On 11 October 2023, the European Securities and Markets Authority (ESMA) published two articles on decentralised finance (DeFi), one on developments and risks in the EU market and another on a methodology for the categorisation of smart contracts. In these articles, ESMA highlighted risks to consumers, new forms of market abuse, and possible vulnerabilities to financial stability.
DeFi: developments and risks in the EU market
In this article, ESMA considers DeFi’s innovative features, its potential benefits and specific risks EU regulators and supervisors should be aware of when dealing with DeFi applications, also in view of any future review of the Regulation on Markets in Crypto-Assets (MiCA). The article provides:
- An introduction to DeFi, from its origins to recent market developments.
- An analysis of the potential benefits and risks of DeFi to users and the wider financial system.
- A discussion of decentralised exchange protocols and the specific challenges that these protocols and DeFi’s features raise for market integrity.
In its conclusion, ESMA notes that while current overall exposures to DeFi remain small, DeFi creates important risks to investor protection and has the potential to create negative externalities on the traditional financial system. ESMA also warns that new forms of market abuse are facilitated by DeFi’s innovative features and this will have to be addressed by the industry. ESMA acknowledges that regulating and supervising DeFi is not easy, not only because of the technicalities involved, but also the need to determine how the current rules may apply to a system that purports to eliminate those entities to which existing rules apply, i.e. traditional finance. It also points to important data gaps, hampering the ability of regulators to understand DeFi and the risks involved. It notes that whilst MiCA sets a comprehensive framework for crypto-assets, it currently does not directly address DeFi but it will be reviewed and might be amended in the future.
DeFi: categorisation of smart contracts
In its article ESMA discusses the role of smart contracts in the blockchain environment, provides an overview of the risks to users and financial stability stemming from smart contracts and presents the methodology used to categorise smart contracts. It identifies five main categories of smart contracts: financial, operational, token, wallet, and infrastructure. It its conclusion ESMA notes that the European Commission acknowledged the limited enforcement power that can be exerted on DeFi, pointing instead to a few potential policy initiatives, including potentially establishing a public observatory of DeFi activity operated by a public authority.
On 25 October 2023, ESMA will host a public webinar on the findings of these articles.