The European Securities and Markets Authority (ESMA) has issued a report titled “Decentralized Finance in the EU: Developments and Risks,” in which it concludes that decentralized finance (DeFi) does not currently pose a substantial risk to overall financial stability. However, the regulator emphasizes the need for continuous monitoring.
DeFi Size Compared to Traditional Finance
ESMA‘s report states that crypto-assets markets, including DeFi, are not seen as meaningful risks to financial stability at this point. The key factors contributing to this assessment are the relatively small size of the DeFi ecosystem and the limited channels of contagion between crypto and traditional financial markets.
DeFi TVL by protocol type. Source: ESMA
The total market capitalization of the entire cryptocurrency market is just above $1 trillion, with DeFi’s total value locked (TVL) standing at approximately $40 billion, according to DefiLlama. In contrast, the assets held by financial institutions in the EU amounted to approximately $90 trillion in 2021, as reported by the European Commission.
Similarities and Vulnerabilities
While DeFi is currently viewed as not posing a significant systemic risk, ESMA acknowledges that it shares similarities and vulnerabilities with traditional finance, such as liquidity and maturity mismatches, leverage, and interconnectedness. The report also highlights the highly speculative nature of many DeFi arrangements, operational and security vulnerabilities, and the lack of a clearly identified responsible party, all of which pose serious risks to investor protection.
Top ten DeFi protocols by TVL. Source: ESMA
ESMA notes that although investor exposure to DeFi remains limited, there is a possibility that DeFi could pose systemic risks if it were to gain significant traction or if it were to become more interconnected with traditional financial markets. The report also points out a “concentration risk” in DeFi activities, as a small number of protocols dominate the ecosystem. The failure of any of these major protocols or blockchains could have far-reaching consequences for the entire DeFi system.
ESMA‘s report underscores the need for vigilant monitoring of DeFi and crypto markets. This heightened focus on DeFi and crypto follows the release of ESMA’s second consultative paper on the Markets in Crypto Assets (MiCA) regulations earlier in the month, indicating the regulatory authority’s commitment to ensuring the stability and security of financial markets in the European Union.