DeFi faces scrutiny from European regulator for risk return balance

DeFi faces scrutiny from European regulator for risk return balance

The European Securities and Markets Authority (ESMA), the supervisory body for financial markets in the European Union, has issued a comprehensive report delving into the world of decentralized finance (DeFi) and its impact on the EU market. Released on October 11, this 22-page document takes a balanced look at the opportunities and challenges that DeFi presents.

On the positive side, the ESMA acknowledges the enticing prospects associated with DeFi. These include the potential for broader financial inclusion, the emergence of innovative financial products, and significant improvements in the speed, security, and cost-effectiveness of financial transactions.

However, the report also underscores what it terms “significant risks” inherent to the DeFi landscape. One of the primary concerns is liquidity risk, closely tied to the speculative and volatile nature of many cryptocurrencies. To illustrate, the ESMA compares the 30-day volatility of Bitcoin to the Euro Stoxx 50 index and finds that cryptocurrencies exhibit on average 3.6 to 4.7 times higher volatility than traditional stocks.

The ESMA does not share the belief that DeFi entirely eliminates counterparty risk, even though, in theory, this risk should be lower or even non-existent due to the use of smart contracts and the concept of atomicity. Smart contracts, while powerful, are not infallible and can contain errors or vulnerabilities.

DeFi, by its very nature, is susceptible to fraudulent activities and illicit practices due to the absence of robust know-your-customer (KYC) protocols. Another crucial point of concern, as emphasized in the report, is the absence of a clearly identifiable responsible party and a recourse mechanism for users.

However, the report concludes that, at the present time, DeFi and the broader crypto sector do not pose “meaningful risks” to financial stability. This is attributed to their relatively modest size and limited interconnectedness with traditional financial markets.

It’s worth noting that the ESMA is closely monitoring developments in the crypto market and recently published its second consultative paper on Markets in Crypto-Assets (MiCA) regulations on October 5. In this 307-page document, the regulator proposes that crypto asset providers have the flexibility to store transaction data in a format of their choice, provided they can readily convert it into a specified format upon authorities’ request.

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