The European Securities and Market Authority (ESMA) recently published a detailed report on the development of decentralized finance (DeFi) and the growing risks associated with its adoption. This 22-page document sheds light on the potential dangers of a sector that has reshaped the financial landscape in the region.
The Positive Impact of DeFi
The rise of DeFi has brought about numerous positive changes in the financial industry. It has fostered the innovation of financial products, making payments easier and facilitating financial inclusion for the unbanked population worldwide. The report acknowledges the benefits of DeFi, such as faster transactions, reduced costs, and enhanced security compared to traditional finance.
“The development of DeFi has led to the creation of innovative financial products, ranging from futures contracts to automated market makers and flash loans, which have effectively disrupted the traditional financial system.”
– European Securities and Market Authority
The Risks in DeFi
However, despite its many advantages, DeFi products also pose significant risks to the market, which have caught the attention of regulators globally. One major concern highlighted in the report is the liquidity risk of financial assets due to the high volatility of the market. This volatility can result in substantial losses for investors.
The report specifically compares the 30-day volatility of cryptocurrencies like Bitcoin and Ethereum to traditional stock markets, such as the Euro Stoxx 50 index. It reveals that the volatility of Bitcoin and Ethereum is 3.6 to 4.7 times higher than that of the Euro Stoxx 50 index, indicating a higher liquidity risk in the cryptocurrency market.
Another risk in DeFi is the counterparty risk, which refers to the risk that one party in a financial agreement fails to fulfill their obligations. While smart contracts were intended to mitigate this risk, the report notes that some DeFi projects have not fully addressed this issue. In particular, lending platforms have inconsistencies in their implementation, leading to under-collateralization and exposing lenders to potential risks.
In addition, the ease of entry into the DeFi space has attracted bad actors who exploit the lack of Know Your Customer (KYC) requirements or their insufficient implementation. This has resulted in significant financial losses, running into billions of dollars, and has created an unstable market for investors.
