Introduction
Decentralized Finance (DeFi) represents a revolution in the financial sector, promising to democratize access to financial services through the use of innovative technologies such as blockchain. DeFi platforms enable the creation of a financial ecosystem that is open, transparent and accessible to all, eliminating the need for traditional intermediaries such as banks and central financial institutions. This article aims to provide a detailed and multidimensional analysis of the decentralized exchange platform landscape, using an interdisciplinary approach that integrates legal, economic and technological aspects.
In the context of DeFi, we will explore the main categories of use, from stablecoins to lending markets, from decentralized exchanges to derivatives, to wallet management, payment protocols and insurance services. Each category represents a fundamental piece of this innovative financial ecosystem, helping to transform the way people interact with financial services.
The regulation of DeFi, particularly in light of the European Union's Markets in Crypto-Assets (MiCA) Regulation, is a crucial aspect in understanding the potential challenges and opportunities this emerging sector presents. While MiCA does not specifically cover DeFi, its analysis provides valuable insights into how existing regulations could evolve to include the peculiarities of decentralized platforms.
Additionally, we will examine the nature of decentralization in DeFi protocols, defining the criteria for determining when a system can be considered truly decentralized and outside the scope of MiCA. Finally, we will discuss possible regulatory strategies to address risks and promote a safe and innovative environment for the development of DeFi, balancing the need for regulation with the potential for economic growth and financial inclusion offered by this emerging technology.
Abstract
This article provides a comprehensive and multi-dimensional analysis of decentralized exchange (DeFi) platforms, integrating legal, economic and technological aspects to offer an overview of the potential transformations of the sector. DeFi represents a set of financial applications based on blockchain technologies that operate without traditional intermediaries, making financial services more accessible and transparent. Major categories of DeFi are explored, including stablecoins, lending markets, decentralized exchanges, derivatives, wallet management, payment protocols, and insurance services. The analysis also considers the interaction between DeFi and the European Union's Markets in Crypto Assets (MiCA) Regulation, highlighting how current regulations could evolve to include decentralized platforms. Finally, the concept of decentralization is discussed and regulatory strategies are proposed to mitigate the associated risks, while promoting innovation and economic growth. The approach adopted highlights the importance of a balanced regulatory framework that maximizes the benefits of DeFi, ensuring protection and stability for users.
What is DeFi?
Decentralized Finance (DeFi) is a set of applications that offer financial services without the need for a bank or central authority. These applications use peer-to-peer networks and technologies that do not require trust between the parties involved. Since 2020, DeFi has become an increasingly relevant phenomenon.
DeFi is seen as an open system, accessible to all and very compatible with different platforms. It relies on distributed public ledgers to replicate traditional financial services in a more transparent and accessible way.
This ecosystem allows various participants, intermediaries and users to provide and consume financial services across different jurisdictions, using a technological infrastructure to facilitate interactions.
As blockchain technology evolves, which can handle an increasing number of transactions, we may see code-based financial systems that are increasingly autonomous and independent of human control.
DeFi category
DeFi is a rapidly growing sector with numerous innovative applications. It is represented by different categories of use at the protocol level:
- Stablecoins are cryptocurrencies designed to maintain a stable value against fiat currencies, such as the dollar or euro. These digital assets operate on distributed ledgers and use cryptographic techniques for transactions. There are three main types of stablecoins: those backed by fiat currencies, those backed by a variety of assets, and algorithmic ones. The former are supported by traditional currencies, maintaining a stable value thanks to their fiat equivalent reserve. The latter are guaranteed by a mix of currencies, raw materials or other cryptocurrencies, while the third ones use algorithms to maintain their stability, regulating supply based on demand. Decentralized stablecoins, created via over-collateralization or algorithmic methods, aim to solve the trust issues of fiat-backed stablecoins. They operate on decentralized ledgers and are governed by decentralized autonomous organizations (DAOs), meaning anyone can verify their reserves. Key elements of these stablecoins include collateral, agents involved, governance rules, issuance mechanisms, and oracle systems for importing external data.
