DeFi may struggle to remain decentralized after new EU legislation.

New regulations in the European Union may soon force decentralized finance (DeFi) protocols to make tough decisions.

At the heart of the problem is the tendency of many DeFi protocols to have centralized front-ends and intermediaries.

In the year The EU Crypto-Assets Regulation (MiCA), which will be fully implemented by the end of 2024, will require DeFi protocols to comply with the same licensing and know-your-customer (KYC) requirements as traditional financial services firms – a burden many DeFi protocols may be unable or unwilling to shoulder.

According to Rune Christensen, co-founder of MakerDAO, “It can be fully decentralized, local, downloaded front-ends or full-KYC only online front-ends.

This leaves DeFi protocols with a choice: either a somewhat centralized “hybrid finance” (HyFi) model to comply with EU regulations, or completely decentralized.

“True” DeFi is independent of MiCA.

As mentioned in Recital 22, within the actual EU regulation, fully decentralized protocols are exempt from falling within the MiCA requirements.

“Crypto-asset services provided in a fully decentralized manner without an intermediary should not fall within the scope of this regulation.”

Oliver Volkel, attorney and partner at the law firm Stadler Volkel, has studied the EU regulation of crypto assets in depth.

He told Cointelegraph that a quick question posed by this part of MiCA is what “without an intermediary” and “fully decentralized” mean.

He said that “smart contracts used in the provision of crypto-asset services are not even suitable for creating a unique form of decentralization by themselves.”

Companies can use smart contracts to provide crypto-asset services on their behalf. Voelkel concludes that smart contracts are just a tool for a company to use in such cases.

Only natural persons and legal entities can hold rights and obligations, issue and receive legal statements, provide and receive services, and be the recipient of a legal address or be regulated by acts such as MiCA.

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However, Voelkel believes that the EU legislators have correctly realized that “none of these crypto-asset services can be accessed independently without an intermediary in a decentralized manner.”

With the MCA coming into full force by the end of 2024, DeFi protocols operating in Europe will have to decide whether to follow fully decentralized, effectively decentralized regulations or KYC measures like any centralized company providing financial services.

Will DeFi split into two?

Nathan Catania, a partner at XReg Consulting, a crypto-asset regulation consulting firm, told Cointelegraph that the new regulatory wave could split the sector.

“Regulation represents a fork in the road for many DeFi projects. They either embrace decentralization and move outside the regulatory perimeter, or accept the need for some regulation based on their unique model and move into more hybrid finance territory.”

In his opinion, “For those who embrace decentralization, regulation like the MCA in Europe draws clearer lines in the sand. This new set of rules provides greater clarity on how to build truly decentralized applications to comply with regulatory requirements.

In fact, many DeFi protocols need to take a hard look at how they do business to ensure their platforms are truly decentralized and unregulated.

Catania suggested that they review the regulation thoroughly and contact their national regulatory authorities if possible.

The DeFi sector can implement several methods to ensure decentralization, one of which is the decentralization of web front ends. Decentralized web hosting involves deploying websites on peer-to-peer (P2P) servers using advanced cryptography.

Thomas Kroes, VP of Urbit – an open source, P2P decentralized private server platform – explained to Cointelegraph that decentralized hosting provides protection for front-end services because they cannot be downloaded. Even Urbit says it can't remove content on its nodes if necessary.

Whichever way Protocol chooses, here's the rule.

Decentralization advocates may soon see DeFi transform into something closer to traditional finance.

Will the industry thrive in a decentralized digital universe or will an injection of capital from traditional market drivers transform the sector?

DeFi must comply to attract institutional investors.

Regulators are paying attention to DeFi as the sector matures and grows in popularity, as exemplified by the enforcement actions taken by the European Union's MCA and the United States' Securities and Exchange Commission against popular DeFi protocols.

On April 10, 2024, Uniswap became the first decentralized protocol to issue a Wales Notice – a public notice issued by regulators to inform individuals or companies that the regulator has completed an investigation and found violations that could be brought to court.

Unsurprised, Uniswap CEO Hayden Adams replied, “I'm angry, disappointed, and ready to fight back.”

Adam Simon, chief strategy officer at Diffie platform Radix, told Cointelegraph that most people agree that some safeguards are needed.

He believes regulatory requirements are inevitable for the Defy sector, especially if the industry plans to gain global acceptance.

“The next evolutionary step for DeFi is to get institutional and traditional financial money involved,” Instalabs CEO Edward Adlard told Cointelegraph.

However, he believes that there are two main obstacles. First, TradFi companies are not set up to use crypto instruments.

Second, TradFi companies need to understand how to legally access these products and offer them to customers: “DeFi DApps must walk the line between implementing adequate AML processes to attract TradFi liquidity and avoid being the target of regulatory actions.

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Compliance tools are already available. Simmons explained that the DeFi sector in Europe could use a system of trusted issuers that independently manage identity verification.

Adlard explained that DeFi KYC service Instapass can create custom credentials that comply with EU regulations, adding that “DeFi DApps can easily access certain parts of their products on users who hold that credential.

Regardless of whether the DeFi protocol chooses to pursue institutional adoption or decentralization, it must adapt to the changing legal landscape in the European Union.