Exploring the Future of DeFi: Insights from the EBA and ESMA Report

LawFlash
January 22, 2025

Overview of the Joint Report

On January 16, 2025, the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) unveiled a comprehensive Joint Report. This document dives deep into specific features of Article 142 of the EU’s Markets in Crypto Assets Regulation (MiCAR). Essentially, it forms a big piece within the puzzle of the European Commission’s larger report back to the European Parliament and Council, specializing in the newest happenings within the cryptoasset world. The report is full of insights drawn from extensive research into decentralized finance (DeFi) and activities like crypto lending and staking.

The Evolution and Status of DeFi

The report takes us on a journey through the evolution of DeFi, tracing its roots back to 2016 and charting its notable rise by 2020. However, it makes a very important point—this sector continues to be a small fish in the large cryptoasset pond. DeFi’s total assets under management, or “Total Value Locked,” only account for about 4% of the whole crypto market’s capitalization.

Unpacking the Risks and Regulatory Concerns

A standout section of the report is the detailed evaluation of potential risks tied to DeFi. These findings are crucial for the European Commission because it evaluates the necessity and possibility of crafting a strong regulatory framework consistent with Article 142 of MiCAR.

The European Supervisory Authorities (ESAs) pinpoint major risks in DeFi, including:

• Cybersecurity Risks: DeFi protocols will be vulnerable to cyber threats as a consequence of flaws in smart contract code, exploitation of economic models, or transactional tactics like Maximum Extractable Value. The AMF and ACPR in France have been proactive here with their work on smart contract certification, a project that Morgan Lewis’s Paris team has been involved in. This ties in neatly with the EU’s Digital Operational Resilience Act (DORA), which got here into effect alongside the report’s release.
• AML/CFT Risks: Without robust anti-money laundering and counter-terrorism financing measures, DeFi could turn into a playground for cybercriminals, fraudsters, and terrorist groups to launder illicit funds or finance illegal activities.

Diving into Cryptoasset Lending and Staking

The report doesn’t stop at DeFi—it also delves into the realms of crypto lending and staking, breaking down different mechanisms, including liquid staking and re-staking.

The ESAs highlight specific risks related to these activities:

• Investor Protection Risks: An excellent chunk of assets used as collateral on these platforms may lead to user losses if the market takes a downturn.
• Legal Risks: There’s an absence of clear legal guidelines around asset pooling, no clear dispute resolution processes for issues like forced liquidations or hacks, and ambiguity concerning applicable laws and insolvency scenarios.
• Market and Operational Risks: Cryptoasset value fluctuations, fragile tech infrastructures, and the challenges of decentralized governance add layers of complexity and risk.

France’s Influential Role

It’s noteworthy how France’s efforts shine through on this report. It references studies by the Banque de France, insights from the ADAN’s “Web3 and Crypto in France” report, and contributions from the AMF/ACPR working group on smart contract certification.

What’s Next?

The European Commission will now weave the findings of this report into its own submission to the European Parliament and the Council, as per Article 142 of MiCAR. This will likely be a vital step in shaping the EU’s future DeFi regulatory strategy and deciding if there’s a necessity for an enhanced framework—potentially MiCAR II.

Image Credit: www.morganlewis.com