The fledgling decentralized finance (DeFi) sector gives rise to serious investor protection threats, according to a new report from the European Securities and Markets Authority (ESMA).
The regulator found that the “highly speculative nature of many DeFi arrangements and important operational and security vulnerabilities” pose risks that the industry needs to address.
It said cryptoassets are particularly vulnerable to traditional forms of abusive trading — such as front running, wash trading, pump-and-dump schemes — and that DeFi has “spawned new market manipulation issues and techniques, such as maximal extractable value and flash loan attacks.”
ESMA noted that the DeFi sector remains a relatively small player within the global financial system so financial stability risks aren’t meaningful, but investor protection threats are significant.
“While current overall exposures remain small, DeFi creates important risks to investor protection and has the potential to create negative externalities on the traditional financial system,” the report said.
“New forms of market abuse are also facilitated by DeFi innovative features, something that the industry will need to address for DeFi to ever reach sustainable growth,” it added.
Additionally, the ability of regulators and investors to “understand DeFi and the risks involved is hampered by important data gaps,” it said.
In an effort to start closing those gaps and better identify significant risks, ESMA published a separate report that proposed a methodology for categorizing smart contracts.
“Smart contracts have been claimed to be a major source of financial innovation. Nonetheless, they bring with them enormous technological complexity. Regulators and supervisors need to understand and monitor this complexity to systematically evaluate the risks to investors and financial stability stemming from DeFi,” it said.