- DeFi lending markets allow anyone to borrow or lend crypto-assets. Lenders earn interest on their assets by contributing to lending pools, while borrowers must provide collateral to obtain loans. Given the anonymous nature of transactions on the blockchain, there are no mechanisms to assess borrowers' credit, so loans must be over-collateralized to mitigate risks. If the value of the collateral falls below a certain threshold, liquidators can intervene to close the debt position.
- DEXs, or decentralized exchanges, allow you to trade cryptocurrencies without having to transfer or store your funds on a centralized platform. There are several variations of DEX, such as DEX Order Books and Automated Market Makers (AMMs). DEX Order Books require users to sign transactions that are executed by the DEX when certain conditions are met, maintaining an off-chain order book. AMMs, on the other hand, use mathematical formulas to determine asset prices, eliminating the need for an order book. Liquidity is provided by participants who deposit funds into liquidity pools, earning a share of the trading fees.
- Derivatives are contracts that derive their value from an underlying asset, such as a stock or commodity. In the context of DeFi, derivatives can be used to manage risks associated with digital assets. There are various types of derivatives, such as typical contracts (futures and options), perpetual swaps (without a fixed expiration date), and synthetic assets (tokens backed by collateral that reflect the value of an underlying asset).
- Portfolio management in DeFi allows for the automation of investment strategies. Cryptocurrencies are stored in smart contracts and allocated according to pre-determined strategies, which can range from portfolio rebalancing to yield aggregation.
- DeFi payment protocols offer fast and low-cost transactions, making it possible to process instant micropayments without relying on third parties. The blockchain allows value transfers without intermediaries, eliminating the risk of delegating the custody of crypto-assets.
- Finally, DeFi insurance protocols provide coverage for on-chain risks, such as smart contract hacks. Users can purchase policies to protect themselves against adverse events, obtaining reimbursement in case of losses.
DeFi payment protocols offer fast and low-cost transactions, making it possible to process instant micropayments without relying on third parties. The blockchain allows value transfers without intermediaries, eliminating the risk of delegating the custody of crypto-assets.
In summary, DeFi offers a wide range of applications, from stablecoins to lending, decentralized exchanges and derivatives, to wallet management, payments and insurance. These innovations are transforming the way people interact with the financial world, offering greater autonomy and transparency.
De.Fi And Mica: Analysis
The MiCA does not specifically deal with decentralized finance (DeFi), as this is still an emerging technology and too new to be regulated by law, so much so that the Regulation excludes its value and operation with respect to De.Fi. However, However, it is useful to see whether DeFi categories fall within the activities covered by MiCA.
The MiCA, in its Recitals, refers only to stablecoins, which is understandable because the term is not very precise. Fiat currencies, commodities and crypto-assets can be stable at certain times and unstable at others. Stability of value is always relative to the value of fiat currencies, commodities or crypto-assets, even though these can be volatile in a macroeconomic sense.
Recital (26) of the MiCA states that algorithmic "stablecoins", which seek to maintain a stable value through protocols that regulate supply in response to demand, should not be considered ARTs, unless they refer to one or more other assets. This point seems confusing because if a crypto-asset did not aim to stabilize its value by referencing other assets, it would not be considered an ART. According to MiCA, it appears that the importance of an ART or EMT is linked to the assets to which their value is anchored, not guaranteed.
If this interpretation is correct, algorithmic stablecoins would be covered by MiCA and classified as ART or EMT, depending on the reference assets. This recital should therefore be amended.
According to MiCA, only legal entities in the European Union can issue ART, unless the offering exceeds €5 million in 12 months or is aimed only at qualified investors. Issuers must provide clear and accurate information to token holders, including a white paper describing the stabilization mechanism, reserve investment policy, reserve custody arrangements and holder rights.
As for EMTs, only credit institutions and electronic money institutions can issue them. Issuers must produce a white paper on crypto-assets and notify the relevant authorities, unless the tokens are held only by qualified investors or the average amount in circulation does not exceed €5 million in 12 months.
