EU’s Securities Regulator Weighs In On The Risk and Benefits of DeFi to the Economy

The European Securities and Market Authority (ESMA) has released a report on the development of decentralized finance (DeFi) and the risk posed by growing adoption.

In a report released on Oct 11, the 22-page document highlights the risks posed by a sector that holds much promise and reshaped finance in the region.

According to the document, the DeFi has led to the innovation of financial products making payments easier and aiding financial inclusion to cater to the unbanked around the world.

Speed, cost, and security 

ESMA stated that the development of DeFi has notched several positives relating to transaction speed, cost, and security to an extent against traditional finance but added that its application in some areas poses a significant risk.

“DeFi could contribute to greater financial inclusion by allowing users to access products and services without an intermediary who may selectively restrict access.”

Still on the positive, the document recommends the openness of blockchain technology as it records transactions on immutable blocks without the existence of intermediaries and “central counterparties.” 

Smart contracts made decentralized finance possible creating “innovative financial products” that range from futures contracts, automated market makers, flash loans, etc.

Risks on the EU market 

Despite the many innovations, DeFi products endanger the market in many ways drawing the attention of regulators globally. 

ESMA cited liquidity risk on financial assets in the market based on its high volatility resulting in loss of investments. The disparity in liquidity risk can be seen in the 30-day volatility of the cryptocurrency and traditional stock markets.

The 30-day volatility of Bitcoin and Ethereum ranges between 3.6 and 4.7 times more than the Euro Stoxx 50 index.

Aside from liquidity concerns, the documents raise counterparty risk, an area smart contracts and DeFi projects have not fully covered. 

Smart contracts should be expected to block counterparty risks but due to the inconsistencies in some projects especially in lending platforms, the lender is at risk due to under-collateralization. 

In the past years, several bad actors have delved into the scene because of a lack of Know Your Customer (KYC) requirements or adequate implementation of such because of the ease of entry. 

As a result, multiple losses have been recorded trickling into billions and plunging asset prices creating an unstable market for investors. 

“Malevolent people can use the technology to anonymously create malicious decentralized applications, which have no other purpose than to deprive users of their money. By identifying and analyzing Ponzi schemes on Ethereum, Chen et al (2019) estimate that before July 2017, as many as 507 smart Ponzi schemes were created (although they represented a tiny portion, around 0.03% of all Ethereum contracts).”