In the context of the ratification and adoption of the Markets in Crypto-Asset (MiCA) Regulation by the European Union in April 2023, an aspect that has garnered substantial discourse is its application to decentralized finance (DeFi) projects.
Central to this debate is the interpretation of Recital 22 within the MiCA framework, specifically its efforts to delineate and potentially exclude projects deemed "fully decentralized." This term, however, remains legally and conceptually nebulous, lacking a universally accepted definition.
Under Recital 22 of MiCA, it applies "including when part of such activities or services is performed in a decentralised manner." However, "Where crypto-asset services are provided in a fully decentralised manner without any intermediary, they should not fall within the scope of this Regulation" [emphasis added]. Obviously, disintermediation and decentralization are what MiCA requires from DeFi to be excluded from the Regulation, but what does it mean?
We tried to answer this question in our article published after MiCA was ratified and adopted. Now, with its second Consultation Paper (link below), the European Security Markets Authority (ESMA) will help us by adding a bit more clarity (emphasis added):
"98. Alongside CEXs, Decentralized Exchanges (DEXs) present a different way to trade crypto-assets. On DEXs, there is no central operator and, as a consequence, no central control over users' assets. Instead, users keep control of their assets by interacting with the distributed ledger (i.e. blockchain) using a self-custody wallet. With DEXs, the blockchain takes the place of the intermediary. DEXs use autonomous code (often referred to as a 'smart contracts'), to execute trades directly on the settlement layer of the blockchain (with differing degrees of decentralisation).
99. DEXs may run an order book but also less traditional models such as Automated Market Makers (AMMs). These decentralised models are increasingly becoming important in particular in decentralised finance (DeFi). Under these AMM models, contrary to CLOBs [author's note: central limit order books] where market makers post bid and offer prices on the order book, the liquidity provision process is decentralised, relying on aggregated pools of liquidity (often comprised of a token pair, e.g., Ethereum (ETH) to USD Coin (USDC)) and on a mathematical formula (e.g., a constant product function) to price assets. The execution price is generally determined based on how many assets an order would consume in the concerned pool of liquidity and the resulting unbalanced quantities of asset between the related pools."
In summary, ESMA's criteria for understanding a "fully decentralised" manner under MiCA focus on:
the absence of a central operator,
the use of autonomous code in executing trades, and
the decentralization of liquidity provision processes.
Also, we can see the following in ESMA's Consultation paper:
"108. 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. In this context, ESMA considers it useful to clarify how pre-trade transparency should apply to such protocols. This is without prejudice to any possible clarification that can be published in the future regarding the scope of the exemption for fully decentralised systems."
Taking this into account, we can summarize the following key points:
Ambiguity in Regulatory Exemption Boundaries. ESMA acknowledges that while Recital 22 suggests such services should ideally be outside the MiCA scope, the precise boundaries of this exemption remain indeterminate.
Individualized System Assessment Approach. ESMA proposes a nuanced, case-by-case evaluation of each system to address these ambiguities.
Clarifying Pre-Trade Transparency in Decentralized Protocols. ESMA highlights the need for clarity on how pre-trade transparency regulations should apply to decentralized protocols. Pre-trade transparency is a cornerstone of financial regulation to ensure fair and efficient markets. However, applying such regulations to decentralized protocols is challenging, given the absence of traditional intermediaries and centralized control mechanisms.
Evolution of Regulatory Interpretations. Current interpretations are not final and may evolve. ESMA leaves open the possibility of future clarifications or adjustments to the regulatory approach for fully decentralized systems.
Also, according to ESMA [emphasis added]:
"‘permissionless distributed ledger technology’ means 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."
Key characteristics we can derive from the definition:
No Central Control: No single entity shall exercise control over the ledger, extending not only to its operation but also to its usage. A single entity must not be in a position where its provision of core services is deemed vital for the operation of the ledger.
Open Participation: Any individual or entity can set up nodes in the DLT network, provided they meet the technical requirements and adhere to the network's protocols.
Absence of Core Service Providers: In a permissionless DLT, no designated entities provide core services essential for the operation of the distributed ledger.
Obviously, the concept of decentralization within the context of distributed ledger technology (DLT) and Decentralized Finance (DeFi) does not possess a definitive endpoint or universally agreed upon criteria. However, three subsequent points can be distilled to minimize the risk of MiCA application:
Identification and Evaluation within MiCA Scope: To ascertain exclusion from MiCA application, the first requisite is evaluating whether an individual or entity meets the definition of a Crypto-Asset Service Provider (CASP) as outlined in Article 3(1)(15) of MiCA. Subsequent to this identification, the next step is to assess if the individual or entity is engaged in providing any of the specific crypto-asset services as listed in Article 3(1)(16).
Decentralization in Functional Roles: A higher degree of decentralization should be achieved with more participants involved in various functions, like development, consensus mechanism, and node operation. No threshold should be set for decentralization, as this would imply permissioned control.
Multiplicity of Access Points: For DeFi technologies, having multiple front-ends for accessing smart contracts is crucial. This minimizes the reliance on a single entity for access and operation, promoting decentralization.
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At Prokopiev Law Group, we specialize in navigating the complex terrain of MiCA Regulation and its implications for Decentralized Finance (DeFi) and blockchain technologies. With our extensive global network of partners, we offer comprehensive legal support, from DAO governance and Web3 compliance strategies to cryptocurrency legal risk assessments and smart contract analysis. Whether you're dealing with crypto regulation advisory, NFT intellectual property rights, or developing Web3 anti-money laundering policies, our team is equipped to ensure your compliance in the EU and worldwide. For expert guidance in this rapidly evolving digital landscape, reach out to us and secure the future of your innovative projects.
The information provided is not legal, tax, investment, or accounting advice and should not be used as such. It is for discussion purposes only. Seek guidance from your own legal counsel and advisors on any matters. The views presented are those of the author and not any other individual or organization. Some parts of the text may be automatically generated. The author of this material makes no guarantees or warranties about the accuracy or completeness of the information.
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