For derivatives, some are considered financial instruments according to Directive 2014/65/EU and do not fall under MiCA. However, some derivatives that do not meet the criteria of the Directive may be considered crypto-assets and fall under MiCA as asset-referenced tokens, e-money tokens or other crypto-assets, depending on their characteristics.
Most DeFi services are not covered by MiCA, such as wallet management, insurance, lending, and payments. However, e-money token payment services are regulated by Directive (EU) 2015/2366. The only case covered by MiCA is DEXs (decentralized exchanges), which can be classified as crypto-asset exchange services or crypto-asset trading platforms. The providers of these services must be legal persons with registered office in an EU Member State and authorized by the competent authority.
Crypto-asset service providers must act honestly, fairly and professionally, provide clear and correct information to customers and comply with certain prudential requirements. However, in DeFi, management should be decentralized and not controlled by a central entity, which creates a problem for MiCA, which only applies to natural or legal persons.
Most DeFi projects have some degree of centralization, meaning there is an identifiable intermediary responsible for complying with MiCA. According to the Financial Action Task Force (FATF), many DeFi platforms have a central party that handles certain functions, such as creating and launching an asset, defining parameters, managing administrative keys, or collecting fees.
In other cases, DeFi projects are completely decentralized and rely only on smart contracts, so they do not fall under MiCA because there is no individual or legal entity responsible.
It is important to understand when a protocol is truly decentralized to determine whether MiCA applies or not.
Decentralized protocol
The term "decentralized" has various meanings in the context of Distributed Ledger Technology (DLT).
First, it is used to describe the Settlement Layer, where a network of independent, unrelated nodes manage a blockchain without the need for a central server or organization. This decentralization, called architectural distribution, is a key aspect. For our discussion, we assume that the regulation layer on which DeFi protocols are based is sufficiently distributed.
Secondly, “decentralized” can refer to the custody of crypto-assets, i.e. management without intermediaries. In traditional finance, custody is a service where custodians hold assets on behalf of clients, offering security against theft or loss thanks to their reputation and a legal and regulatory framework. With DeFi, trust is based on robust and transparent technology, where only the user has access to their assets stored in a smart contract. In non-custodial protocols, users fully control their crypto-assets without the need for a central entity, and the interaction occurs automatically without intervention from the development team.
Third, “decentralized” refers to the management and ownership of a protocol. This type of decentralization is essential in all levels of DeFi. Decentralized Autonomous Organizations (DAOs) are entities in which participants have voting rights through tokens that influence the automatic execution of smart contracts. Governance tokens allow holders to vote and own parts of the protocol, influencing various operational and strategic aspects.
However, to have true decentralization in governance, you need a system where all decisions and code maintenance are handled by token holders. Often, developers maintain master keys to the system, allowing them to make changes or shut down the protocol in case of emergency. Thus, the voting rights of governance tokens are not as binding as those of shareholders in traditional companies.
Currently, DeFi protocols are not fully decentralized and offer non-custodial financial solutions based on a decentralized settlement layer. A protocol can only be called decentralized if it is built on a decentralized (architectural) foundation, does not control user assets (non-custodial), and all aspects of governance and maintenance are managed by the token holders, with code that operates automatically without the possibility of intervention by a single entity.
Other criteria may include the absence of economic benefits for developers or anyone else involved in the operation of the protocol. If someone receives compensation, it is a commercial service, which implies centralization. Furthermore, a decentralized protocol should not have an interface controlled by a single entity, as this would create responsibilities and benefits for that entity, and therefore centralization.
Finally, a system can only be considered decentralized if there are no commissions attributed to a small group of entities and if there is no centralized interface to interact with it. Identifying these criteria helps us understand when a protocol is truly decentralized and therefore outside the scope of MiCA (Markets in Crypto-Assets).
Our goal is to continue exploring how the law should treat DeFi, i.e. those projects that use decentralized protocols as we have defined here.
How to regulate decentralized protocols?
Brokerage is a key element for financial operations: commercial and investment banks, stockbrokers, mutual funds, insurance companies and stock exchanges form the basis of modern financial structures. Since the financial system is intrinsically interconnected, financial regulations establish standards of conduct for intermediaries. However, with the advent of decentralized protocols that allow financial services without intermediaries, this concept must be revised.
