In a recent publication from the European Securities and Markets Authority (ESMA), attention is drawn to the risks associated with Decentralized Finance (DeFi). This report, released today, sheds light on the potential hazards and vulnerabilities posed by DeFi to both investors and the financial system.
DeFi has garnered significant interest as a groundbreaking advancement in the realm of cryptocurrency. It seeks to deliver financial services without the involvement of conventional intermediaries, employing blockchain technology and smart contracts to achieve this goal. While it offers the allure of efficient, transparent, and accessible financial services, the ESMA report underscores that DeFi is not devoid of risks.
ESMA has raised significant concerns, with one of the primary worries being the speculative nature of many DeFi arrangements. The report highlights the substantial market and liquidity risks faced by investors due to the volatility of cryptocurrencies. Additionally, DeFi lending protocols often lack thorough creditworthiness assessments, leading borrowers to over-collateralize their loans, leaving them susceptible to liquidation in the event of a decline in the value of their collateral.
Scams and illicit activities are identified as another major issue in the DeFi space. The decentralized and pseudonymous nature of DeFi protocols renders them an attractive playground for malicious actors. The absence of proper identification requirements for users means that they are exposed to fraudulent schemes.
Furthermore, the ESMA report underscores the absence of a clearly defined responsible entity within DeFi. Unlike traditional financial systems, where regulatory authorities and institutions provide safeguards, DeFi lacks mechanisms for users to seek redress in case of adverse events.
Operational, technological, and security risks are also pronounced challenges within the DeFi ecosystem. The complex infrastructure, composability, and autonomous smart contracts make DeFi a prime target for hackers. In 2022, blockchain analytics firm Chainalysis reported that DeFi protocols accounted for the majority of crypto assets stolen by hackers, totaling over $3 billion in losses during that year.