How should DeFi be regulated? A European approach to decentralization

Decentralized money, referred to as DeFi, is a brand-new use blockchain modern technology that is proliferating, with over $237 billion in worth secured in DeFi jobs since January 2022. Regulators recognize this sensation and also are starting to act to control it. In this short article, we quickly assess the principles and also threats of DeFi prior to offering the regulative context.

The principles of DeFi

DeFi is a collection of different monetary systems based upon the blockchain that enables advanced monetary procedures than the easy transfer of worth, such as money exchange, loaning or loaning, in a decentralized way, i.e., straight in between peers, without experiencing an economic intermediary (a central exchange, for instance).

Schematically, a procedure called a DApp (for decentralized application), such as Uniswap or Aave, is created in open resource code on a public blockchain such as Ethereum. This procedure is powered by clever agreements, i.e., agreements that are implemented instantly when specific problems are satisfied. For instance, on the Uniswap DApp, it is feasible to exchange cash in between 2 cryptocurrencies in the Ethereum environment, many thanks to the clever agreements made to execute this procedure instantly.

Users are incentivized to generate liquidity, as they obtain a part of the purchase charge. As for loaning and also loaning, clever agreements enable those that desire to provide their funds to make them offered to consumers and also consumers to straight obtain the cash offered by ensuring the financing with security (or otherwise). The exchange and also rates of interest are established by supply and also need and also arbitrated in between the DApps.

The wonderful particularity of DeFi procedures is that there is no central organization accountable of validating and also accomplishing the purchases. All purchases are done on the blockchain and also are irreparable. Smart agreements change the intermediary function of central banks. The code of DeFi applications is open resource, which enables customers to confirm the procedures, improve them and also make duplicates.

The threats of DeFi

Blockchain offers even more power to the person. But with even more power comes much more obligation. The threats DeFi are of numerous kinds:

Technological threats. DeFi procedures depend on the blockchains on which they are developed, and also blockchains can experience strikes (referred to as “51% attacks”), pests and also network blockage issues that decrease purchases, making them much more expensive and even difficult. The DeFi procedures, themselves, are likewise the target of cyberattacks, such as the exploitation of a protocol-specific pest. Some strikes go to the crossway of modern technology and also money. These strikes are executed with “flash loans.” These are fundings of symbols without security that can after that be utilized to affect the rate of the symbols and also earn a profit, in the past promptly paying back the financing.

Financial threats. The cryptocurrency market is extremely unstable and also a fast rate decline can happen. Liquidity can go out if every person withdraws their cryptocurrencies from liquidity swimming pools at the very same time (a “bank run” circumstance). Some destructive designers of DeFi procedures have “back doors” that enable them to suitable the symbols secured the clever agreements and also hence take from customers (this sensation is called “rug-pull”).

Regulatory threats. Regulatory threats are also better since the reach of DeFi is international, peer-to-peer purchases are normally confidential, and also there are no determined middlemans (usually). As we will certainly see below, 2 subjects are especially crucial for the regulatory authority: the battle versus cash laundering and also terrorist funding, on the one hand, and also customer defense, on the various other.

The FATF “test”: Truly decentralized?

As of Oct. 28, 2021, the Financial Action Task Force (FATF) released its newest advice on electronic properties. This global company looked for to specify policies for recognizing accountable stars in DeFi jobs by recommending an examination to figure out whether DeFi drivers should be subject to the Virtual Asset Service Provider or “VASP” regimen. This regimen enforces, to name a few points, Anti-Money Laundering (AML) and also Counter-Terrorist Financing (CFT) commitments.

The FATF had actually originally thought about, last March, that if the decentralized application (the DApp) is not a VASP, the entities “involved” in the application might be, which holds true when “the entities engage as a business to facilitate or conduct activities” on the DApp.

The brand-new FATF advice goes down the term “facilitate” and also rather takes on a much more useful “owner/operator” requirement, where “creators, owners, and operators … who retain control or influence” over the DApp might be VASPs despite the fact that the task might show up decentralized.

Related: FATF advice on online properties: NFTs win, DeFi sheds, remainder stays unmodified

FATF, under the brand-new “owner/operator” examination, specifies that indicia of control consist of working out control over the task or keeping a continuous partnership with customers.

