Decentralized Finance (DeFi): The European Regulatory Perspective
Decentralized finance is challenging the centralized traditional financial system by disempowering intermediaries and facilitate peer-to-peer transactions where the users are able to retain control over their money. Where there is a lack of regulation at the time of writing this article, DeFi promises a dynamic, disintermediating revolution in finance, steadily taking over the traditional financial world. In this article I will discuss some of the most important implications of DeFi for existing financial regulations, as well as the challenges regulators are confronted with focusing especially on EU’s approach.
What is DeFi?
Decentralized Finance refers to platforms that allow users to perform different types of financial transactions. The goal is to improve the availability and efficiency in financial services through disintermediation. DeFi uses blockchain technology, cryptocurrencies (mainly stablecoins) and smart contracts to manage financial transactions such as lending, borrowing, and trading outside the control of traditional financial institutions like banks, brokerage firms, and centralised exchanges. Therefore, users interact with the open software protocols through the so called “unhosted” wallets. Unhosted wallets are digital wallets that are managed by the users themselves rather than by a service provider.
How does DeFi work?
Decentralized finance uses blockchain platforms to disintermediate centralized models and enable the provision and settlement of financial services anywhere in the world by using cryptocurrencies, rather than going through traditional financial intermediaries. By eliminating intermediaries, DeFi users are able to maintain full control over their money through personal wallets (DeFi smart contract tokens) and trading services, as well as directly interact with them via DeFi applications (“dApps”).
- Smart Contracts
DeFi makes use of smart contracts that provide the fundamental components for the functioning of dApps encoding the necessary terms and activities for the operability of these apps. Smart contracts are computer programs run on a blockchain that controls digital assets, and automate agreement terms between buyers and sellers or lenders and borrowers. They are used to execute a transaction between two or more parties, thereby reducing conflicts and costs.
- Software protocols
DeFi software protocols run on blockchain are based on rules written to govern specific tasks or activities. They are interoperable, meaning they can be used by multiple entities at the same time to build a service or an app, enabling buyers, sellers, lenders, and borrowers to interact with each other. DeFi protocols achieve their investment purposes through self-executing smart contracts that allow users to invest cryptoassets in a pool from which other users can borrow. The most common protocols for current DeFi projects are built on Ethereum.
- Decentralised applications (dApps)
The so called dApps abstract the underlying protocols into simple consumer-focused services. DeFi can be used for the full range of financial services including cryptoasset trading, lending, and borrowing, savings, payments, trading on derivatives, insuring risk etc.
- Governance tokens
Some DeFi protocols distribute the so called “governance tokens” to reward users for engaging with the system and for conducting or supporting different type of transactions. Participants typically earn tokens by interacting with and providing services to a protocol, for example by providing liquidity in a decentralized exchange or collateral on a lending platform.
These governance tokens generally give users a right of return (reward) from the project and allow users to vote on changes proposed within the protocols. Based on the associated rights, governance tokens have value and can be traded. This structure gives a wide range of holders the ability to contribute to a project’s governance and evolution by voting on proposals to change the protocol and, therefore, its incentives and operations.
- DeFi Platforms
DeFi does not just build financial services natively as software, but it recreates the entire ecosystem of finance on novel technical foundations, the so-called DeFi platforms. These platforms are consumer-facing financial interfaces that require blockchain technology as well as crypto holders in order to operate. The blockchain technology acts like digital highways allowing DeFi transactions to move. Several decentralized platforms exist including decentralized exchanges (DEX), lending and borrowing, trading (complex) derivatives, insurance, asset management etc.
- Decentralised exchanges (DEXs)
DEXs are marketplaces that allow the trading of digital assets without any centralized control. They replace the market-making and custody features of exchanges with a powerful algorithm that dynamically adjusts prices and executes trades based on available liquidity. Automated Market Makers (AMMs) have become a popular means of providing liquidity. They match buyers and sellers of digital assets or let them “swap” one cryptocurrency or token for another. Rewards on these platforms result from providing liquidity in token pools. Some examples currently featuring in the crypto space are Uniswap and Justswap.
- DeFi Lending Platforms
DeFi lending platforms are platforms that allow cryptocurrency holders to lend anonymously vast sums of funds instantly to people who want to borrow, provided that they can provide enough collateral to deposit in a smart contract and settle the loan within an agreed timeframe. Lenders earn interest on the loaned amount (credit intermediation). Some DeFi protocols offer crypto loans against fiat collateral and vice versa. Apart from loans, DeFi users can borrow a token to participate in blockchain activities such as governance. Some examples currently featuring in the crypto space are Compound, Makerdao, and Aave.
