New regulations within the European Union may soon present decentralized finance (DeFi) protocols with difficult choices to make. The main issue lies in the fact that many DeFi protocols have centralized front-ends and intermediaries. The Markets in Crypto-Assets Regulation (MiCA) of the EU, which will be fully implemented by 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. This could be a burden that many DeFi protocols are unable or unwilling to bear.
According to Rune Christensen, the co-founder of MakerDAO, “Only fully decentralized, local, downloaded frontends or full-KYC online frontends would be possible.” This leaves DeFi protocols with a choice: either adopt a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations, or fully decentralize.
However, it’s important to note that true DeFi is exempt from MiCA. The actual EU regulation states that fully decentralized protocols are not subject to MiCA requirements, as stated in Recital 22. Oliver Völkel, an attorney and partner at the law firm Stadler Völkel, has extensively studied the EU’s regulation of crypto assets. He explains that the immediate question raised by this section of MiCA is what exactly is meant by “without an intermediary” and “in a fully decentralized manner.” Völkel concludes that smart contracts alone are not enough to create the appearance of exclusive decentralization, as companies can use smart contracts to provide crypto-asset services in their name.
Despite this exemption, DeFi protocols operating in Europe will still face the decision of whether to fully decentralize or implement KYC measures to comply with the regulations. Nathan Catania, a partner at XReg Consulting, believes that this new wave of regulation could potentially split the DeFi sector. He suggests that those protocols that embrace decentralization will have clearer guidelines to follow when building truly decentralized applications.
To ensure decentralization, the DeFi sector can explore various workarounds, such as decentralized web hosting. This involves using peer-to-peer (P2P) servers and advanced cryptography to deploy websites, providing protection for front-end services from being taken down. Thomas Kroes, deputy executive director of Urbit, an open-source P2P decentralized personal server platform, explains that even Urbit cannot remove content from its nodes if required.
Regardless of the path chosen by DeFi protocols, regulation is becoming a reality. Regulators are increasingly focusing on DeFi as the sector matures and gains popularity. For the industry to attract institutional investors, compliance is necessary. Adam Simmons, chief strategy officer at DeFi platform Radix, believes that regulatory requirements for the DeFi sector are likely inevitable if it wants to achieve global adoption.
Compliance tools are already available, and DeFi protocols in Europe could consider using a system of trustworthy issuers to handle ID verification independently. Additionally, DeFi protocols could implement custom credentials that fulfill EU regulations, making access to specific parts of their products contingent on users having those credentials.
Ultimately, whether DeFi protocols choose institutional adoption or complete decentralization, they will need to adjust and adapt to the changing legal landscape in the European Union.