The European Securities and Markets Authority (ESMA) has issued a report on the status of decentralized finance (DeFi) within the European Union. Titled “Decentralized Finance in the EU: Developments and Risks,” the report provides insights into the current state of the DeFi ecosystem and its potential implications for financial stability. ESMA’s key finding is that DeFi while growing rapidly, does not presently pose a substantial risk to overall financial stability.
ESMA’s report emphasizes that DeFi remains relatively small in scale and therefore does not represent a meaningful risk to financial stability at this point. The total market capitalization of the entire cryptocurrency market is slightly over $1 trillion, with DeFi’s Total Value Locked (TVL) standing at approximately $40 billion. I
n contrast, financial institutions within the European Union held around $90 trillion in assets in 2021. This stark contrast demonstrates the relative insignificance of DeFi in the broader financial landscape. The report compares the total crypto market size to the EU’s 12th largest bank, indicating that crypto assets constitute only 3.2% of the total assets held by EU banks.
ESMA report
ESMA’s assessment further cites the limited contagion channels between the crypto market and traditional financial markets as a contributing factor to the absence of significant risks to financial stability. Notably, the report also highlights that recent crypto events, such as the collapse of the Terra ecosystem and FTX, did not result in any meaningful impact on traditional markets, akin to a “Lehman moment.”
Despite DeFi’s current size and limited risk to financial stability, the report underscores that DeFi shares traits and vulnerabilities with traditional finance. These commonalities include liquidity and maturity mismatches, leverage, and interconnectedness. While investors’ exposure to DeFi is presently limited, the report warns of serious risks to investor protection due to the highly speculative nature of many DeFi arrangements, as well as operational and security vulnerabilities. The absence of a clearly identified responsible party adds an additional layer of risk.
ESMA emphasizes that these risks could potentially translate into systemic threats if DeFi were to gain significant traction or if its interconnections with traditional financial markets were to become substantial. Therefore, ESMA argues that continued vigilance and monitoring of DeFi are necessary to mitigate potential risks.
The ESMA report also identifies a concerning “concentration risk” within DeFi activities. It notes that DeFi is concentrated in a small number of protocols, with the three largest of these representing 30% of the Total Value Locked (TVL). The report highlights the risk that the failure of any of these large protocols or blockchains could have cascading effects throughout the entire DeFi ecosystem.
ESMA’s interest in DeFi and the broader crypto market has been growing. In response to the rapidly evolving landscape, ESMA recently published its second consultative paper on the Markets in Crypto-Assets (MiCA) regulations. These regulations are part of the European Union’s efforts to create a regulatory framework for digital assets and address the challenges and risks associated with cryptocurrencies and DeFi.
