The European Securities and Markets Authority contends that while decentralized finance (DeFi) has yet to present significant risks to the overall financial stability, it warrants vigilant monitoring. This assertion stems from the European Union’s regulatory body overseeing financial markets and securities.
On October 11, the European Securities and Markets Authority (ESMA) published a comprehensive report titled “Decentralized Finance in the EU: Developments and Risks.” In this report, alongside an exploration of the benefits and risks associated with this emerging ecosystem, the regulator arrived at a noteworthy conclusion. It stated that DeFi, along with the broader crypto-assets markets, doesn’t pose substantial risks to financial stability at present. This conclusion primarily hinges on the relatively modest scale of the crypto market, with a total capitalization of just over $1 trillion and DeFi’s total value locked (TVL) amounting to a mere $40 billion, as reported by DefiLlama.
To put this into perspective, when juxtaposed with the financial institutions in the EU, which held assets totaling around $90 trillion in 2021 according to the European Commission, the entire crypto market appears as significant as the EU’s 12th largest bank, constituting a mere 3.2% of the total assets held by EU banks.
The ESMA’s investigation also encompassed various crypto-related events in 2022, including the collapses of the Terra ecosystem and FTX. Notably, it remarked that these events did not yield any “Lehman moment” with a significant impact on traditional markets. Nevertheless, the regulator discerned that DeFi shares certain traits and vulnerabilities with traditional finance, such as liquidity and maturity mismatches, leverage, and interconnectedness.
Furthermore, the ESMA underscored that while investors’ exposure to DeFi remains limited, there are still grave concerns about investor protection due to the highly speculative nature of many DeFi arrangements, coupled with significant operational and security vulnerabilities. The absence of a clearly identified responsible entity further compounds these concerns. The ESMA cautioned that these risks could evolve into systemic threats should DeFi gain substantial traction or become significantly intertwined with traditional financial markets.
In addition, the report highlighted a “concentration risk” associated with DeFi activities. It pointed out that a small number of protocols dominate DeFi, with the three largest ones commanding 30% of the total value locked (TVL). The failure of any of these major protocols or blockchains could potentially send shockwaves throughout the entire system.
Following the release of its second consultative paper on the Markets in Crypto-Assets (MiCA) regulations earlier this month, the regulator has intensified its scrutiny of the DeFi and crypto markets.