Bridging the Gap: Can DeFi Coexist with Regulations?

Traditional and decentralized finance have always been like two separate poles. Only the boldest cryptocurrency visionaries believed that they would ever merge.

However, the wave of Real World Assets ( RWA ) tokenization is changing attitudes and making history. It’s bringing institutional attention to DeFi but also highlighting its major hurdle: DeFi regulation.

DailyCoin explores what the DeFi regulatory landscape looks like and where the biggest challenges lie.

RWA Tokenization Brings Historic Chance for DeFi 

Real-world asset (RWA) tokenization is now the crypto industry’s hottest narrative, fueled by wealth management giant BlackRock, which launched its tokenized asset fund earlier this year. 

And BlackRock is not the only one in the field. The world’s major banks, such as JPMorgan Chase, HCBC, and Citi, are also exploring ways to tokenize RWA.

RWA tokenization allows physical assets—such as real estate, gold, or debt securities—to be represented on the blockchain, bridging traditional and decentralized finance markets and opening doors to trillions of dollars of capital.

Industry players agree that tokenizing real-world assets could finally bring utility to blockchain, transform DeFi, and further evolve the financial system. 

The entry of investment giants like BlackRock marks a significant milestone for DeFi. Big institutional players getting involved do not only make the tokenized asset market grow faster. With more money flowing in and investments becoming more stable, the market is set to rise higher.

The market’s interest in RWA-related protocols is already evident in the numbers. The value of RWA protocols has surged by over 4,000 percent in the past year, rising from $146 million to over $6.31 billion by April 2024. 

At the same time, it still represents a mere 6.1 percent of the total $102 billion value locked in DeFi protocols as of this writing.

The growth of total value locked on RWA protocols climbed more than 588% during a single year. Source: DeFiLlama

Considering the total value of real-world assets, like the $380 trillion real estate market alone, tokenized RWAs have massive potential. Experts predict that the industry of tokenized physical assets could reach $16 trillion by 2030.

However, seamless integration between traditional finance and DeFi is crucial for this merger to become a reality. As always, regulatory clarity holds a pivotal role in such scenarios.

Regulations Remain a Grey Area

No government has yet implemented clear regulatory frameworks on DeFi, which operates differently from traditional finance. 

Regulating DeFi remains challenging worldwide due to its decentralized nature. DeFi operates without centralized authorities and relies on automated smart contracts to facilitate operations, which makes it difficult to enforce rules and ensure compliance. In addition, the rapid pace of innovations and evolving technologies further complicate regulatory efforts.

Although individual initiatives on crypto asset regulation are emerging in various countries, no formally adopted policy on DeFi regulation exists anywhere.

Even the European Union’s (EU) Markets in Crypto Assets ( MiCA ), set to be the world’s most comprehensive crypto regulatory standard, which comes into effect in December 2024, has left DeFi regulation entirely out of its scope. 

DeFi Protocol Decentralization Varies 

The EU’s MiCA framework sets rules for crypto asset services providers and stablecoin issuers but does not address how decentralized finance should be treated and regulated. 

The document only mandates the EU authorities to review DeFi sector progress within 18 months after MiCA comes into effect. It also requires the European Commission to evaluate whether MiCA laws are sufficient for addressing DeFi and to decide if specific rules for DeFi are needed and feasible.

The approach might change if EU lawmakers follow the guidance from the Financial Action Task Force (FATF), a global authority on anti-money laundering standards. 

FATF suggests that individuals or entities with significant influence over DeFi might be labeled Virtual Asset Service Providers (VASPs), subject to anti-money laundering and counter-terrorism financing (AML/CFT) obligations.

However, the question of full or partial DeFi decentralization is one of the key issues in the debate over DeFi regulation.

“Only partially decentralized crypto services are subject to the MiCA regulation while fully decentralized services provided without intermediaries are excluded from its scope,” states Carolina Veas, a completion lawyer at CMS law firm. 

According to her, the key challenge is that the DeFi industry operates across a wide spectrum of decentralization, making it hard to determine when protocols become partially or fully decentralized.

Despite that, DeFi protocols have a complex architecture composed of multiple layers, each of which vary in their level of decentralization. Figuring out which layers are most critical for decentralization remains a difficult question to answer. 

According to Veas, regulating DeFi is a political matter. While issues around DeFi regulation remain unresolved, service providers must improvise and decide how decentralized their business model is.

Who Could Become an Exemption? 

The anticipated European Commission’s report is expected to illuminate some issues around DeFI regulation, including jurisdiction, licensing, and ownership questions.

Defining DeFi jurisdiction alone is a challenge, requiring clarity on whether assets should be subject to the laws of the territories where their owners reside or their servers are located. 

There is also a question of licensing and governance. In traditional finance, services are provided by identifiable entities subject to licensing regimes.

Meanwhile, in DeFi, protocols are often run by smart contracts, with governance rights held by investors or DAOs, who collectively make decisions regarding protocol changes or management.

As of today, investors holding more tokens have a more significant influence on making decisions. Thus, for projects to be genuinely decentralized, it’s crucial to eliminate the risk of voting power concentrated in the hands of a few.

Maxim Galash, CEO of the Coinchange DeFi platform, says projects keen on a genuine commitment to decentralization could be exempt from DeFi regulation. 

“This hinges on achieving de facto decentralization, limiting the influence of key individuals over the protocol and ensuring an ongoing relationship with users, facilitated through smart contracts or voting protocols.”

However, to achieve that, the industry needs to limit governance token holding or attract more new investors into DeFi governance, potentially via various incentive programs. 

AML and Cybersecurity as a Starting Basis 

DeFi regulation carries subtleties and might establish enduring precedents for future market development. Therefore, it’s crucial to make well-discussed decisions involving various parties.

“The implications of how we regulate DeFi are incredibly nuanced and must be grappled with by industry, government, academia, and civil society,” believes Caroline Malcolm, the global head of public policy at Chainalysis.

She suggests that DeFi protocols could adopt measures that meet minimum security standards, such as anti-money laundering and cyber security safeguards independently, without waiting for explicit regulatory guidance.

AML/CFT standards are typical across the financial sector, where financial institutions are mandated to review individuals’ or entities’ operating accounts to prevent illicit financial activities.

According to Malcolm, the existing technologies already allow DeFi to conduct sanction screenings or address screenings while whitelisting or blacklisting solutions are also available and help manage access or privacy pools.

Regarding cybersecurity , the industry has also developed solutions that help enhance protocols’ resistance against smart contract vulnerabilities, which hackers often exploit. Tools offering visibility into smart contract auditing and on-chain governance are already available.

DeFi Must Decide on Its Own

Institutions increasingly focus on DeFi, opening opportunities to enter the $16 trillion real-world asset market. By tokenizing various illiquid asset classes like real estate, commodities, security debts, and art, they’re integrating with DeFi and bridging the gap between traditional and decentralized finance.

This marks a historic growth opportunity for the decentralized space. However, as it often happens, legitimacy is often dependent on regulation. Thus, DeFi now faces a pivotal choice: adapt to regulatory compliance or stay true to the core principles of decentralization.

Find out more about  MiCA regulations on CASPs:
MiCA Tames CASPs, But How Does It Affect Retail Investors?

Learn about MiCA’s approach toward stablecoins:
Will MiCA Force USD Stablecoins Out of the European Union?