Decentralized finance (DeFi) does not yet pose a significant risk to overall financial stability, but requires monitoring, according to the European Union's securities and financial markets regulator.
On October 11, the European Securities and Markets Authority (ESMA) released a report titled Decentralized finance in the EU: news and risks. In addition to discussing the benefits and risks of the nascent ecosystem, the regulator concluded that it does not yet pose a considerable risk to financial stability.
“Crypto asset markets, including DeFi, do not pose significant risks to financial stability at this time, primarily due to their relatively small size and limited contagion channels between crypto and traditional financial markets.”
The total crypto market capitalization is just over $1 trillion, and DeFi The total value locked is just $40 billion, according to DefiLlama. Comparatively, the total assets of financial institutions in the EU amounted to around $90 trillion in 2021, according to the European Commission.
The report says that the total crypto market is approximately the same size as the 12th largest bank in the EU or 3.2% of the total assets held by EU banks.
ESMA also analyzed several cryptocurrency contagions of 2022, including the collapse of the Terra and FTX ecosystem, noting that this crypto "lehman moment” has not yet had “a significant impact on traditional markets.”
However, the regulator noted that DeFi has similar characteristics and vulnerabilities as traditional finance, such as liquidity and maturity mismatches, leverage, and interconnection.
He also highlighted that although investor exposure to DeFi remains small, there are still serious risks to investor protection due to the "highly speculative nature of many DeFi agreements, significant operational and security vulnerabilities, and the lack of a clearly identified responsible party".
He warned that this could “translate into systemic risks if the phenomenon gained significant strength and/or if interconnections with traditional financial markets became material.”
Related: The New EU Crypto Law: How MiCA Can Make Europe a Digital Asset Hub
Additionally, the report identified a “concentration risk” associated with DeFi activities.
"DeFi activities are concentrated in a small number of protocols," he noted, adding that the three largest represent 30% of the TVL.
"The failure of any one of these large protocols or blockchains could impact the entire system," he said.
The regulator is paying much more attention to the DeFi and crypto markets following the publication of its second consultation document on the Crypto Asset Markets (MiCA) regulations earlier this month.
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