- DeFi derivatives platforms
DeFi derivatives platforms establish markets for synthetic assets, in which users can establish derivative positions in cryptocurrencies while posting collateral (guarantee) to support those positions (trading in derivatives). They automatically track the value of commodities, stocks, indices, or any combination of financial instruments. Most known example to date is Synthetix.
- Non-Custodial Lending Platforms
Cryptocurrencies have further extended into the world of DeFi through the recent creation of non-custodial lending platforms. These are decentralized markets where users participate as depositors or borrowers. The concept of these lending platforms is designed to mitigate any potential losses or defaults through controlling collateral on the blockchain. Retail lenders are able to quickly liquidate unhealthy loans on these lending platforms through the underlying technology of the platform itself. DeFi pools also have the potential of opening up liquidity in different markets that have previously not been able to transact. Theoretically, DeFi users are able to extend credit and liquidity through cryptocurrencies to users across the world, including markets in developing countries that traditionally do not see inflows of western funds.
- New DeFi Services
Based on the DeFi technology, users can now obtain financial services such as margin trading, yield farming, liquidity mining, and crypto staking on a distributed ledger. Especially staking platforms and yield farming protocols have surged in popularity. Yield farming is a tool to help provide liquidity to the network. It can be classified as “the act of hunting for rewards” by interacting with DeFi protocols, by temporarily putting depositing assets as collateral in a liquidity pool, that could be used by other users including investors and start-ups, in exchange for financial rewards.
Liquidity mining is a specific form of yield farming, in which digital asset owners provide liquidity to DEXs in return for rewards. Since DEXs historically suffered from low liquidity, this is an important development for the ecosystem as well as a major source of revenue for some digital asset investors. While liquidity miners and yield farmers add funds to liquidity pools, stakers either hold funds in a wallet or delegate their coins to a validator node. This technique involves locking assets in a wallet in order to gain governance rights and token rewards in proof of stake (PoS) blockchain’s native asset.
- DeFi market
Since 2019, DeFi has been one of the fastest-growing crypto sectors. Interest in crypto and DeFi rose swiftly during the Covid-19 pandemic and investment has accelerated due to the aforementioned reason. However, DeFi is still in the early stages of its evolution, where the total value locked into DeFi of various types (collateral pools, DeFi smart contracts/protocols) in leading platforms such as Maker, Compound, Uniswap and Aave has grown from less than 1 billion USD in 2019 to over 90 billion USD in January 2022.
This growth was driven partially by investors looking for enhanced transparency and control of their funds regarding its open network as an attractive alternative to traditional banking. Another reason evidencing this growth was the maturation of stablecoins, for example cryptocurrencies designed to track the value of stablecoins, such as the US dollar (USDT). Incentive structures were developed such as yield farming and governance tokens through which participants can earn returns for providing liquidity to DeFi services.
- DeFi and benefits
Using DeFi applications has a number of interesting advantages beyond the traditional financial services, in terms of easier access to financial products and liquidity, improved market efficiency, enhanced financial privacy, lower fees and quicker as well as faster innovation.
- Peer-to-peer trade
Since dApps fuel the ecosystem without intermediaries thereby using self-executing codes that envisage the outcome and resolution of activities on these platforms, it also provides flexibility, as well as direct person-to-person trade with high levels of transparency and zero joining requirements.
There are also theoretical benefits for international financial transactions. The distributed nature of DeFi platforms and protocols make them available across the world. The idea is that with a cheaper alternative, remittance charges and commission fees will drop, and currency conversion will have to get cheaper in order to be more competitive.
- Lower costs
Such decentralised and non-custodial platforms have low costs as market competitors often remain unregulated and have minimal operating and regulatory costs. The absence or lack of central intermediaries makes it hard for regulators to forbid and not fully regulate DeFi services.
It may also lead to new types of services, triggering further innovations. If a community of users is displeased with the service provided by a protocol, that community can vote to change the services supported by it or can separate the existing open-source code base and develop a new protocol to meet the needs of the community better.
