Crypto assets and distributed ledger technology (DLT) topped the European Securities and Markets Authority’s (ESMA) 2021 financial innovation scoreboard, according to a new report published by the institution.

The 110-page report, titled “Trends, Risks and Vulnerabilities,” treated cryptocurrency as a trending financial innovation as well as a threat to sustainable finance due to its “soaring” environmental cost, particularly in relation to crypto mining. The report suggested that crypto asset volatility, along with the rise of decentralized finance (DeFi), central bank digital currencies (CBDC) and stablecoins, are contributing to increasing risk across all asset classes.

“Most crypto assets (CAs) are highly volatile in price and operate outside of the existing EU regulatory framework, which raises investor protection issues,” the report said.

ESMA is an independent European Union (EU) authority tasked with improving investor protection and promoting stable and orderly financial markets. The scoreboard prioritizes financial innovations that require deeper analysis and potential policy responses, and ranks them based on how they relate to ESMA objectives.

The ESMA report was released just as EU regulators began gearing up for the implementation of all-encompassing cryptocurrency regulations, new anti-money laundering (AML) rules and tax reporting requirements for virtual asset service providers and investors. Additionally, the European Central Bank (ECB) is set to begin a two-year investigation into a digital euro in October.

According to the report, a rise in risk-taking behavior and market exuberance are to blame for increasing volatility in equity markets.

“Increased [risk-taking] behavior has led to volatility in equity (e.g., GameStop-related market movements) and crypto asset markets, as well as to the materialization of event-driven risks such as in the case of Archegos or Greensill,” the report said, referring to the recent fall of New York investment giant Archegos, and London-based lender Greensill Capital.

Earlier this year, retail investors came together to rally behind GameStop stock, leading to massive losses for new traders as the price plummeted following initial hype of the movement.

“Going forward, we expect to continue to see a prolonged period of risk to institutional and retail investors of further – possibly significant – market corrections and see very high risks across the whole of the ESMA remit,” the report said.

The report cautions against the risks surrounding crypto assets, adding that the crypto market capitalization fell by almost 40% in May, highlighting their high price volatility.

The report suggests that the EU’s upcoming Markets in Crypto Assets (MiCA) regulatory framework is designed to address these risks. The sweeping framework will apply in 27 member states, and includes particularly harsh restrictions on stablecoins (crypto backed by fiat reserves like the U.S. dollar), including requiring stablecoin issuers to own at least 3% of the coin’s reserves.

The report reiterates that stablecoins are not an EU favorite.

“Market developments around private stablecoins continue to be under scrutiny by global regulators, given the potential impact mass stablecoin adoption could have on financial systems. This call for more transparency and legal certainty has been reinforced as tether, the largest stablecoin, presented a breakdown of its reserves for the first time in May 2021,” the report said, referring to Tether revealing 49% of its reserves were made up of unspecified commercial paper.

The EU’s stance on stablecoins was made clearer when, just last week, ECB President Christine Lagarde said that in her view, stablecoins were pretending to be currencies, and that they are actually assets.

According to the report, sustainable finance is expanding in Europe, with a 20% growth of environmental, social and governance (ESG) fund assets and a 40% rise in outstanding sustainable debt instruments in 2020.

But the energy consumption of certain DLT protocols is a source of environmental concern, the report said.

“Innovation can support sustainability by addressing ESG information gaps through Green financial technology (FinTech) solutions, but the environmental cost of one particular innovation – cryptocurrencies – is soaring,” the report said.

With mounting pressure on global leaders and institutions to up their game against climate change, cryptocurrencies, particularly bitcoin, have come under fire for the large amounts of energy required to mine and maintain their networks.

“Estimates vary but they agree that the carbon footprint of cryptocurrencies is far from negligible,” the report said. “These developments trigger discussions about possible regulatory responses to the unintended consequences of innovation, and in particular of crypto mining.”

Alongside innovations like artificial intelligence and machine learning, the report emphasized the proliferation of distributed ledger technology (DLT), DeFi and CBDCs.

“DeFi holds the same benefits as blockchain technology on which it is built, namely disintermediation, round-the-clock availability and censorship resistance. It also faces similar challenges and risks, including in relation to operational resilience, scalability and governance,” the report said.

It goes on to say that CBDCs and stablecoin use combined with an increased interest in crypto assets from institutional investors are blurring the boundaries between centralized traditional financial systems and DeFi, and thereby “increasing the risks of potential spillover of DeFi risks to the real economy.”

“These risks are further intensified by the rapid growth of DeFi and the recent price performance of the main crypto assets,” the report said.

The growing risk to investors might be pushing regulators to step in throughout the EU, according to the report.

“Regulators’ engagement with FinTech through innovation hubs and regulatory sandboxes is becoming mainstream across the EU, with benefits for both parties,” the report said.

Fintech innovation hubs are working efficiently, the report suggests, adding that all member states have at least one hub set up. Regulatory sandboxes are less common, with eight currently operating in the EU, including in Denmark and the Netherlands.

“Both regulators and innovators increasingly recognize the benefits of innovation hubs and regulatory sandboxes, namely spurring innovation while staying alert to emerging risks,” the report said.

Aside from the risks involved, DLT has the potential to enhance efficiency in financial processes and firms while improving consumer outcomes, the report said, adding that applications are still limited.

“Scalability, interoperability and cyber-resilience will require monitoring as DLT develops. Other challenges include anonymity as well as governance and privacy issues,” the report said.