By Daniel Ramirez Escudero
Compiled by: TaxDAO
New EU regulations may soon force decentralized finance (DeFi) protocols to make difficult decisions, largely due to the preference of many DeFi protocols to have centralized front-ends and intermediaries.
The EU’s MiCA, which is due to fully come into effect at the end of 2024, will require DeFi protocols to comply with the same licensing and know-your-customer (KYC) requirements as traditional financial services firms — something many DeFi protocols may be unable or unwilling to undertake.
“This is only possible with a fully decentralized, localized, downloaded front end or a full KYC online front end,” said Rune Christensen, co-founder of MakerDAO. This leaves DeFi protocols with a choice: either move to a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations, or go fully decentralized.
1. “Real” DeFi is not subject to MiCA
In the actual EU regulation, fully decentralized protocols are not subject to the MiCA requirements, as Article 22 states: “Crypto-asset services are not within the scope of this Regulation if they are provided in a fully decentralized manner and without the need for any intermediaries.”
Oliver Völkel, attorney and partner at Völkel Law Firm, has delved into the EU’s regulation of crypto assets. He points out that the immediate question raised by this part of MiCA is: What exactly do “no intermediaries” and “a completely decentralized approach” mean?
“Smart contracts for the provision of crypto-asset services are not themselves suitable for creating even the appearance of exclusive decentralization,” he said. Companies can use smart contracts to provide crypto-asset services on their own behalf, Völkel concluded, in which case the smart contract is merely a tool used by the company. Only natural and legal persons can have rights and obligations, make and receive legal declarations, provide and receive services, and become the object of law or be subject to supervision by acts such as MiCA.
However, Völkel believes that EU lawmakers are right to recognize that "none of the above situations exist if crypto-asset services can be accessed in a fully decentralized manner and without intermediaries."
With MiCA set to come into full effect by the end of 2024, DeFi protocols operating in Europe will have to decide whether to go fully decentralized, effectively circumventing regulation, or apply KYC measures like any other centralized company providing financial services.
2. Will DeFi split?
Nathan Catania, partner at XReg Consulting, a consulting firm specializing in the regulation of crypto assets, claims that a new wave of regulation could split the industry: "Regulation represents a fork in the road for many DeFi projects. They can either embrace decentralization and push the boundaries of regulation further, or accept certain regulations that are required based on their specific model and move towards a more hybrid financial state." In his view, "for those who truly embrace decentralization, regulations such as MiCA will draw clearer lines." This new set of rules will make it clearer how truly decentralized applications can be built to comply with regulatory requirements.
In fact, many DeFi protocols must take a hard look at the way they operate to ensure that their platforms are truly decentralized and do not violate the law. Catania recommends that they thoroughly evaluate regulations and work with national regulators to ensure they are protected where possible.
There are a number of workarounds that the DeFi industry can implement to ensure decentralization, one of the most important being the decentralization of the website’s front end. Decentralized web hosting involves deploying websites on P2P servers using advanced cryptography.
Thomas Kroes, deputy executive director of Urbit, an open-source, P2P decentralized personal server platform, explained that decentralized hosting provides protection for front-end services because they cannot be shut down. Even Urbit would not be able to delete content on its nodes if necessary, he said.
But no matter which path the protocol chooses, regulation will exist.
Decentralization advocates may soon see DeFi morphing into something closer to traditional finance, the very industry they seek to disrupt. Will the industry thrive in a decentralized, digital world? Or will a potential capital infusion from traditional market movers transform the sector?
3. DeFi needs to comply with regulations to attract institutional investors
As the DeFi industry matures and becomes more popular, regulators’ attention to DeFi is also increasing. The enforcement actions taken by the EU’s MiCA and the U.S. Securities and Exchange Commission against popular DeFi protocols are good examples.
On April 10, 2024, Uniswap became the first decentralized protocol to be issued a Wells notice - a Wells notice is an official notice issued by a regulator to inform an individual or company that the regulator has completed its investigation and found violations and will take the case to court.
Uniswap CEO Hayden Adams responded that he was not surprised, "just annoyed, disappointed, and ready to fight back."
Adam Simmons, chief strategy officer of DeFi platform Radix, believes that most people would agree that some protective measures need to be put in place. He noted that regulatory requirements in the DeFi field may be inevitable, especially if the industry aims to achieve global adoption.
Instalabs CEO Edward Adlard noted that "the next evolution of DeFi is to get institutions, traditional financial funds involved." However, he believes there are two main obstacles. First, TradFi companies are not operationally prepared to use crypto tools. Second, TradFi companies need to figure out how to legally acquire these products and offer them to customers:
"DeFi DApps need to find a balance between implementing sufficient AML procedures to attract TradFi liquidity and not becoming a target of regulatory action."
Compliance tools are already available. Simmons explained that the European DeFi industry could use a system of trusted issuers to independently handle identity verification.
Adlard noted that DeFi KYC service Instapass can create custom credentials that comply with EU regulations, adding that “DeFi DApps could easily give users access to specific parts of their product depending on whether the user has that credential.”
Whether a DeFi protocol chooses to pursue institutional adoption or fully decentralize, it will have to adjust to the EU’s changing legal landscape.
Financial regulations are evolving to adapt to the evolving digital landscape. The EU is taking important steps to include cryptocurrencies and other digital assets in its regulatory framework and has issued the Administrative Cooperation Directive (DAC 8) to help achieve this goal. DAC 8 aims to increase transparency and help combat tax evasion related to crypto assets. The introduction of DAC 8 is a major step forward for EU member states in the management and reporting of crypto assets.