The examination is this:

Does an individual or entity have control over the properties or the procedure itself?Does an individual or entity have “a commercial relationship between it and customers, even if exercised through a smart contract”?Does an individual or entity make money from the solution supplied to clients?Are there various other indicators of an owner/operator?

FATF explains that a state should translate the examination extensively. It includes:

“Owners/operators should undertake ML/TF [money laundering and terrorist financing] risk assessments prior to the launch or use of the software or platform and take appropriate measures to manage and mitigate these risks in an ongoing and forward-looking manner.”

The FATF even states that, if there is no “owner/operator,” states may require a regulated VASP to be “entailed” in DeFi project-related activities… Only if a DeFi project is completely decentralized, i.e., fully automated and outside the control of an owner/operator, is it not a VASP under the latest FATF guidance.

It is regrettable that a principle of neutrality of blockchain networks has not been established, similar to the principle of neutrality of networks and technical intermediaries of the internet (established by the European directive on electronic commerce more than 20 ago).

Indeed, the purely technical developers of DeFi solutions often do not have the physical possibility to perform the checks imposed by the AML/CFT procedures in the design of current DApps. The new FATF guidance will likely require DApp developers to put in Know Your Customer (KYC) portals before users can use the DApps.

Application of security law?

We are all familiar with the legal debate that has become classic when it comes to qualifying a token: Is it a utility token, now subject to the regulation of digital assets (ICOs and VASPs), or is it a security token that is likely to be governed by financial law?

We know that the approach is very different in the United States where the Securities Exchange Commission (by applying the famous “Howey Test”) qualifies tokens as securities that would be seen as digital assets in Europe. Their approach is, therefore, more severe, and this will certainly result in more prosecutions of “proprietors” of DeFi platforms in the U.S. than in Europe.

Thus, if DeFi services do not involve digital assets, but tokenized financial securities as defined by the European Markets in Financial Instruments Directive (MiFID Directive), the rules for investment services providers (ISPs) will have to be applied. In Europe, this will be a rare case as the tokens traded would have to be actual financial securities (company shares, debt or investment fund units).

Related: Collateral damage: DeFi’s ticking time bomb

However, national regulations are likely to apply. For example, in France, it will be necessary to determine whether the regulation on intermediaries in various goods (Article L551-1 of the Monetary Code and following) applies to liquidity pools.

Indeed, pools allow clients to acquire rights on intangible assets and put forward a financial return. Theoretically, it would no longer be excluded that the Autorité des marchés financiers (AMF) decides to apply this regime. As a consequence, an information document will have to be approved by the AMF before any marketing.

However, in practice, there is not one person who proposes the investment, but a multitude of users of the DApp who bring their liquidity in a smart contract coded in open source. This brings us back to the test proposed by the FATF: Is there an “proprietor” of the platform who can be held accountable for compliance with the regulations?

The MiCA regulation

On November 24, the European Council decided its position on the “Regulation on Cryptoasset Markets” (MiCA), before submitting it to the European Parliament. It is expected that this fundamental text for the cryptosphere will be adopted by the end of 2022 (if all goes well…).

The draft EU regulation is based on a centralized approach by identifying a provider responsible for operations for each service, which does not work for a decentralized exchange platform (like Uniswap) or a decentralized stablecoin.

Related: Europe awaits implementation of regulatory framework for crypto assets

We should think about a legal system that takes into account the automated and decentralized nature of systems based on blockchain, so as not to impose obligations on operators who do not have the material possibility of respecting them or who run the risk of hindering innovation by removing the reason for progress: decentralization.

Europe has already shown itself capable of subtle arbitration in matters of technological regulation if we refer in particular to the proposal for a European Union regulation on artificial intelligence. This approach could serve as a source of inspiration.

Regardless of the balance chosen by the regulator, investors should become as informed as possible and pay attention to the technological, financial and compliance risks before undertaking a DeFi transaction.

As for DeFi application developers and service providers in this field, they must remain attentive to regulatory developments and cultivate a culture of transparency in their operations to anticipate regulatory risk as much as possible.

This article was co-authored by Thibault Verbiest and Jérémy Fluxman.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The sights, ideas and also point of views revealed below are the writers’ alone and also do not always show or stand for the sights and also point of views of Cointelegraph.