Decentralised finance in the EU : developments and risks

Decentralised finance (DeFi) has attracted attention from investors and regulators, as the latest and arguably most innovative development in the crypto area. This article assesses the development of DeFi, its distinctive features, and the risks it raises to ESMA's objectives, with a view to informing the future review of the markets in crypto-assets regulation (MiCA). It highlights that 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. DeFi does not represent a meaningful risk to financial stability at this juncture, considering its small size, but this is something that requires monitoring as the phenomenon continues to evolve quickly. Looking at one specific type of DeFi application, namely decentralised exchanges, the article shows that they purport to eliminate important pain points in the trading of crypto-assets but bear their own flaws and challenges. While market integrity in DeFi and crypto-asset markets is still under-researched, due to important data gaps and the technicalities involved, the article shows that DeFi has spawned new market manipulation issues and techniques, such as maximal extractable value and flash loan attacks, that the industry needs to address.