The European Union Commission wrote a chapter on decentralized finance (DeFi) in a report from last month, weighing out the implications of its prominence and suggesting comprehensive regulation.
According to Patrick Hansen, Head of Strategy at Unstoppable Finance and widely followed for his analysis of European crypto regulation, the report shows that the officials have a good grasp on DeFi and how it works, including individual protocols.
Hansen says that the report could provide a glimpse of the stance that the EU takes on DeFi in the future.
One passage in the report states:
“Compared to the traditional financial system, DeFi could potentially increase the security, efficiency, transparency, accessibility, openness and interoperability of financial services. As a result, DeFi could provide substantial opportunities to foster cross-border financial integration, which is an important policy objective of the EU. It could also enhance financial stability via risk sharing, which is rooted in its decentralised governance and liquidity provision. While its contribution to the financing of real economic activity is so far minimal, it is already proving to be useful in the virtual economy.”
However, the Commission says that the DeFi ecosystem is “subject to many risks, notably conduct and operational risks.”
The officials believe that conduct risks are present due to the absence of any regulation, as well as the quasi-anonymous nature of DeFi. Operational risks exist because of the reliance on software, the report says.
The rapid growth of DeFi will have implications on financial stability, namely due to the role played by stablecoins, and applying traditional financial regulations to the space calls for new discussions, according to the Commission.
“Adapting the EU financial services regulatory framework to a decentralised environment will require a rethink; and regulatory cooperation with the main jurisdictions relevant to the DeFi ecosystem might prove indispensable,” they said. “To benefit from the inherent data transparency on public blockchains, the Commission announced that it would launch a pilot project on embedded supervision in 2022.”
The report also revealed the Commission’s decision to launch a pilot project to use “embedded supervision” to monitor the DeFi space to assess specific risks before going further with regulations.
“Embedded supervision would imply a technological solution that would enable supervisors to automatically monitor compliance with the regulatory framework by reading blockchain transaction data, thus reducing the need for market participants to actively collect, verify and deliver data to supervisory authorities,” the Commission said, adding “It would also reduce the administrative burden for firms, while facilitating supervisors’ access to transaction data.”
Last week, Fabio Panetta from the European Central Bank said in a speech that a global framework would be needed to curb the “Wild West” of crypto. He suggested universal standards for tax, KYC and AML rules, transparency, and regulations for operators of exchanges.