The European Securities and Markets Authority (ESMA) — the European Union’s financial markets supervisory authority — released an article on decentralized finance (DeFi) and the risks it poses to the EU market on Oct. 11. 

In a 22-page report, the ESMA admits the promised benefits of DeFi, such as greater financial inclusion, the development of innovative financial products, and the enhancement of financial transactions’ speed, security and costs.

However, the paper also highlights the “significant risks” of DeFi. According to the ESMA, the first is liquidity risk tied to the highly speculative and volatile nature of many crypto assets. The authority compares the 30-day volatility of Bitcoin (BTC) and Ether (ETH) with the Euro Stoxx 50 index, with the cryptocurrencies being, on average, 3.6 and 4.7 times higher than the stock index.

The ESMA doesn’t believe that DeFi manages to avoid counterparty risk, even if, in theory, it should be lower or even nonexistent due to smart contracts and atomicity. However, smart contracts are not immune to errors or flaws.

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DeFi is especially vulnerable to scams and illicit activities as it lacks Know Your Customer (KYC) protocols, according to the ESMA. Another important source of risk for DeFi users, as specified in the report, is the lack of an identifiable responsible party and the absence of a recourse mechanism.

However, currently, DeFi and crypto, in general, do not represent “meaningful risks” to financial stability, the report concludes. That is because of their relatively small size and limited interconnectedness between crypto and traditional financial markets.

The ESMA pays close attention to the crypto market, releasing its second consultative paper on the Markets in Crypto-Assets regulations on Oct. 5. In the 307-page document, the regulator suggested allowing crypto asset providers to store transaction data in “the format they consider most appropriate,” if they can convert it into a specified format should the authorities request it.

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