European regulator issues warning on DeFi’s serious risks

• ESMA acknowledged that while investors’ exposure to DeFi remains relatively limited, there were substantial risks to investor protection.
• The agency vowed to delve deeper into this burgeoning market and pledged to provide annual reports on the sector.

The European Securities and Markets Authority (ESMA) has issued a stern warning about the “serious risks” associated with decentralized finance (DeFi), highlighting concerns despite the nascent state of this innovative technology.

ESMA, a key EU agency tasked with establishing regulations under the Markets in Crypto Assets Regulation (MiCA), expressed its apprehension about the DeFi space.

Policymakers are grappling with the challenge of crafting regulatory frameworks for a field that operates without centralized intermediaries, unlike traditional entities like banks or securities exchanges.

In a report released on 11 October, ESMA acknowledged that while investors’ exposure to DeFi remains relatively limited, there are substantial risks to investor protection.

These concerns stem from the highly speculative nature of many DeFi arrangements, operational and security vulnerabilities, and the absence of a clearly identified responsible party.

Authority expresses concerns over DeFi despite its nascent state

The Paris-based agency vowed to delve deeper into this burgeoning market and pledged to provide annual reports on the sector. DeFi operates through smart contracts, automating financial services like loans.

In principle, DeFi reduces the risk of counterparties defaulting. However, ESMA’s report noted the heightened volatility in crypto markets and the anonymity inherent in DeFi, which can facilitate dubious practices such as wash trading, a manipulation tactic involving inflated sale volumes.

Just last week, ESMA introduced a series of new regulations for crypto asset service providers under MiCA. These rules included requirements for environmental disclosures in issuers’ white papers.

In the report issued on 11 October, ESMA highlighted the diverse nature of smart contracts used in DeFi, ranging from financially motivated Ponzi schemes to operational memory management.

ESMA’s concerns over DeFi regulation are not unique. Regulators worldwide are grappling with how to address DeFi projects. The International Organization of Securities Commissions has recently proposed that DeFi projects should be treated on par with conventional finance.

Responding to a consultation by the French financial regulator, AMF, the EU Crypto Initiative, a lobby group, argued that DeFi warrants a tailored approach. They emphasized that programmers should not be held legally responsible merely because they are aware that their code could potentially be misused.