First, it must be recognized that the current regulatory framework does not adapt to decentralized protocols. With the entry into force of the MiCA regulation, and the potential growth of DeFi, it is urgent to find a solution that maximizes the benefits of DeFi, such as openness and transparency, and mitigates its risks. DeFi represents the idea that computer code can replace traditional legal systems.
One possible solution is to combine the role of the regulatory state with that of the entrepreneurial state. The State should encourage self-regulation and establish public debt management policies, financing projects that achieve public objectives. In this way, the state would act in the market like any private entity, which makes sense for DeFi since it is not possible to have a public body with sovereign power within a decentralized system.
DeFi, in theory, does not present serious risks for investor protection since there are no problems of information asymmetry and there is no customer-intermediary relationship. However, public intervention cannot be ruled out to address risks to financial stability, such as cyber risks, fraud, price manipulation, frontend issues, credit, foreign exchange and liquidity risks.
To prevent these risks, a public body should actively intervene in decentralized protocols, ensuring that they are secure, reliable and compliant with the law. This body must have adequate skills, such as in cybersecurity, and choose to participate only in protocols that comply with anti-money laundering regulations, by purchasing governance tokens.
This approach will reward developers who create protocols with the necessary restrictions and promote good governance within DeFi communities by partnering with expert private bodies to ensure the quality of public information. The public body should provide advice and disseminate best practices on DeFi, maintaining technological neutrality and focusing on financial processes and technological risks.
With the MiCA regulation and the authorization of crypto-asset service providers by the relevant authorities, there will be more useful information about the crypto-asset ecosystem. This will help the public body to choose the most appropriate decentralized protocols, promoting innovation and economic growth in line with public management principles, such as efficiency, transparency, citizen participation and equity.
However, if serious systemic risks are identified in decentralized protocols, the public body must monitor them and report them to financial regulators, such as central banks and supervisors. This requires an international approach, as decentralized protocols often have a global reach. Therefore, the issue should be promoted in international forums such as IOSCO, IMF and the World Bank Group.
As proposed in the 2021 European AI Regulation, creators of decentralized protocols that pose high risks to financial stability should take preventative measures and be held accountable in case of failure. For example, a DEX without AML/CFT and KYC checks would need to be registered and authorized by a financial regulator to ensure accountability.
In summary, while MiCA and financial regulators oversee crypto-assets in centralized protocols, a new public body should manage assets in decentralized protocols. This body should prevent risks for consumers and investors, promote innovation and economic growth and provide advice, always maintaining an open and adaptable mind in the face of the challenges and risks of DeFi. A harmonized and international approach is crucial to avoid market fragmentation and to effectively address the systemic risks of DeFi, while ensuring a more equitable and accessible society.
Final thoughts
Decentralized Finance (DeFi) is radically transforming the global financial landscape, offering unprecedented opportunities for access to financial services, economic inclusion and technological innovation. However, this evolution also poses significant challenges for regulators, who must balance promoting innovation with the need to protect users and ensure financial stability.
The current regulatory framework, represented by the European Union's Markets in Crypto-Assets (MiCA) Regulation, is an important step towards regulating the cryptocurrency sector, but it still leaves many questions regarding DeFi open. The decentralized nature of DeFi protocols requires a flexible and adaptable regulatory approach, capable of recognizing when a system is truly decentralized and defining new forms of supervision and control.
To unlock the full potential of DeFi, it is essential that regulators take a proactive approach, working with industry experts and DeFi communities to develop regulations that are both effective and conducive to innovation. This includes identifying and mitigating systemic risks, promoting cybersecurity best practices, and creating incentives for the development of secure and reliable protocols.
In conclusion, DeFi represents a fascinating and promising frontier of modern finance. With a balanced and forward-thinking regulatory approach, it is possible to create a more open, transparent and inclusive financial ecosystem, capable of delivering significant benefits globally, while maintaining the security and stability necessary to support user trust and economic growth.
