In a recent report, the European Securities and Markets Authority issued a paper discussing the potential risks that the decentralized finance (DeFi) concept poses to investors and the financial stability of a nation. Also, the regulator suggested a new categorization for smart contracts.
According to the report, the EU regulator pointed out in its new report that even though investors have a relatively small exposure to the Defi world, it still poses a severe financial risk to investors because of its decentralized nature. The regulator added that many DeFi protocols are highly speculative, lack specific central authority, and consist of significant security and operational vulnerabilities.
In the report, the EU authority pointed out that DeFi does not have trusted intermediaries, which are important for reducing risks concerning investors’ protection while maintaining the nation’s financial stability. Furthermore, the agency also highlighted its primary duty of regarding the complex DeFi innovation. Also, it classified smart contracts into five different groups to aid regulators’ understanding of the technologically complex systems.
DeFi Poses Risks To Investors And Market Stability
According to the report, the EU regulator highlighted that the existing DeFi governance adopts the code of law principle, where all smart contract protocols are unregulated. Consequently, the adoption of this principle promotes a tendency where the outcomes of smart contracts are accepted regardless of the legal or moral considerations.
In the study, the authority disagreed that the automated and immutable nature of DeFi exacts little risk to defaulting counterparties when compared with traditional payment settlement. Nonetheless, it was emphasized that the anonymity of DeFi developers who launch these smart contracts and the lack of central authority to oversee their activities aids the growth and proliferation of illegal activities such as Ponzi Schemes on smart contracts.
EU Regulators Classify Smart Contract Classifies Finance.
Furthermore, it pointed out in the study that the faults in the system can be amplified by the composability of smart contracts, which could consequently cause increased contagion vulnerabilities. The composability components of smart contracts enable DeFi developers to build projects on each other, creating a long range of services for users. This also promotes dependencies among DeFi projects, causing contagion risks.
The report revealed that the EU regulatory body had drafted a classification model to help regulators decipher the utility cases of different smart contracts, grouping them into five classes, including Infrastructure, Wallet, Tokens, Operational, and Financial. Furthermore, the agency also pointed out the challenges involved in implementing regulations caused by the decentralized nature of DeFi protocols.
Furthermore, the European Securities and Markets Authority plans to control rules under the Markets in Crypto Assets regulatory framework of the European Union (MiCA). The report also pointed out that many regulatory agencies face difficulties when they attempt to gain control of decentralized finance protocols.
Regulatory Yet To Upgrade MiCA Laws
Erwin Voloder, the Head of Policy at the European Blockchain Association, stated that cryptocurrency service providers that deal with DeFi could play an important role in upholding compliance among entities. He said that if an individual launches a smart contract that implements transactions, then service providers would help place such orders even if the trading platform works on the permissionless protocol. For instance, you can get a tech firm to provide an anchor to the rules.
In his report, Voloder pointed out that if a DAO is the issuer of the smart contract, there would be additional challenges when trying to boilerplate regulations. He added that the EU regulators are evaluating the DeFi innovation closely, and he pointed out that in the next 18 months, they plan a general communication. But, Voloder stated that he believed there was no standing agreement regarding the update of the MiCA regulation, simply doing another thing and buying more time.
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