New regulations in the European Union may soon force decentralized finance (DeFi) protocols to make tough decisions. 

At the heart of the issue is the tendency of many DeFi protocols to have centralized front-ends and intermediaries.

The EU’s Markets in Crypto-Assets Regulation (MiCA), which will come into full force by the end of 2024, will require DeFi protocols to adhere to the same licensing and Know Your Customer (KYC) requirements as traditional financial services firms — a burden many DeFi protocols may be unable or unwilling to bear.

According to MakerDAO co-founder Rune Christensen, “Only fully decentralized, local, downloaded frontends or full-KYC online frontends would be possible.”

This leaves DeFi protocols with a choice: Either pivot to a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations or decentralize entirely.

“True” DeFi is exempt from MiCA

Within the actual EU regulation, fully decentralized protocols are exempt from falling into the MiCA requirements, as mentioned in Recital 22:

“Where crypto-asset services are provided in a fully decentralized manner without any intermediary, they should not fall within the scope of this Regulation.”

Oliver Völkel, an attorney and partner at the law firm Stadler Völkel, has studied the EU’s regulation of crypto assets in depth.

He told Cointelegraph that the immediate question posed by this section of MiCA is what exactly is meant by “without an intermediary” and “in a fully decentralized manner”?

He said, “Smart contracts that are used in the provision of a crypto-asset service are in themselves not even suitable to create the appearance of exclusive decentralization.”

Companies can use smart contracts to provide crypto-asset services in their name. Völkel concluded that in such cases, the smart contract is merely a tool used by a company.

Only natural persons and legal entities can hold rights and obligations, make and receive legal declarations, provide and receive services, and be the addressee of a law or be supervised under an act such as MiCA.

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However, Völkel believes that EU lawmakers correctly recognize that “none of this is the case if a crypto-asset service can be accessed without an intermediary in an exclusively decentralized manner.”

With MiCA set to come fully into force by the end of 2024, DeFi protocols operating in Europe will have to decide whether to fully decentralize, effectively side-stepping regulations, or apply KYC measures like any other centralized company that offers financial services.

Will DeFi split in two?

Nathan Catania, a partner at XReg Consulting — a consulting firm specializing in crypto-asset regulation — told Cointelegraph that the new wave of regulation could split the sector:

“Regulation represents a fork in the road for many DeFi projects. They will either embrace decentralization and move further outside the regulatory perimeter or accept that some regulation is required based on their particular model and move toward more of a hybrid finance state.”

In his opinion, “For those that do embrace decentralization, regulation such as that MiCA in Europe will draw clearer lines in the sand.” This new set of rules will provide more clarity on how to build truly decentralized applications to comply with the regulatory requirements.

Indeed, many DeFi protocols will have to take a hard look at how they do business to ensure their platforms are truly decentralized and don’t fall afoul of the law.

Catania suggested they thoroughly assess the regulation and engage with their national regulatory authorities to ensure they are protected, if possible.

The DeFi sector can implement several workarounds to ensure decentralization, one important one being the decentralization of website front ends. Decentralized web hosting involves deploying websites on peer-to-peer (P2P) servers using advanced cryptography.

Thomas Kroes, deputy executive director of Urbit — an open-source, P2P decentralized personal sever platform — explained to Cointelegraph that decentralized hosting offers protection for front-end services, as they can’t be taken down. He said that even Urbit couldn’t remove the content on its nodes if required.

Whichever path a protocol chooses, regulation is here.

Advocates of decentralization may soon see DeFi transform into something closer to traditional finance, the very industry they set out to disrupt.

Will the industry thrive in a decentralized digital universe, or will the potential injection of capital from traditional market movers change the sector?

DeFi needs to comply to attract institutional investors

Regulators are giving increased attention to DeFi as the sector matures and grows in popularity, as exemplified by the EU’s MiCA and the United States Securities and Exchange Commission’s enforcement actions against popular DeFi protocols.

On April 10, 2024, Uniswap became the first decentralized protocol to be issued a Wells notice — an official notification issued by regulators to inform individuals or companies that the regulator has completed an investigation and discovered infractions that will be brought to court.

The CEO of Uniswap, Hayden Adams, responded that he wasn’t surprised, “just annoyed, disappointed, and ready to fight.”

Adam Simmons, chief strategy officer at DeFi platform Radix, told Cointelegraph that most people would agree that some safeguards are needed.

He believes that regulatory requirements for the DeFi sector are likely inevitable, particularly if the industry aims to achieve global adoption.

Instalabs’ CEO Edward Adlard told Cointelegraph, “DeFi’s next evolutionary step is to get institutional, traditional finance money to participate.”

However, he believes there are two main obstacles. First, TradFi companies are not operationally set up to use crypto tools.

Second, TradFi companies need to figure out how they can legally access these products and offer them to clients: “DeFi DApps need to walk a line between implementing enough AML procedures to attract TradFi liquidity and not become a target for regulatory action.”

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Compliance tools are already available. Simmons explained that the DeFi sector in Europe could use a system of trustworthy issuers that handle ID verification independently.

Adlard noted that DeFi KYC service Instapass could create custom credentials that fulfill EU regulations, adding that “DeFi DApps could easily make access to specific parts of their product contingent on users having that credential.”

Regardless of whether a DeFi protocol chooses to pursue institutional adoption or complete decentralization, it will have to adjust to adapt to the shifting legal landscape in the European Union.