DeFi and the associated risks
DeFi is an emerging trend that comes with the associated risks, such as user errors. A crucial question associated with DeFi risk is the question that who takes responsibility for any mistakes occurred during a transaction since we are very well aware that it is nearly impossible to alter things on blockchain.
The smart contract vulnerability comes to the scene since the engine that runs dApps is embedded in the code in order to make the said smart contract. When this code has a flaw, it exposes the entire project leading to loss of funds.
Software systems may also malfunction due to a wide variety of factors. For example, what if an incorrect input causes the system to crash? Or, what if a compiler which is responsible for composing and running codes makes a mistake. Who is liable for these changes and/or mistakes?
While many DeFi tokens have already delivered lucrative returns, they come with considerable risk and price volatility where exceeds the well-established digital assets (Bitcoin and Ethereum). Their lower liquidity means that they are more susceptible to large price swings.
Finally, the anonymity of participants in DeFi transactions, makes it vulnerable for cyberattacks, hacks, and scams. This may lead to loss and/or theft of funds, without any available regulated remedy.
Lack of consumer protection
DeFi has thrived in the lack of rules and regulations. DeFi users however do not receive the protection benefits of transacting with regulated intermediaries. In centralized finance, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and at any time to provide to its customers their available funds. In DeFi they do not receive risk disclosures. Protocols are not subject to risk management requirements, such as capital and liquidity requirements, that protect against loss of customer funds and systemic risks. Also, there is no helpdesk or relationship manager in DeFi in order to contact if a problematic transaction arise.
DeFi is currently subject to existing regulations. However, the regulatory framework that applies to cryptocurrency projects do not regulate the spectrum of DeFi yet. Their approach is still based on the regulation of centralized intermediaries, where it will not work for decentralised DeFi digital asset classes. DeFi transactions conducted between individual users through unhosted wallets would not be subject to existing regulatory requirements, including KYC and AML reviews. Since DeFi protocols support anonymised transactions, there is no meaningful way for market participants to determine what requirements apply to their DeFi transactions.
Regulators are sceptical and enigmatic at the same time
Regulators across the world are making steps to get involved more closely. However, they are sceptical on how to deal with DeFi and how to fill the regulatory gaps. Considering the fragmented and diverse nature of the DeFi market, the task for regulators seems impressive. From a regulatory perspective, DeFi poses several crucial and multifaceted risks and challenges, that will become more serious as the market grows even further. DeFi does not fit within the historic practical and regulatory model used for traditional financial transactions.
World Economic Forum Policy Toolkit: regulatory clarity and balanced approach
Policymakers and regulators are urgently looking for frameworks to address these issues responsibly. The World Economic Forum recently published a policy toolkit for DeFi, in order to assist governments around the world to appropriately address this phenomenon and help integrate regulation of digital asset marketplaces between different countries. Regulators worldwide contributed to the policy statement including representatives from lawmakers involved in creating the new European Markets in Crypto Assets (MiCA) rules. The toolkit provides the basics for understanding and examining the critical factors concerning DeFi regulations that should drive policy-making decisions. Technological neutral approach is necessary in order to balance the objectives of regulatory regimes, innovation and market development with policies that are fair, efficient, and enforceable.
Regulation is key to set minimum standards to market participants in the DeFi industry, to protect the capital and clearly define the regulatory treatment of all cryptoassets that are not covered by existing financial services regulation. Regulators will need to further clarify these guidelines for reporting entities as soon as possible in order to reinforce international adoption.
Balanced approach from regulators
To promote the development of various DeFi markets, it is necessary to put in place a safe and proportionate regulatory framework to support innovation and fair competition. Regulators should thereby maintain an adequate balance between safeguarding positive blockchain-based financial innovation in terms of greater efficiency and broader inclusiveness in finance on one hand and limit the potential of these financial applications being misused for money laundering and terrorism financing on the other hand.
European DeFi regulation: Markets in Crypto-Assets
In September 2020, the European Commission adopted the Markets in Crypto-Assets Regulation (MiCA) proposal. The aim is to improve harmonisation and legitimisation of how tokens are being regulated generally and the supervision of issuers as well as firms that qualify as CryptoAsset Service Providers (CASPs). MiCA would set clear rules of the cryptoassets throughout the European Economic Area (EEA) establishing a common framework by avoiding any potential inconsistencies.
