New regulations in the European Union may soon present a dilemma for decentralized finance (DeFi) protocols. The issue at hand is 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 firms. This may be a burden that many DeFi protocols are unable or unwilling to bear.
Rune Christensen, the co-founder of MakerDAO, stated that 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 to a partially centralized “hybrid finance” (HyFi) model to meet EU regulations or fully decentralize.
However, it should be noted that “true” DeFi is exempt from MiCA regulations. According to Recital 22 of the EU regulation, fully decentralized protocols are not subject to MiCA requirements. The question raised by this section is what exactly is meant by “without an intermediary” and “in a fully decentralized manner”? Smart contracts alone cannot create the appearance of exclusive decentralization as they are tools used by companies to provide crypto-asset services.
To comply with the regulations, DeFi protocols operating in Europe will have to decide whether to fully decentralize or apply KYC measures like centralized companies offering financial services. Nathan Catania, a partner at XReg Consulting, believes that this new wave of regulation could split the DeFi sector. Those that embrace decentralization will have clearer guidelines on how to build truly decentralized applications that meet regulatory requirements.
DeFi protocols will need to thoroughly assess the regulations and engage with national regulatory authorities to ensure their compliance and protection. One possible workaround to ensure decentralization is the decentralization of website front-ends through the use of peer-to-peer servers and advanced cryptography.
Regardless of the path chosen, regulation is inevitable for the DeFi sector. As the sector matures and gains popularity, regulators are paying more attention to DeFi. This is exemplified by the EU’s MiCA and the US Securities and Exchange Commission’s enforcement actions against popular DeFi protocols.
DeFi protocols need to comply with regulations in order to attract institutional investors. However, there are obstacles to overcome, such as the operational setup of traditional finance companies and their ability to legally access and offer DeFi products to clients. Compliance tools are already available, and the DeFi sector in Europe could utilize trustworthy issuers and KYC services to meet regulatory requirements.
In conclusion, DeFi protocols will need to adjust and adapt to the changing legal landscape in the European Union, whether they choose institutional adoption or complete decentralization.