The European Securities and Markets Authority (ESMA) has pointed out risks associated with decentralized finance (DeFi).
The regulator in a report outlined multiple risks that investors in DeFi are exposed to, as well as risks to financial stability. Specifically, the ESMA warned that DeFi operates without any trusted intermediaries, which “could otherwise mitigate risks pertaining to financial stability and investor protection.”
“Although investors’ exposure to DeFi remains small overall, there are serious risks to investor protection, due to the highly speculative nature of many DeFi arrangements, important operational and security vulnerabilities, and the lack of a clearly identified responsible party,” the report said.
The crypto industry has been a point of focus for regulators for years, but the coming of DeFi has taken their concerns to another level. This is because unlike the centralized crypto space where exchanges can collect information about their customers who are required to complete KYC, decentralized exchanges don’t require such information and users deal with such platforms directly.
The report highlighted the major concerns of the regulator, describing the “enormous technological complexity of these systems.” it broke down smart contracts into five categories for regulators to better understand this complexity.
The Risks of “Code is Law”
The ESMA report highlighted several concerns, one of which is the “code is law” mantra. The phrase is common in the DeFi space, and means that whatever the code of a smart contract permits is legal. This is a concern to the ESMA because smart contracts run the DeFi space, rather than humans.
“Smart contracts remain an unregulated phenomenon where the accepted principle is exemplified by the notion that ‘code is law,” the regulator said. the report also said adherence to this principle creates a tendency to accept smart contract outcomes, “regardless of any moral or legal consideration.”
While the regulator admitted that the automated, immutable functions of DeFi pose less of a risk to counterparties defaulting than traditional settlement, it stressed that developer pseudonymity can enable a proliferation of illicit smart contracts.
“The pseudonymity of the developers who deploy smart contracts and their unaccountability favored the rise of ‘illicit’ smart contracts, such as Ponzi schemes,” the paper added.
It further stated that “the composability feature of smart contracts, which allows for DeFi protocols to build on top of each other, enabling a variety of services for users, also creates dependencies among protocols, leading to a risk of contagion.” “The default of one actor can quickly propagate through the system,” the paper added.
Wider Concerns Around DeFi
The concerns highlighted by the ESMA report are quite real, and they are not restricted to the European region alone. In the U.S, crypto regulation has been approached from an enforcement viewpoint which has led to many crypto firms being taken to court.
The main regulator responsible for this action, the securities and exchange commission, has also threatened that DeFi firms will not be left out of such enforcement action.
“We’re going to continue to conduct investigations, we’re gonna be active in the space, and adding the label of DeFi is not going to be something that’s going to deter us from continuing our work,” head of the SEC’s enforcement office David Hirsch said in an interview.
This shows that regulators the world over may be looking towards regulating DeFi soon, which may be difficult but probably achievable.