European regulator urges reducing the debt burden when trading cryptocurrencies

The European Union’s financial stability watchdog has said that new regulations may be needed to cover large crypto conglomerates and smart contracts, as it warns that a growing digital asset and decentralized finance (DeFi) sector may come to pose a systemic risk to the economy.

With the new Markets in Crypto Assets regulation (MiCA) set to take effect within the bloc in 2024, the European Systemic Risk Board (ESRB), chaired by EU central bank chief Christine Lagarde, warned in a Thursday report of the risks of crypto lending and staking, and of high leverage in digital asset markets.

Under one policy option, “DeFi developers could be required to abide by specific regulations covering the design and creation of smart contracts,” the report said. It floats 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 sets governance, licensing and reserve requirements for players such as wallet providers and stablecoin issuers, it leaves out areas such as crypto lending and staking – though the report warns those areas can pose “significant risks to consumers.”

Companies will have to manage conflicts of interest between their business lines under MiCA – but, the ESRB said, there’s no overarching requirement to identify and mitigate the operational or reputational risks that might mount up from offering services like trading and custody.

“Taking account of any market developments, and experience acquired with the application of MiCA, the activity of crypto-asset conglomerates in the EU should be studied,” the report said, citing existing payment laws that mean supervisors can force risky services to divest to a separate subsidiary.

“While this past year has been turbulent for crypto-assets and DeFi, systemic implications have not materialized,” the report said, adding that “exponential growth dynamics” could mean future upsets may pose a major threat similar to the 2008 collapse of Lehman Brothers.

In March, the ESRB suggested that financial technology firms could face bank-style lending caps to stop crypto markets overheating, citing the rising popularity of crypto.