DeFi and MiCA: How much decentralisation is enough?

The European Union Council has recently adopted a regulation on Markets in Crypto-Assets (MiCA) that applies to crypto-assets, their issuers and service providers, and covers a range of services that are not addressed in the European financial regulation.

However, for blockchain-based financial services developed in a highly automated manner with minimal or no intermediaries (commonly known as Decentralised Finance or DeFi) determining whether the MiCA regulation covers these services is not a straightforward task. This issue particularly challenges the provision of crypto-asset exchange services or the operation of trading platforms for crypto-assets (known as decentralised exchanges or DEX).

Only partially decentralised crypto services are subject to the MiCA regulation while fully decentralised services provided without intermediaries are excluded from its scope.

The challenge lies in the fact that players in the DeFi market operate across a spectrum of decentralisation. So it is not clear when decentralisation transitions from being partial to full. In practice, “decentralisation" is not a binary fact, and this circumstance has generated a heated debate in the crypto industry that to this day discusses what the content and scope of this concept should be.

So, what are we to understand by “full” decentralisation within MiCA?

Since blockchain services are built on a series of layers and compartments that enable their operation, it is difficult to establish a priori at which layer or compartment the level of decentralisation is relevant for regulatory purposes. For example, should we be concerned with decentralisation at the infrastructure level, or should decentralisation also extend to the front end and custody?

On the other hand, it is reasonable to think that decentralisation for the MiCA regulation is not just a question of how many nodes or physical computers support the service, but rather a political question of how many individuals control it and how they control it. Ultimately, what should matter is that many players control the network (and its underlying protocols) and make their decisions independently.

But how many players and how much control must each have for a service to be fully decentralised? Should there be a ratio between validator nodes, ownership, transactions or other factors to assess decentralisation (e.g. the Nakamoto coefficient)?

In this scenario, in the absence of specific guidelines, crypto service providers will need to determine for themselves where on the decentralisation spectrum their business model no longer qualifies as being only partially decentralised.

The European Commission has already been asked to present a further assessment of decentralised finance, which is likely to shed light on this matter. However, given the dynamic nature of these technologies, the open interpretation of concepts such as "decentralisation," "distribution," "intermediation" and the associated semantic difficulties, a continuous flow of soft-law instruments and guidelines will be necessary to provide interpretative tools. Such guidelines can serve as a flexible mechanism to implement the MiCA regulation in this area and would also be useful in providing and applying common interpretations internationally.

For more information, contact your CMS client partner, Carolina Veas or send an email to [email protected].  

An article on theoretical considerations about the term “decentralised” will follow shortly.

For more information on crypto regulation before the introduction of MiCA, please visit CMS Expert Guide to European Crypto Regulation.