New regulations in the European Union may soon force decentralized finance (DeFi) protocols to make difficult decisions.
The crux of the problem is that many DeFi protocols tend to have front-ends and central intermediaries.
The EU’s Markets in Cryptoassets (MiCA) regulation, which will come into full effect by the end of 2024, will require DeFi protocols to adhere to the same licensing and know-your-customer (KYC) requirements as traditional financial services companies – a burden that many DeFi protocols may have Unable or unwilling to bear it.
According to “Only fully decentralized, local, downloaded front-ends or fully online front-ends for KYC will be possible,” said Ron Christensen, co-founder of MakerDAO.
This leaves DeFi protocols with a choice: either shift to a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations or become fully decentralized.
“Real” DeFi is exempt from MiCA
Within the de facto EU regulation, decentralized protocols are fully exempt from falling into the MiCA requirements, as stated in Recital 22:
“When crypto asset services are provided in a completely decentralized manner without any intermediary, they should not fall within the scope of this regulation.”
Oliver Völkel, lawyer and partner at the law firm Stadler Völkel, has studied EU regulation of crypto assets in depth.
He told Cointelegraph that the immediate question this section of MiCA asks is what exactly is meant by “disintermediate” and “fully decentralized”?
“Smart contracts used to provide service for crypto assets are not in themselves suitable even for creating the appearance of exclusive decentralization,” he said.
Businesses can use smart contracts to provide crypto asset services in their name. In such cases, the smart contract is just a tool used by the company, Voelkel concluded.
Only natural persons and legal entities can have rights and obligations, make and receive legal announcements, provide and receive services, and be transmitters of the law or subject to supervision under a law such as MiCA.
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However, Volkel believes that EU legislators correctly realize that “none of this is the case if the service of crypto assets can be accessed without an intermediary and in an exclusively decentralized manner.”
With MiCA coming into full effect by the end of 2024, DeFi protocols operating in Europe will have to decide whether to implement full decentralization, actively avoid regulations, or implement KYC measures like any other centralized company providing financial services.
Will DeFi split into two parts?
Nathan Catania, partner at XReg Consulting – a consultancy specializing in crypto asset regulation – told Cointelegraph that the new wave of regulation could lead to a fragmentation of the sector:
“Regulation represents a crossroads for many DeFi projects. They either embrace decentralization and move outside the regulatory realm or accept that some regulation is needed based on their own model and move toward a more hybrid fiscal state.
In his opinion, “For those who embrace decentralization, regulation like Europe’s MiCA will draw clearer lines in the sand.” This new set of rules will provide greater clarity on how to build truly decentralized applications to comply with regulatory requirements.
In fact, many decentralized finance (DeFi) protocols will have to take a hard look at how they do business to ensure that their platforms are truly decentralized and not running afoul of the law.
Catania suggested that they comprehensively evaluate the regulation and engage with national regulatory authorities to ensure their protection, if possible.
The DeFi sector can implement many solutions to ensure decentralization, one of the most important of which is the decentralization of website front-ends. Decentralized web hosting involves publishing websites on peer-to-peer (P2P) servers using advanced encryption.
Thomas Cross, deputy CEO of Urbit – an open source decentralized P2P platform – explained to Cointelegraph that decentralized hosting provides protection for front-end services, as they cannot be removed. He said that even Urbit cannot remove content on its contract if necessary.
Whichever path the protocol chooses, regulation is here.
Advocates of decentralization may soon see DeFi turning into something closer to traditional finance, the very industry they set out to disrupt.
Will the industry thrive in a decentralized, digital world, or will the potential injection of capital from traditional market engines transform the sector?
DeFi needs compliance to attract institutional investors
Regulators are paying increasing attention to decentralized finance (DeFi) as the sector matures and increases in popularity, as evidenced by the European Union’s MiCA and the US Securities and Exchange Commission’s enforcement actions against popular DeFi protocols.
On April 10, 2024, Uniswap became the first decentralized protocol to issue a Wells Notice – a formal notice issued by regulatory bodies informing individuals or companies that the regulatory body has completed an investigation and discovered violations that will be taken to court.
Uniswap CEO, Hayden Adams, He responded He wasn’t surprised, “just annoyed, frustrated, and ready to fight.”
Adam Simons, Chief Strategy Officer at DeFi Platform Radix told Cointelegraph that Most people agree that some safeguards are needed.
He believes that regulatory requirements for the DeFi sector are likely to be inevitable, especially if the industry aims to achieve global adoption.
“The next evolutionary step for DeFi is getting traditional institutional finance money to participate,” Edward Adlard, CEO of Instalabs, told Cointelegraph.
However, he believes there are two major hurdles. First, TradFi companies are not practically set up to use crypto tools.
Second, TradFi companies need to know how to legally access these products and offer them to customers: “DeFi DApps need to walk the line between implementing sufficient anti-money laundering measures to attract TradFi liquidity and not becoming the target of regulatory action.”
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Compliance tools are already available. Simons explained that the DeFi sector in Europe could use a system of trustworthy issuers that handle identity verification independently.
Adlard noted that DeFi KYC Instapass can generate custom credentials that meet EU regulations, adding that “DeFi DApps can easily make access to certain parts of their products contingent on users having these credentials.”
Regardless of whether a DeFi protocol chooses to pursue institutional adoption or full decentralization, it will have to adapt to adapt to the changing legal landscape in the EU.
