Decentralized finance protocols in Europe could soon be under new regulations as the European Commission evaluates the space. 

According to the markets in Crypto-Assets (MiCA) — the regulatory framework that governs digital assets within the region — the European Commission is required to prepare a report by Dec. 30, 2024, evaluating the decentralized finance market and the feasibility of specific regulations for the sector.

“In preparation for this report, we have initiated a number of actions. For instance, we are running a study on embedded supervision. No policy decisions have been taken yet,” a Commission spokesperson told Cointelegraph.

The report is tasked with exploring how decentralized systems, particularly those without a clear issuer or service provider, should be regulated. “A significant aspect of this assessment will be to explore the regulation of crypto-asset lending and borrowing, a core activity within the DeFi space,” Maxim Galash, CEO of CoinChange Financials, explained in an analysis.

DeFi represents a shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on blockchain. While traditional finance laws often depend on regulating central parties like banks or financial services providers, decentralized systems operate without such intermediaries.

Upcoming DeFi rules in Europe could ban non-decentralized protocols image 0 Global total value locked on decentralized finance protocols. Source: DefiLlama.

A potential new regulation has raised concerns about the legal viability of some crypto projects. MakerDAO co-founder Rune Christensen noted that the rules could place some DeFi interfaces, such as decentralized exchanges, under licensing requirements.

“This would make DeFi frontends on normal internet domains, as we know them today, impossible. Only fully decentralized, local, downloaded frontends or full-KYC online frontends would be possible. Sad,” he wrote on X (formerly Twitter).

In the same vein, XReg Consulting partner Nathan Catania believes that an eventual DeFi regulation would apply to all non-fully decentralized applications, including DeFi frontends. According to Catania, the MiCA regulation does not define what constitutes decentralization, and the extent of DeFi rules would significantly depend on the criteria used to determine the concept.

“Even protocols which are not decentralised enough could be seen to be performing CASP services such as exchanging crypto-assets for other crypto-assets. For front-ends, there are also services such as reception and transmission of orders on behalf of third parties. So it could come down to how strict regulators want to be when enforcing this.”

Under the MiCA regulation, a Crypto-Asset Service Provider (CASP) is any entity that provides services related to digital assets to third parties, including exchange services, transfer services, and custodian wallets, for example.

According to Catania, one of the key factors that regulators might consider in evaluating the level of decentralization is whether a professional service is being performed.

“A front-end that simply provides users an interface to access DeFi without any control over users’ funds, and which doesn’t charge a fee is less likely to be at risk than a front-end that adds a fee on top and even then you would need to consider the legal and technical details to be able to determine whether that activity should be licensed under MiCA.”

Another possible route for DeFi regulation would be through the Financial Action Task Force (FATF).

According to Coinchange’s Galash, the FATF proposes that in certain scenarios, individuals or entities maintaining control or significant influence over DeFi arrangements may be categorized as Virtual Asset Service Providers (VASPs). “This classification applies even if the arrangements appear decentralized, underscoring the complexity of defining and regulating DeFi activities,” Galash wrote.

Based on data from DefiLlama, the total value locked (TVL) in DeFi protocols has experienced a substantial increase over the past four years, from $570 million in April 2020 to $96.7 billion at the time of writing, representing a 16,865% growth over the period.

“The key question is whether the DeFi arrangement is simply a technological arrangement or whether there is actually a controlling party behind it that can influence user value," said Catania.

Additional reporting by Helen Partz.

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