ESMA Report Highlights DeFi’s Current Size and Risks, Stresses Need for Continued Oversight
In a recent report titled “Decentralized Finance in the EU: Developments and Risks,” the European Securities and Markets Authority (ESMA) stated that decentralized finance (DeFi) is yet to present a significant risk to overall financial stability. However, the regulator emphasized the necessity of continuous monitoring due to the sector’s potential vulnerabilities.
Released on October 11, the report acknowledges the benefits and risks associated with the nascent DeFi ecosystem. ESMA’s primary conclusion is that, given the relatively small size of crypto-assets markets, including DeFi, and the limited contagion channels between crypto and traditional financial markets, there is no meaningful risk to financial stability at this point.
The total market capitalization of the entire cryptocurrency market is slightly over $1 trillion, with DeFi’s total value locked (TVL) standing at $40 billion, as reported by DefiLlama. In comparison, the total assets of financial institutions in the EU reached around $90 trillion in 2021, according to the European Commission.
ESMA highlighted that the entire crypto market is roughly equivalent to the size of the EU’s 12th largest bank or 3.2% of the total assets held by EU banks. Despite this, the regulator remains cautious and recognizes the need for ongoing scrutiny.
The report delves into specific crypto events in 2022, including the collapse of the Terra ecosystem and FTX, but notes that these incidents did not have a meaningful impact on traditional markets, terming them a crypto “Lehman moment.”
However, ESMA expressed concern about DeFi’s similarities to traditional finance, including liquidity and maturity mismatches, leverage, and interconnectedness. While acknowledging that investor exposure to DeFi is currently limited, the regulator stressed the serious risks to investor protection due to the highly speculative nature of many DeFi arrangements and the lack of a clearly identified responsible party.
ESMA cautioned that these risks could escalate into systemic threats if DeFi gains significant traction or develops substantial interconnections with traditional financial markets.
The report also drew attention to a “concentration risk” associated with DeFi activities. Noting that DeFi activities are concentrated in a small number of protocols, it highlighted that the three largest ones represent 30% of the total value locked. ESMA warned that the failure of any of these large protocols or blockchains could have repercussions across the entire system.
In light of these observations, ESMA revealed that it is intensifying its focus on DeFi and crypto markets. This follows the publication of its second consultative paper on the Markets in Crypto-Assets (MiCA) regulations earlier this month, emphasizing the importance of regulatory frameworks to address potential risks in the rapidly evolving DeFi space.