Decentralized finance (DeFi) has not yet posed a significant risk to the overall financial stability, as stated by the European Union’s financial markets and securities regulator. On October 11, the European Securities and Markets Authority (ESMA) released a report titled “Decentralized Finance in the EU: Developments and Risks.” The regulator discussed the pros and cons of the emerging DeFi ecosystem and concluded that it currently does not present a substantial threat to financial stability.
The report emphasized that crypto-assets markets, including DeFi, are not currently significant risks to financial stability due to their relatively small size and limited connections with traditional financial markets. The total market capitalization of all cryptocurrencies is just over $1 trillion, and the total value locked in DeFi is approximately $40 billion, according to DefiLlama. To put this in perspective, the total assets of financial institutions in the EU were around $90 trillion in 2021, according to the European Commission.
ESMA also pointed out that the total crypto market is roughly equivalent in size to the EU’s twelfth largest bank, representing only 3.2% of the total assets held by EU banks.
While discussing the crypto events of 2022, including the collapse of the Terra ecosystem and FTX, ESMA noted that these incidents did not have a substantial impact on traditional markets, labeling them as a “crypto Lehman moment.”
However, the regulator highlighted that DeFi shares some characteristics and vulnerabilities with traditional finance, such as liquidity and maturity mismatches, leverage, and interconnectedness. It also noted that while investor exposure to DeFi remains small, there are significant risks to investor protection due to the speculative nature of many DeFi arrangements, operational and security vulnerabilities, and the absence of a clearly identified responsible party.
ESMA cautioned that these risks could turn into systemic risks if DeFi were to gain significant traction or if it were to become significantly interconnected with traditional financial markets.
Furthermore, the report identified a “concentration risk” associated with DeFi activities, as a small number of protocols hold a large share of DeFi assets. The failure of any of these major protocols or blockchains could have repercussions across the entire system.
The regulator has increased its monitoring of DeFi and crypto markets following the release of its second consultative paper on the Markets in Crypto Assets (MiCA) regulations earlier in the month.
