The European Union’s financial stability watchdog, the European Systemic Risk Board (ESRB), has recently expressed concerns about the growing digital asset and decentralized finance (DeFi) sector, suggesting that new regulations may be necessary to cover large crypto conglomerates and smart contracts. With the Markets in Crypto Assets regulation (MiCA) set to take effect within the bloc in 2024, the ESRB, chaired by EU central bank chief Christine Lagarde, warned about the risks of crypto lending and staking, and high leverage in digital asset markets.
One policy option considered by the ESRB includes requiring DeFi developers to abide by specific regulations covering the design and creation of smart contracts. The report floated the possibility of mandatory code audits, pharmaceutical-style intellectual property restrictions, and rules for the “oracles” that transmit real-world data to automated software.
While MiCA addresses governance, licensing, and reserve requirements for players such as wallet providers and stablecoin issuers, it has yet to focus on areas like crypto lending and staking. These financial activities can pose significant risks to consumers, according to the ESRB report. The ESRB also mentioned that companies will have to manage conflicts of interest between their business lines under MiCA, but there is no overarching requirement to identify and mitigate operational or reputational risks that might arise from offering services like trading and custody.
In light of these concerns, the ESRB suggested studying the activity of crypto-asset conglomerates within the EU, taking account of market developments and experiences acquired through the application of MiCA. The report cited payment laws currently in place, allowing supervisors to force risky services to divest to a separate subsidiary as a potential coping mechanism.
Although the past year has been turbulent for crypto-assets and DeFi, systemic implications have not yet materialized. Nevertheless, the ESRB cautions that exponential growth dynamics could lead to significant risks in the future, posing a major threat similar to the 2008 collapse of Lehman Brothers.
Back in March, the ESRB proposed that financial technology firms could face bank-style lending caps to prevent crypto markets from overheating, citing the rising popularity of cryptocurrencies. The balance between regulation and innovation will remain a hot topic in the crypto industry while authorities aim to protect consumers and safeguard financial stability without stifling the development of this transformative technology.
Edited by Sandali Handagama.