The Risks and Regulation of Decentralized Finance

Abstract

In the past several years, financial applications of the blockchain technology experienced significant growth, development and adoption among the public and institutional investors. With the rise of stablecoins and major events such as the announcement of Facebook’s own cryptocurency Libra in 2019, the EU regulators felt the urgent need to address the digital currencies that may pose financial and security risks if left unsupervised. In 2020, the European Commission introduced the Markets in Crypto-Assets (MiCA) framework to regulate the crypto-asset issuers and service providers located in the EU or serving EU clients from abroad. One of the regulation’s objectives is to address the risks of the crypto-markets while leveraging its benefits, yet there has been no evaluation of the proposed regulation besides the Commission’s own impact assessment.

Thus, this research offers an evaluation of the MiCA framework by adopting World Economic Forum’s DeFi white paper risk framework and interviews with the industry experts to generate both qualitative and quantitative data that is used to construct policy considerations for future amendments. By conducting interviews with 8 legal experts, the study provides insights into the strengths and weaknesses of the MiCA framework, while the interviews with 2 respondents from crypto-asset issuer entities, 6 from crypto-asset service providers entities and 3 from institutional investors entities provided further insights into the perceptions of the industry participants on the EU crypto regulation. Moreover, the study presents the risk perceptions of each respondent groups as during the interview rounds the participants were presented 18 risks of DeFi and were asked to select the most 5 critical risks perceived by them. This information is used to reveal what risks are perceived by each group. Lastly, the study presents a content analysis to assess the extent to which the 18 risks ranked by the interviewees are addressed in the MiCA framework. In summary, the results of the study suggest many points of improvement to the MiCA framework with respect to definitions, scoping, classifications and the regulatory approach. Moreover, the results suggest that the policy makers should focus on the unaddressed risks in the future amendments and policies, most importantly on technical and operational risks that have been left out from the framework.