Since it was ratified and adopted by the European Union (EU) in April this year, one aspect of the Markets in Crypto-Asset (MiCA) regulation that has been debated has been its application to decentralised finance (DeFi) projects. Attention has focused on Recital 22 and its attempt to exclude so-called "fully decentralised" projects. The notion of what it means to be "fully decentralised" does not have a fixed definition and is a matter of debate among industry experts.
This Regulation should apply to natural and legal persons and certain other undertakings and to the crypto-asset services and activities performed, provided or controlled, directly or indirectly, by them, including when part of such activities or services is performed in a decentralised manner. Where crypto-asset services are provided in a fully decentralised manner without any intermediary, they should not fall within the scope of this Regulation.
(our emphasis)
Critics have pointed out that it is practically impossible for a project to be "fully decentralised" depending on how the term is defined, and also that decentralisation and disintermediation (which appear to be confused as the same thing in MiCA) are very different concepts.
In response, the European Security Markets Authority (ESMA) has released a consultation paper offering commentary on various issues im MiCA and proposing implementing regulations. The consultation paper acknowledges uncertainty in determining whether something is fully decentralised:
Finally, regarding DEXs, ESMA acknowledges Recital 22 of MiCA that “(…) Where crypto-asset services are provided in a fully decentralised manner without any intermediary” should fall outside the scope of MiCA but also notes that the exact scope of this exemption remains uncertain. ESMA considers that an assessment of each system should be made on a case-by-case basis considering the features of the system.
ESMA goes on to define "permissionless distributed ledger technology" as:
a technology that enables the operation and use of distributed ledgers in which no entity controls the distributed ledger or its use or provides core services for the use of such distributed ledger, and DLT network nodes can be set up by any persons complying with the technical requirements and the protocols.
ESMA's approach acknowledges the fact that DeFi can operate in a manner in which a person can access a blockchain or smart contract based application as a mere user of a tool or piece of technology, rather than through forming a contractual relationship as service provider and customer.
While the question of whether a particular suite of smart contracts is decentralised will remain subject to nuanced analysis, as Jonathan Galea points out, there is likely to be a need to establish decentralisation at multiple levels, which may not exist where there is an ability to unilaterally alter the underlying code base of a blockchain based application or apply fees to access activities or services.
ESMA's approach seems somewhat at odds with recent IOSCO recommendations which asserted that DeFi is not sufficiently different to existing financial services and so should be addressed in broadly the same way. It has been reported that the US Securities and Exchange Commission had a heavy involvement in preparing the report and in IOSCO's working groups.
However, ESMA's attempt to grapple with this issue is welcome and acknowledges the incongruity of seeking to regulate a piece of technology as opposed to the activities of a person or corporation developing or operating that technology. It is hoped that further clarity can be provided in the final MiCA regulations or guidance specifying a number of indicative factors which would assist in carrying out an assessment of whether a DeFi application or other decentralised project is in fact "fully decentralised" or subject to oversight and control by a single entity. ESMAis due to propose implementing regulations for adoption by the European Commission before MiCA comes into force in June 2024.
By Steven Pettigrove, Michael Bacina and Luke Misthos