New EU regulations pose risk to future of decentralization

New European Union regulations could soon force decentralized finance (DeFi) protocols to face important decisions. At the center of this problem is the tendency of many DeFi protocols to use centralized front-ends and intermediaries, raising questions about their compliance with upcoming laws.

The impact of MiCA on DeFi protocols

The European Markets in Crypto Assets (MiCA) Regulation, which is expected to come into full force by the end of 2024, requires DeFi protocols to adhere to the same licensing and know-your-customer (KYC) requirements as traditional financial services. This could present a significant challenge for many DeFi protocols, potentially making compliance difficult or undesirable. Rune Christensen, co-founder of MakerDAO, highlighted the implications of MiCA, noting that DeFi protocols would be left with two main options: fully decentralized, local, uploaded frontends or fully KYC-compliant online frontends.

This regulatory change forces DeFi protocols to choose between a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations or complete decentralization. The EU regulation states that fully decentralized protocols are exempt from MiCA requirements, as stated in recital 22: “Where crypto-asset services are provided in a fully decentralized manner without any intermediaries, they should not enter into the scope of this regulation. »

Defining decentralization

Oliver Völkel, lawyer and partner at Stadler Völkel, has studied European regulation of crypto assets in depth. He points out that the regulation raises immediate questions about the definitions of “without intermediary” and “in a completely decentralized manner”. According to Völkel, smart contracts used to provide services on cryptoassets do not necessarily create the appearance of exclusive decentralization, as companies can use these contracts to provide services on their behalf.

Only natural and legal persons can have rights and obligations, make and receive legal representations and be subject to laws such as MiCA. However, Völkel believes that European lawmakers rightly recognize that none of these conditions apply if a crypto-asset service is accessible without an intermediary and in a fully decentralized manner. With MiCA coming into force by the end of 2024, DeFi protocols in Europe must decide whether to be completely decentralized, thereby avoiding regulations, or implement KYC measures like any other centralized financial service provider.

Nathan Catania, partner at XReg Consulting, a firm specializing in the regulation of crypto-assets, suggests that this regulatory wave could divide the DeFi sector. He believes that regulation represents a crucial moment for many DeFi projects, pushing them to either embrace complete decentralization and operate outside of regulatory boundaries, or accept some level of regulation and transition to a hybrid financial model.

Practical steps for decentralization

For those choosing decentralization, MiCA will provide clearer guidance on building truly decentralized applications that comply with regulatory requirements. Many DeFi protocols will need to reevaluate their business models to ensure they remain compliant. Catania advises DeFi projects to fully understand the regulations and engage with national regulatory authorities to protect their interests. A workaround to ensure decentralization is to decentralize website front-ends through peer-to-peer (P2P) web hosting, which uses advanced cryptography to deploy websites on P2P servers.

Whatever path a protocol chooses, regulation becomes an unavoidable reality. Proponents of decentralization could see DeFi evolving into something closer to traditional finance, the very industry they originally aimed to disrupt. The question remains whether the industry will thrive in a decentralized digital universe or whether the influx of capital from traditional market players will transform the sector.

Growing Regulatory Attention on DeFi

As the DeFi sector matures and gains popularity, regulators are paying increased attention to it, as evidenced by the actions of the EU’s MiCA and the US Securities and Exchange Commission against major DeFi protocols. On April 10, 2024, Uniswap became the first decentralized protocol to receive a Wells Notice, indicating regulatory violations.

Hayden Adams, CEO of Uniswap, expressed his frustration, feeling “annoyed, disappointed and ready for a fight.” Adam Simmons, chief strategy officer of DeFi platform Radix, believes some safeguards are necessary, predicting that regulatory requirements for DeFi are inevitable, especially if the sector aims for global adoption.

Edward Adlard, CEO of Instalabs, sees the next stage of DeFi evolution as attract money from institutional and traditional finance. However, he identifies two main obstacles: traditional financial companies are not operationally equipped to use crypto tools, and they must figure out how to legally access and offer these products to their customers. Adlard suggests that DeFi DApps must balance implementing anti-money laundering (AML) procedures to attract traditional financial liquidity without becoming targets for regulatory action.

Compliance and future adaptation tools

Compliance tools are already available. Simmons mentions that the DeFi sector in Europe could use a system of trusted issuers to handle identity verification independently. Adlard notes that the DeFi KYC service Instapass could create personalized credentials that comply with EU regulations, allowing DeFi DApps to restrict access to specific parts of their products based on user credentials.

Ultimately, whether a DeFi protocol aims for institutional adoption or full decentralization, it must adapt to the changing legal landscape of the European Union.

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