Code will not be law. Two important regulatory texts for the crypto sector were adopted on October 10 by the European Parliament. The two MiCA regulations (“Markets in Crypto-Assets”) and FRR (“Transfer of Funds Regulation”) have been definitively adopted. Except that it does not concern decentralized finance (DeFi). Excluded from this text, it is nonetheless the subject of intense reflection, between reports and calls for tenders.
A report to enlighten the EU on how to regulate decentralized finance
In decentralized finance, there is by definition no central entity that acts as an intermediary between users. This role is assigned to smart contracts. But that doesn’t mean parts of the DeFi ecosystem are beyond the reach of regulators.
In this respect, the EU seems to draw its inspiration from its American counterparts, and in particular the SEC. This has been particularly active against DeFi since 2021: an activity that ranges from simple survey on Uniswap and its operation, until the sanction on various operators of decentralized exchanges (DEX) like EtherDelta, accused of operating as unregistered securities exchanges.
The European Commission has therefore been given a report on possible approaches to overseeing, monitoring and regulating DeFi. A rapport available on the EU Publications Portal, produced by Professor Tarik Roukny of the Catholic University of Louvain. During an introductory webinar, a representative from the digital finance department said:
“This report is part of our ambition to better understand DeFi, to inform our thinking on how to address any concerns about the potential implications for public policy”
TradFi and DeFi: same problems, different solutions
The report itself doesn’t reveal anything that we don’t already know. The main element lies in the fact that the analysis and review of the various works converge to recognize that:
“standard policies [sont] inadequate for processing DeFi services”
It is indeed important to remember that DeFi protocols are startups. Even the oldest protocols are only a few years old, while the majority have only been around for a few months.
By looking at their models, we quickly realize that many of the rules applied to traditional finance are revealed automatically lapse in most of the cases.
But what rules are we talking about? In a nutshell, this is the Financial Instruments Directive (directive MiFID 2), deposit guarantee mechanism (DGS), retail fund regulations (UCITS), framework on market abuse (directive MAD).
1 – Decentralized exchanges (DEX)
- Description : these are protocols that operate on the model of regulated exchanges to execute futures, spot or perpetual transactions.
- Examples : Uniswap, Curve, Balancer, GMX, dYdX, PancakeSwap
- Functioning : them DEX Spot and perpetual futures generate their income from trading fees. Although the fee rate differs per exchange, these fees are always distributed between the protocol and the DEX liquidity providers. And often the protocol chooses to allocate part (or all) of its share to the holders of governance tokens (ex : UNI for Uniswap, CRV pour Curve).
Traditional rules on trading currencies or commodities definitely do not apply to trading digital assets without an intermediary. In the legal sense, these are simple exchanges between individuals.
The problem could come from governance tokens. Some protocols (such as Uniswap et PancakeSwap) also distribute governance tokens to liquidity providers in addition to the usual liquidity tokens. Remember that these tokens are generally limited in number and that they allow holders to vote on proposed changes. On other platforms such as protocol Mirrortokens can also be staked to generate interest.
Basically, governance tokens confer voting rights on holders and sometimes a right to share part of the transaction and airdrop costs when they are staked. Mechanisms that are reminiscent of the dividends attached to shares of listed companies where the units of investment funds and other ETFs …
2 – Lending
- Description : These are protocols that facilitate over- or under-secured borrowing and lending.
- Examples : Aave, Compound, Euler Finance, Maple Finance, TrueFi
- Functioning : over-collateralised / over-collateralised loan markets generate income by taking a difference in the interest paid to lenders. Sub-secured loan markets generate revenue by charging origination fees, with some also taking the difference from interest paid to lenders.
Again, although lenders pool their crypto-assets for loan purposes, these pooled assets are not managed as a whole by a centralized entity as in an investment fund. DeFi lending is executed on a peer-to-peer basis: Lending and borrowing are executed by smart contracts whose code is made available to anyone who wants it.
Then, the crypto-assets are not grouped into other issued assets (we say “securitized”) which are issued and tradable again on the crypto markets.
And although crypto-asset lending resembles lending in traditional financial markets (the securities lending in the case of short sales), they are unlikely to be counted as securities lending activities. Indeed, even securities lending and leverage arrangements are not themselves considered as such.
3 – Asset management
- Description : this refers to protocols that exploit vaults (literally “yield generation vaults”) as well as to those who create and maintain structured products.
- Examples : Yearn Finance, Badger DAO, Galleon DAO, Index Coop
- Functioning : asset managers generate income from management fees based on assets under management, performance fees and/or issue and redemption fees for structured products.
Here it is more complicated, because it seems that the traditional regulators can have their say on the services. This is the case of Yearn Financewhose robot continuously scans the Ethereum blockchain: seen from a certain angle, Yearn Finance is a self-investment platformwhich moves its users’ capital between different pools, seeking to obtain the best possible return at all times.
4 – Staking
- Description : These are protocols that issue liquid staking derivatives (LSD).
- Examples : Lido, Rocket Pool, StakeWise
- Functioning : Liquid staking protocols generate revenue by taking a commission from the total staking rewards earned by validators. Staking rewards consist of issuance, transaction fees, and MEV.
Staking certainly has similarities with a a term deposit in a retail bank. Where an amount principal “staked” does not change, a sum ofinterests variable is paid to the depositor.
You will have understood it, the regulation of DeFi per se is not for tomorrow. In an attempt to overcome the limited scope of the current financial rules, the EU will surely draw inspiration from the SEC wet finger methods to clean up DeFi, which continues to assert that securities laws apply on DeFi operations, regardless of decentralization and tech/blockchain veneer.