The European Commission is currently evaluating decentralized finance protocols in Europe and considering the implementation of new regulations. As part of this process, the Commission is required to prepare a report by December 30, 2024, to assess the decentralized finance market and determine the feasibility of specific regulations for the sector. To prepare for this report, the Commission has initiated various actions, including a study on embedded supervision. However, no policy decisions have been made yet, according to a Commission spokesperson.
The report will focus on how decentralized systems, particularly those without a clear issuer or service provider, should be regulated. One important aspect of the assessment will be the regulation of crypto-asset lending and borrowing, which is a core activity within the DeFi space. Maxim Galash, CEO of CoinChange Financials, explained in an analysis that decentralized finance represents a shift from traditional finance systems to peer-to-peer finance enabled by blockchain-based decentralized technologies. Unlike traditional finance, decentralized systems operate without intermediaries like banks or financial service providers.
The potential introduction of new regulations has raised concerns about the legal viability of certain crypto projects. For example, MakerDAO co-founder Rune Christensen pointed out that the rules could require some DeFi interfaces, such as decentralized exchanges, to obtain licenses. This could make DeFi frontends on normal internet domains impossible, limiting them to fully decentralized, local, downloaded frontends or full-KYC online frontends.
Nathan Catania, a partner at XReg Consulting, believes that any eventual DeFi regulation would apply to all non-fully decentralized applications, including DeFi frontends. The definition of decentralization and the extent of DeFi rules would depend on the criteria used to determine the concept. Under the regulatory framework known as Markets in Crypto-Assets (MiCA), a Crypto-Asset Service Provider (CASP) is any entity that provides services related to digital assets to third parties. This includes exchange services, transfer services, and custodian wallets.
Catania suggests that regulators may evaluate the level of decentralization based on whether a professional service is being performed. Another possible route for DeFi regulation is through the Financial Action Task Force (FATF). The FATF proposes that individuals or entities with control or significant influence over DeFi arrangements may be classified as Virtual Asset Service Providers (VASPs), even if the arrangements appear decentralized. This highlights the complexity of defining and regulating DeFi activities.
According to data from DefiLlama, the total value locked (TVL) in DeFi protocols has experienced significant growth over the past four years, reaching $96.7 billion at the time of writing. This represents a 16,865% increase since April 2020. The question remains whether a DeFi arrangement is simply a technological arrangement or if there is a controlling party behind it that can influence user value, according to Catania.
In conclusion, the European Commission is evaluating decentralized finance protocols in Europe and considering the implementation of new regulations. The assessment will explore how decentralized systems should be regulated, with a particular focus on crypto-asset lending and borrowing. The introduction of regulations could impact the legal viability of certain crypto projects and require DeFi interfaces to obtain licenses. The extent of DeFi rules would depend on the criteria used to determine decentralization. The Financial Action Task Force may also play a role in regulating DeFi activities. The total value locked in DeFi protocols has experienced significant growth in recent years. Ultimately, the key question is whether a DeFi arrangement is purely technological or if there is a controlling party influencing user value.