The European Securities and Markets Authority (ESMA) released a report on 11 October warning of “serious risks” to investors of decentralized finance (DeFi). The report comes as ESMA is preparing to set new rules under the European Union’s Markets in Crypto Assets Regulation (MiCA).
The goal of the report was to examine the growth of DeFi, its key features, and the risks it poses in relation to ESMA’s objectives. ESMA’s intends on using this information for the upcoming review of MiCa.
The main challenge for policymakers is that DeFi doesn’t align with traditional centralised regulatory frameworks meant for entities like banks, according to ESMA.
The report said: “While current overall exposures remain small, DeFi creates important risks to investor protection and has the potential to create negative externalities on the traditional financial system.”
ESMA’s new DeFi report
DeFi, characterised by its use of smart contracts to autonomously process loans or other financial services, in theory carries a reduced risk related to counterparty defaults, according to ESMA.
However, the report highlighted certain challenges, such as the higher volatility commonly seen in crypto markets.
“There are serious risks to investor protection, due to the highly speculative nature of many DeFi arrangements, important operational and security vulnerabilities, and the lack of a clearly identified responsible party,” the report said.
Anonymity in DeFi platforms was also recognised as a downfall as it can encourage bad actors, like wash traders.
While DeFi’s current size means it doesn’t significantly threaten financial stability, ESMA said there is need for continuous monitoring due to the sector’s rapid growth.
It pointed to the example of decentralised exchanges, which address “pain points” in the financial system. But the report said they also have their own downfalls.
ESMA stated: “Many crypto exchanges also inflate their traded volumes on purpose to attract new users and crypto-asset issuers.”
Upcoming ESMA crypto regulations
Last week, ESMA introduced a set of proposed regulations for crypto asset service providers as part of MiCA.
“The aim of these public consultations is to collect views, comments, and opinions from stakeholders and market participants on the appropriate implementation of MiCA,” the document said.
This 307-page “consultation package” focuses on five main areas: sustainability indicators for distributed ledgers, inside information disclosures, white paper technical requirements, trade transparency guidelines, and record-keeping for crypto-asset service providers.
In terms of the sustainability indicators, ESMA proposed that ledgers disclose data related to energy consumption, greenhouse gas emissions, and waste.
For post-trade transparency, ESMA suggests crypto providers should give detailed information about trades, including data on the crypto-asset involved, its price, quantity, venue of execution, and a unique transaction ID.
Moving forwards, a third consultation package will be published by ESMA in Q1 2024.
The authority will then release a final report, which will incorporate the feedback received on these proposals. The authority aims to submit the draft technical standards to the European Commission by June 2024.
