The European Securities and Markets Authority warned investors of the risk of decentralized finance in a Wednesday report despite the innovative technology being in its infancy.
The EU agency ESMA, which is due to set rules under the landmark Markets in Crypto Assets Regulation, has pledged to look further into the nascent market, which has posed a puzzle for policymakers who are used to pinning regulatory obligations on centralized institutions like banks or securities exchanges.
exposure to DeFi remains small overall, exposure to DeFi remains small, due to the highly speculative nature of many DeFi arrangements, important operational and security vulnerabilities, and the lack of a clearly identified responsible party, said the report, published by the Paris-based agency.
While in principle, DeFi - which uses smart contracts to automate loans or other financial services - has less of a risk of counterparties defaulting, the report observes that heightened volatility in crypto markets and anonymity that enables dubious behavior like wash trading, in which sale volumes are inflated to manipulate markets.
ESMA proposed last week a swathe of new rules for crypto asset service providers under the MiCA, such as the environmental disclosures that will need to be included in issuers' white papers. A further report highlighted the potentially innovative nature of the smart contracts used in DeFi, noting they can range from financial-motivated Ponzi schemes to operational memory management.
The International Organization of Securities Commissions recently proposed to treat DeFi projects as akin to conventional finance, the only regulatory agency that has been able to deal with them. In response to a consultation from the French financial regulator AMF, the lobby group EU Crypto Initiative has recently argued that DeFi needs a tailored approach - with programmers not held legally liable merely because they realize their code could be misused.