It’s no secret that the crypto space carries a significant risk. However, according to the European Union financial markets and securities regulator, while DeFi appears to be relatively small to be a major issue in the financial market, it still requires monitoring.
The European Securities and Markets Authority (ESMA) has released a report that examines the developments and risks associated with decentralized finance (DeFi) in the EU. While the report highlights the potential benefits of DeFi, it also notes that it currently does not pose a major threat to financial stability. This suggests that DeFi is still a relatively small and emerging industry in the EU.
In the report, it was mentioned that the crypto asset markets, including DeFi, are not a significant risk to financial stability at this time. This is because the crypto markets are relatively small in size and do not have significant links to traditional financial markets. However, it also notes that the crypto markets are evolving and the risks they pose could change over time.
According to DefiLlama, the overall crypto market capitalization is around one trillion dollars, whereas DeFi’s total value locked (TVL) is merely $40 billion. In contrast, the European Commission stated that the total assets of financial institutions in the EU were approximately 90 trillion dollars in 2021.
The report stated that the total crypto market is equivalent to the 12th largest bank in the EU, or 3.2% of the total assets held by banks in the EU.
The ESMA examined the impact of the 2022 crypto contagion events, including the Terra ecosystem collapse and the FTX crash. It noted that the events were akin to the collapse of Lehman Brothers, but the impact on traditional markets was minimal.
However, it was observed by the regulator that there are similar traits and vulnerabilities between DeFi and traditional finance, like liquidity and maturity mismatches, leverage, and interconnectedness.
The ESMA highlighted the speculative nature of DeFi arrangements, their security vulnerabilities, and the lack of a clear party responsible for protecting investors. These factors pose serious risks to investor protection, despite the relatively minor exposure of investors to DeFi.
It warned that the risks associated with DeFi could become systemic if the sector were to grow significantly or become more interconnected with traditional markets. The ESMA also identified a “concentration risk” associated with DeFi activities.
The ESMA pointed out that the DeFi sector is highly concentrated, with a small number of protocols accounting for a large portion of the total value locked. This means that the failure of any large protocol could have a significant impact on the entire sector.
The regulator is paying closer attention to DeFi and crypto markets in light of its second consultation paper on the Markets in Crypto-Assets (MiCA) regulations.
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