Why it is Time To Advocate For Sensible E.U. DeFi Policy

Guest post by Kadan Stadelmann, who is a blockchain developer, operations security expert and Komodo Platform’s chief technology officer. 

The European Union’s Market Crypto Assets (MiCA) law does not define decentralization, suggesting fully decentralized entities may fall outside the scope of the new E.U.-wide regulation set for a February vote. In some parts of the text, MiCA states that only partially decentralized projects, colloquially known as centralized finance (CeFi), will be subject to the regulation’s purview.

Why it is Time To Advocate For Sensible E.U. DeFi Policy

Presumably, projects will need to be so decentralized as to be fully-automated, in order to not be governed by MiCa. One primary intention of MiCa’s legislators seems to be limiting the use of crypto assets as a means of exchange—the legislation does, after all, come down particularly hard on stablecoins—which then begs the question how to ensure that such tokens are only used as a means of payment. The more decentralized a project, the more difficult it is to effectively control and manage the native token, after all.

MiCA seems to imply decentralization eludes to a system sans any intermediary—a la Bitcoin—but technical guidelines will be needed to legally define this common crypto term. Decentralization, which might take various shapes and forms, could be defined by network features, the role of developers, tokenomics, legal structure, etc.

Many questions remain unanswered by MiCa. Rather than focusing on decentralized finance, the E.U. has focused on stablecoins and crypto asset service providers (CASPs). Protocols and decentralized finance will not be treated as crypto asset service providers, because there would arise many-a-difficulty in applying these provisions to DeFi.

When in the future decentralization becomes regulated, it will be done with an instrument other than MiCA. Therefore, the landmark regulation won’t apply to true NFTs, Web3, etc. Truly decentralized projects will not be undermined by MiCA, though modestly funded companies and organizations could struggle in a more limited MiCA world.

Unfortunately, that poses a serious problem for projects who seek to one day become decentralized, which is common in the crypto industry—developers discuss “centralized to decentralized flight paths.” Even Bitcoin was at one time relatively centralized in a few people—at first, Satoshi Nakamoto and Hal Finney, and then from there others.

How Might The European Commission (E.C.) Regulate DeFi?

European legislators and regulators envision a new set of DeFi-focused regulations. Finance professor Tarik Roukny told the European Commission that it immediately needs new regulation to minimize the “severe threats” DeFi poses to consumers, producers, and the economy at large.

“DeFi tools hold a credible promise for new forms of financial services adapted to a globalized, competitive, fair and digital economy,” Roukny, an assistant professor from Belgium’s Leuven University, told the Commission during a webinar. In addition, he issued a report on DeFi.

“You need to find incentives to make it attractive for protocol designers and protocol developers to enter a policy framework or to enter the sandbox you have in mind – and that is crucially different from a lot of other services,” Roukny adds. Perhaps the European crypto industry will lobby for prosecutorial immunity for a certain period of time before entering into any regulatory sandboxes.

He suggests oracles, which interface between protocols and real world apps, data sources, etc. as a possible point for controls. “T??here may be large benefits from interventions like public oracles, licensed oracles or more generally regulated oracle markets that compensate for the unverifiable nature of the information.”  The term “interventions” should be made very clear in any future regulations.

Mattias Levin, deputy head of the commission team responsible for digital finance, said that regulators seek to inform themselves about the economics and legal implications of DeFi. “DeFi is rapidly emerging, albeit from a low base – but there’s a strong policy interest in understanding the phenomenon further, and to try to see what are the economics and the legal implications of it.”

How DeFi Legislation Might Work

The law currently struggles with how to handle DeFi. In the world of DeFi, there are no contracts other than smart contracts, which might not always qualify as a legal contract. Old frameworks have been described as square pegs not fitting into the circle of DeFi. Across the pond, some examples of where European legislators might go when it comes to regulating DeFi exist.

Vermont became the first U.S. state to progress blockchain-based LLC (BBLLC) legislation, having done so in July 2018. Although the word “DAO” is not in the law,  it applies to entities using “blockchain technology for a material portion of its business activities.”

The law stipulates that a BBLLC must include more than a standard LLC in its operating agreement—an explanation of the company’s mission and/or purpose, information about the underlying blockchain, security protocols, membership and voting procedures, as well as rights and obligations—suggesting perhaps DeFi regulations will prove more onerous than standard LLCs.

The State of Wyoming passed in July 2021 a DAO law creating a particular type of incorporated DAO LLC designed to delimit the liability of partners (i.e. certain members of the DAO who qualify as partners). This avoids the individual and personal liability of mere token holders. But, there, too, the requirements to form a DAO LLC seem more onerous than standard LLCs.

Tennessee passed Wyoming-inspired DAO legislation in April 2022 with a statute that refers to the new entity type as a “decentralized organization” or “DO,” withholding the “autonomous.” DOs must make similar disclosures to Wyoming DAOs.

Meanwhile, DeFi builders are working on questions they know regulators will pose: how to create wallet scores, build in decentralized identifiers, broaden financial inclusion, and more. DeFi developers are working on tools at the protocol level, creating on-chain know your customer features. Other solutions entail smart contracts that allow verified entities to deposit funds and mint “fully compliant assets” sans the need for repetitive KYC operations.

The Spirit Of DeFi

It’s clear that the E.C. will begin the pursuit of a separate DeFi regulatory regime, so the time is now to begin advocating for the sensible approach. Regulators will analyze potential choke points—such as oracles—where they can regulate decentralized markets.

The wrong type of regulation, however, could destroy DeFi. And it’s important for industry advocates to focus on both CeFi and DeFi in the future regulatory discussion and debate. The spirit of DeFi is no different than those of many-a-nation’s founding documents, and should not be treated as alien. DeFi is simply creating fairer, more transparent, and more liquid markets.

Kadan Stadelmann is a blockchain developer, operations security expert and Komodo Platform’s chief technology officer. His experience ranges from working in operations security in the government sector and launching technology startups to application development and cryptography. Kadan started his journey into blockchain technology in 2011 and joined the Komodo team in 2016.

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