EU regulator sees crypto as sign of increased risk-taking in current climate

The European Securities and Markets Authority (ESMA) has published its report on trends, risks and vulnerabilities in the European Union markets during the first half of 2021 (1H21).

Its takeaways included the argument that crypto markets’ extraordinary volatility and growth make a compelling case for the need for a targeted regulatory regime, as sketched out in the European Commission’s proposed Markets in Crypto-Assets regulations.

Much has been riding on the EU and global market’s recovery during 1H21 amid the ongoing impact of the COVID-19 pandemic. ESMA’s report notes that the economic outlook has continued to improve overall, with the European economy now forecast to have reached its pre-pandemic output by the end of 2022, earlier than had been expected. 

This recovery has been fueled by the relaxation of public health restrictions, some reduction in uncertainty, and central banks’ activism in providing supportive monetary policies. When it comes to the medium-term risks of the current climate, ESMA has taken the crypto markets as a bellwether of market sentiment and dynamics during the past six months:

“Rising valuations across asset classes, massive price swings in cryptoassets and event-driven risks observed in 1H21 amid elevated trading volumes raise questions about increased risk-taking behaviour and possible market exuberance.”

This exuberance, in the ESMA’s view, has been visible in the GameStop saga and the broader rise of social media-fueled retail trading, coupled with the huge price growth in crypto assets in the first quarter of this year. Much of this increase in trading activity has been happening outside the EU’s regulatory perimeter, the report underlines, raising investor protection concerns.

The ESMA attributed rising consumer confidence during this period to a range of factors, including innovative new business models and gamified features in online and mobile trading platforms. Parallel to the retail trading boom, ESMA is keeping a close eye on decentralized finance (DeFi), noting that the 47 billion euros ($55.3 billion) locked in DeFi in early September was down from its heights in mid-May, yet up 1,200% from the end of July 2020.

The ESMA recognized DeFi’s benefits, including disintermediation, 24/7 availability and censorship resistance, and noted that the increasing use of stablecoins and central bank digital currencies are likely to make the boundaries between traditional finance and DeFi more porous over time. However, especially due to institutional investors’ proactivity, the ESMA considered that there is a growing possibility that DeFi risks will spill over into the real economy, even though the market remains small for the time being.

Related: EU securities regulator warns about risks of ‘non-regulated’ cryptocurrencies

The report also noted that institutional investors are starting to consider Bitcoin’s (BTC) environmental impact in terms of their ESG targets, which is feeding into the growing interest in Ether (ETH). Alongside its environmental credentials, the ESMA attributed ETH’s success to its smart contract functionality, the DeFi boom, and the blockchain’s role in the nonfungible token ecosystem.

The regulator’s assessment has been echoed by Pantera Capital CEO Dan Morehead, who this summer argued that the blockchain’s upgrade will likely help Ether to outflank Bitcoin as the largest cryptocurrency.