New EU law could put DeFi at a fork in the road

Source: TaxDAO

New EU regulations may soon force decentralized finance (DeFi) protocols to make a difficult decision, largely due to the preference of many DeFi protocols to have centralized front ends and intermediaries. 

The EU’s MiCA, which will 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 companies - something many DeFi protocols may not be able or willing to undertake. 

“It’s 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. “True” DeFi is not subject to MiCA

In actual EU regulation, fully decentralized protocols are not subject to the requirements of MiCA, as stated in Article 22: “Crypto-asset services are not covered by this Regulation if they are provided in a fully decentralized manner and without any intermediaries”.  

Oliver Völkel, lawyer and partner at Völkel Law Firm, has delved into the EU regulation of crypto-assets. He points out that the immediate question that arises from this section of MiCA is what exactly does “without intermediaries” and “in a fully decentralized manner” mean?  

“Smart contracts used to provide crypto-asset services are not even suitable in themselves to create the appearance of exclusive decentralization,” he says. Companies can use smart contracts to provide crypto-asset services on their own behalf, and Völkel concludes that in this 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 statements, provide and receive services, and be the subject of law or subject to supervision under acts such as MiCA. Völkel believes, however, that EU lawmakers correctly recognise that “none of this would exist if crypto-asset services could be accessed in a fully decentralized manner and without intermediaries”. With MiCA set to fully come into force by the end of 2024, DeFi protocols operating in Europe will have to decide whether to be fully decentralized, effectively circumventing regulation, or to apply KYC measures like any other centralized company providing financial services. 2. Will DeFi split?  

Nathan Catania, partner at XReg Consulting, a consultancy specialising 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 decentralisation and push the boundaries of regulation further, or accept certain regulations that are required based on their particular model and move towards a more hybrid financial state". In his view, "regulations such as MiCA will draw a clearer line for those who truly embrace decentralisation". 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 advises them to thoroughly evaluate regulations and work with national regulators to ensure that they are protected where possible.  

There are a number of workarounds that the DeFi industry can implement to ensure decentralisation, one of the most important being the decentralisation of the website frontend. Decentralized web hosting involves deploying websites on P2P servers using advanced encryption. 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 cannot delete content on its nodes if necessary, he said. But whichever path the protocol chooses, regulation exists. Decentralized advocates may soon see DeFi transform into something closer to traditional finance, the industry they want to disrupt. Will the industry thrive in a decentralized digital world? Or will a potential capital injection from traditional market movers change the industry?   

3. DeFi needs to comply with regulations to attract institutional investors 

As the DeFi industry matures and becomes more popular, regulators are paying more attention to DeFi. 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 that it has violated regulations and will go 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 at DeFi platform Radix, believes that most people would agree that some protections need to be put in place. He noted that regulatory requirements in the DeFi space may be inevitable, especially if the industry aims to achieve global adoption. Edward Adlard, CEO of Instalabs, pointed out 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 ready to use crypto tools. Second, TradFi firms need to figure out how to legally acquire these products and offer them to customers: “DeFi DApps need to find a balance between implementing adequate 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 can easily give users access to specific parts of their products, 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.