DeFi activities as their adoption grows, emphasizing the importance of controlling the associated risks.
In June 2023, the Association for Financial Markets in Europe (AFME) formally called for the inclusion of DeFi in the EU’s Markets in Crypto-Assets (MiCA) regulatory framework.
According to AFME, excluding DeFi from regulatory frameworks could lead to regulatory arbitrage and present challenges in implementing new frameworks.
AFME also highlighted DeFi’s significant role in innovation within the financial sector, stating that
“although DeFi is one of the most significant innovations within the financial system, it has been proposed that existing DeFi efforts be viewed as externalised sources of innovation and R&D laboratories for the formal financial sector.”
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