Decentralized finance still does not pose a ‘significant risk’ to stability – EU regulator

Decentralized finance (DeFi) poses a meaningful risk to overall financial stability but needs monitoring, says the European Union's financial markets and securities regulator.

On October 11, the European Securities and Markets Authority (ESMA) released a report entitled “Decentralized Finance in the European Union: Developments and Risks”. Apart from discussing the environmental benefits and risks, the regulator concluded that it does not yet pose a significant risk to financial stability.

“Crypto-asset markets, including DeFi, do not currently represent meaningful risks to financial stability, primarily because of their small scale and limited transmission channels between crypto and traditional financial markets.

The total crypto market capitalization is over $1 trillion, and DeFi's Total Value Locked (TVL) is only $40 billion, according to Defillama. In comparison, the total assets of financial institutions in the European Union will reach about 90 trillion dollars by 2021, according to the European Commission.

The report says the total crypto market is the same as the 12th largest bank in the EU, or 3.2% of the total assets held by EU banks.

ESMA also noted several crypto contagions for 2022, including the collapse of Terra Ecosystem and FTX, stating that this crypto “Lehman moment” still has “no meaningful impact on traditional markets”.

However, the regulator noted that Diffie has similar characteristics and exposures to traditional finance, such as liquidity and maturity mismatches, leverage and interdependence.

He also highlighted that while investors' exposure to DeFi is small, “there are still serious risks to investor protection with the highly speculative nature of many DeFi arrangements, significant operational and security vulnerabilities, and the lack of a responsible entity.” “

He cautioned that the phenomenon could turn into systemic risks if significant traction and/or linkages with traditional financial markets materialize.

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Additionally, the report identified a “concentration risk” associated with DeFi activities.

“The activities of DeFi are concentrated in small protocols,” he explained, the three largest represent 30% of TVL.

“The failure of these large protocols or blockchains can affect the entire system,” he said.

After publishing the second consultation paper on Crypto-Assets (MiCA) markets earlier this month, the regulator is paying more attention to the DeFi and crypto markets.

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