New regulations within the European Union may soon impose difficult decisions on decentralized finance (DeFi) protocols. The issue at hand is the prevalence of centralized front-ends and intermediaries in many DeFi protocols. The Markets in Crypto-Assets Regulation (MiCA) of the EU, set to take effect by the end of 2024, will require DeFi protocols to comply with the same licensing and Know Your Customer (KYC) requirements as traditional financial service firms. This burden may be too much for many DeFi protocols to handle or be unwilling to bear.
According to Rune Christensen, the co-founder of MakerDAO, only fully decentralized, locally downloaded front-ends or full-KYC online front-ends would be allowed under the new regulations. This leaves DeFi protocols with a choice: either pivot towards a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations or fully decentralize.
However, “true” decentralized finance (DeFi) is exempt from MiCA regulations. The EU regulation states that fully decentralized protocols are not subject to MiCA requirements, as mentioned in Recital 22. The immediate question raised by this section of MiCA is what exactly “without an intermediary” and “in a fully decentralized manner” mean. Smart contracts used in providing a crypto-asset service are not suitable for creating the appearance of exclusive decentralization. Smart contracts can be used by companies to provide crypto-asset services in their name. Therefore, the smart contract is merely a tool used by the company.
Only natural persons and legal entities can hold rights and obligations, make and receive legal declarations, provide and receive services, and be the addressee of a law or be supervised under an act such as MiCA. Despite this, EU lawmakers recognize that if a crypto-asset service can be accessed without an intermediary in an exclusively decentralized manner, then none of these requirements apply.
With MiCA set to take full effect by the end of 2024, DeFi protocols operating in Europe will have to decide whether to fully decentralize to avoid regulations or implement KYC measures like any other centralized financial services company.
Nathan Catania, a partner at XReg Consulting, believes that the new regulations could split the DeFi sector. For those embracing decentralization, regulations like MiCA will provide clearer boundaries. These rules will offer more clarity on how to build truly decentralized applications that comply with regulatory requirements. DeFi protocols will need to assess the regulations thoroughly and engage with national regulatory authorities to ensure their protection, if possible.
To ensure decentralization, the DeFi sector can implement various workarounds, such as decentralizing website front-ends. Decentralized web hosting involves deploying websites on peer-to-peer (P2P) servers using advanced cryptography. Decentralized hosting provides protection for front-end services as they cannot be taken down. Even the platform Urbit cannot remove content on its nodes if required.
Regardless of the path chosen by DeFi protocols, regulation is inevitable. Advocates of decentralization may witness DeFi transforming into something resembling traditional finance, the very industry it sought to disrupt. The question is whether the industry will thrive in a decentralized digital universe or if the injection of capital from traditional market players will change the sector.
DeFi needs to comply with regulations to attract institutional investors. Regulators are paying increased attention to DeFi as the sector matures and gains popularity. Examples include the EU’s MiCA and the United States Securities and Exchange Commission’s enforcement actions against popular DeFi protocols. Uniswap became the first decentralized protocol to receive a Wells notice on April 10, 2024. This notice informs individuals or companies that the regulator has completed an investigation and found infractions that will be brought to court. The CEO of Uniswap, Hayden Adams, responded that he was not surprised, but rather annoyed, disappointed, and ready to fight.
According to Adam Simmons, the chief strategy officer at DeFi platform Radix, some safeguards are necessary. Regulatory requirements for the DeFi sector are likely inevitable, especially for global adoption. Edward Adlard, the CEO of Instalabs, believes that DeFi’s next step is to attract institutional traditional finance money. However, there are two main obstacles. First, traditional finance companies are not operationally prepared to use crypto tools. Second, they need to figure out how to legally access and offer these products to clients without becoming regulatory targets.
Compliance tools are already available. Simmons suggests that the DeFi sector in Europe could utilize a system of trustworthy issuers for independent ID verification. Adlard notes that DeFi KYC service Instapass could create custom credentials that meet EU regulations. DeFi DApps could restrict access to specific parts of their product based on users having that credential.
Regardless of whether a DeFi protocol pursues institutional adoption or complete decentralization, it will need to adapt to the changing legal landscape in the European Union.