ESMA assesses market developments in DeFi and explores the smart contracts system

ESMA has recently released two articles in its TRV analysis, addressing the ever-evolving world of DeFi. These articles provide important insights into the challenges and risks associated with DeFi and smart contracts in the EU market. ESMA acknowledges the need for vigilant monitoring of these developments to safeguard investor protection and financial stability.
In the first article, ESMA explores the developments and risks of DeFi within the EU market. It brings attention to the serious risks posed to investor protection due to the highly speculative nature of many DeFi arrangements, highlighting important operational and security vulnerabilities. DeFi’s decentralized and trustless nature, while bringing innovation, also presents significant challenges for regulators. Furthermore, the article points out the absence of a clearly identified responsible party in DeFi transactions, making it difficult to enforce investor protection measures. While DeFi’s current size is relatively small compared to traditional financial markets, ESMA emphasizes the need for ongoing monitoring, as the DeFi ecosystem is rapidly evolving. Additionally, it mentions the emergence of new market manipulation issues specific to DeFi that must be addressed to maintain market integrity.
The second article introduces a methodology for categorizing smart contracts, which are the core building blocks of DeFi. Smart contracts are self-executing pieces of code that facilitate financial transactions without intermediaries. ESMA categorizes these smart contracts based on their source code and topic modeling, allowing them to track the deployment of these contracts over time. They have identified five major smart contract categories. Notably, they observed a significant increase in complexity and interdependence between different protocols, especially during two distinct surges in smart contract deployment in 2017-2018 and 2021-2023.