The European Securities and Market Authority (ESMA) has issued a report on the development of decentralized finance (DeFi) and the associated risks arising from its increasing adoption. Released on October 11, the 22-page document acknowledges the potential of the DeFi sector, which has shown promise in reshaping finance in the European region.
The report emphasizes that DeFi has been instrumental in innovating financial products, facilitating easier payments, and contributing to financial inclusion by catering to the unbanked population globally. While recognizing the positive impact, the report also highlights the risks associated with DeFi, underscoring the need for regulatory scrutiny and frameworks to address potential challenges and ensure investor protection in the evolving decentralized financial landscape.
Speed, cost, and security
ESMA acknowledges the positive aspects of decentralized finance (DeFi) development, noting improvements in transaction speed, cost efficiency, and security when compared to traditional finance. The report recognizes that DeFi has the potential to enhance financial inclusion by enabling users to access products and services without relying on intermediaries who might selectively restrict access.
The document further highlights the openness of blockchain technology, emphasizing its capability to record transactions on immutable blocks without the need for intermediaries or central counterparties. Smart contracts play a crucial role in enabling decentralized finance, facilitating the creation of innovative financial products such as futures contracts, automated market makers, flash loans, and more. The report suggests that these technological advancements have the potential to reshape and expand the financial landscape.
Risks on the EU market
Despite the numerous innovations in decentralized finance (DeFi), these products also bring about risks that have garnered the attention of regulators globally. ESMA specifically pointed out liquidity risk in financial assets due to their high volatility, leading to potential losses in investments. The report highlights the significant disparity in liquidity risk between the cryptocurrency market and traditional stock markets, with the 30-day volatility of Bitcoin and Ethereum being 3.6 to 4.7 times higher than that of the Euro Stoxx 50 index.
Additionally, the document raises concerns about counterparty risk, an area that smart contracts and many DeFi projects have not fully addressed. Counterparty risk refers to the risk that one party in a financial transaction may default on its obligations, potentially leading to financial losses for the other party involved. These challenges underscore the importance of regulatory scrutiny and the need for comprehensive frameworks to address potential risks associated with the growing adoption of decentralized finance.
Smart contracts are designed to mitigate counterparty risks, but inconsistencies in certain projects, particularly lending platforms, can expose lenders to the threat of under-collateralization. The decentralized finance (DeFi) space has witnessed the entry of several bad actors in recent years, largely due to the absence of robust Know Your Customer (KYC) requirements or their inadequate implementation, facilitated by the ease of entry.
Consequently, substantial losses, amounting to billions, have been recorded, contributing to the destabilization of asset prices and creating an unpredictable market for investors. The report highlights the misuse of technology by malicious actors who can anonymously create harmful decentralized applications. These applications, such as Ponzi schemes, have the sole purpose of defrauding users of their funds. According to the findings, researchers estimate that up to 507 smart Ponzi schemes were created on Ethereum before July 2017, although they represented a minimal portion, approximately 0.03%, of all Ethereum contracts.