MiCA aims to provide greater legal certainty, supporting innovation, ensuring appropriate levels of consumer and investor protection, promoting market integrity and financial stability and thus transform EU’s current fragmented crypto-asset legislation and regulatory framework into a more uniform approach. MiCA will apply to persons engaged in the issuance of cryptoassets and to CASPs within the EU-27. MiCA itself may be implemented between mid-2021 and early 2022 with the ultimate aim to be fully operational by 2024.
This new MiCA regime clarifies on the one hand which tokens will qualify as “financial instruments” and thus fall under the existing financial services regulatory regime, as amended, and on the other hand which tokens will qualify as “cryptoassets” and thus fall under MiCA’s specific regime for CASPs.
Assessment of whether a digital asset will be a cryptoasset and subject to MiCA or a token that is a financial instrument subject to the existing financial services regime, will depend on the content of the financial instrument and not the technology behind it.
With the introduction of MiCA, the European Commission intends to include stablecoins within the scope and to modify the e-money regime in order to include a new definition of e-money. The new definition will be ‘electronic money token’ or ‘e-money token’ meaning a type of cryptoasset whose main purpose is to be used as a means of exchange and that purports to maintain a stable value by being denominated in a fiat currency.
Other stablecoins are defined as ‘asset-referenced tokens’ which is a type of cryptoassets whose main purpose is to be used as a means of exchange and that purports to maintain a stable value by referring to the value of several fiat currencies, one or several commodities or one or several cryptoassets, or a combination of such assets. Stablecoin (being a type of ‘asset-referenced token’) issuers not already regulated as credit institutions or e-money institutions will need to be authorised as well as publish a white paper approved by their home state regulator in order to be able to market it accordingly.
For stablecoins that do not fall within the above definition, the issuers of such stablecoins must still publish a white paper, notify the regulator, and may not refer to their coins as being ‘stable’.
Issuers of ‘significant e-money tokens’ and ‘significant asset-referenced tokens’ will be directly regulated by the European Banking Authority (EBA) and will have additional obligations in respect of capital, interoperability, and liquidity management.
The European Central Bank (ECB) perspective in relation to MiCA Regulation
In February 2021 the ECB published its opinion on the MICA regulation. Their proposals generally aim to grant greater powers to the ECB, set prudential requirements for certain stablecoin issuers and generally improve anti-money laundering and take measures for the prevention of terrorist financing.
The ECB is generally in favour of MiCA’s views and its contribution to the harmonisation of the cryptoasset regulation. The ECB however suggests several adjustments and clarifications, in order to improve which tokens and what activity will fall under and be regulated by MiCA, the regulatory authority that these tokens will fall under as well as what activity will be subject to the MIFIR/MIFID II framework. The ECB also recommends the provision of clearer definition as to what constitutes a cryptoasset that falls into MiCA regulation in order to support the provision of cryptoasset services cross boarder and to establish a truly harmonised set of rules for the cryptoasset industry.
The ECB has suggested a clear distinction between cryptoassets that would be classified and thus treated as MIFID II financial instruments and those that will fall under the scope of MiCA’s regulatory regime. Specifically, the ECB has requested a number of changes regarding the supervision of stablecoins. The ECB asks for additional safeguards under MiCA, including prudential and liquidity requirements for such stablecoin issuers.
Regulatory sandboxes and safe harbours
The implementation of full-fledged regulations right now however would be too risky. Regulators should get well-required time to gain experience in this new technological era, interact efficiently with the DeFi industry, and provide informal regulatory guidance to them.
In the meantime, regulators can learn from techniques that are proving effective for the existing cryptocurrency market through the so-called regulatory sandboxes. These could create a safer space for regulators and innovative services to work through the various obstacles. In addition, regulators should start by clarifying relatively more clearer structures first in order to provide guidance to the industry. This can provide them enough time to solve the more complicated issues at a later stage, while ensuring market participants remain confident in the broad contours of the regulatory environment.
Since DeFi encompasses a broad range of applications and protocols, many of which may lie outside securities law, US SEC Commissioner Pierce suggested implementing a so-called ‘safe harbour’ policy with respect to DeFi and cryptocurrency projects. Disclosure requirements or safe harbours can encourage market participants to provide regulators information that helps them better understand market dynamics and develop best practices. Without this safe harbour rules in place, it is currently impossible for someone to develop a truly decentralized system without potentially being in breach of securities law throughout the development process.
Panayiotis A. Koussis – Author