Decentralized finance (defi) brings risks for investors but is yet to pose “meaningful risks” to financial stability, according to Europe’s securities watchdog. The agency believes, however, the phenomenon deserves attention in light of the EU’s new crypto rules as well as growing user base and has presented its assessment of the sector’s development.

Defi Requires Monitoring as It Continues to Evolve Quickly, ESMA Says

The European Securities and Markets Authority (ESMA), the European Union’s financial markets and securities regulator, has published an article focused on decentralized finance which it recognizes as the most innovative development in the crypto space.

While investors’ exposure to defi remains limited, it comes with “serious risks” to investor protection, the report notes, emphasizing on the speculative nature of defi offerings, the absence of responsible parties as well as associated operational and security vulnerabilities. At the same time, ESMA remarks:

Defi does not represent a meaningful risk to financial stability at this juncture, considering its small size, but this is something that requires monitoring as the phenomenon continues to evolve quickly.

Defi employs blockchain technology and smart contracts to provide financial services in a decentralized and permissionless manner, without involving traditional financial intermediaries. This can create challenges for EU supervisors as even EU’s latest legal framework, the Markets in Crypto-Assets (MiCA) law, is centered on the regulation of intermediaries, ESMA points out.

The authority also highlights the relatively small size of the defi market. The exponential growth in 2021, when the total value of digital assets locked in defi products (TVL) spiked to $225 billion, was followed by an abrupt decline in 2022, amid falling crypto prices and collapses of crypto platforms like Terra. TVL has since hovered around $70-80 billion.

The European regulator has also noticed that while defi accounts for a small portion of crypto markets, with its TVL representing only around 6% of the total crypto market capitalization, defi protocols rival their centralized equivalents in terms of usage or size.

“The estimated number of defi users continues to grow, although at a slower pace, and some predict continued growth in the years to come, mainly as a result of the ongoing development of new defi use cases, the increasing adoption of crypto assets by mainstream investors, and the continued emergence of new defi protocols,” ESMA elaborated.

However, crypto assets and defi do not pose sizable risks to financial stability, the agency said. As of the end of June 2023, the crypto market had a capitalization of around $1.1 trillion, roughly equal to the assets of Intesa Sanpaolo, the EU’s 12th largest bank, which accounted for 3.2% of the total assets held by banks in the Union at end of 2022.

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