The European Commission is currently assessing the DeFi sector and may soon mandate protocols to acquire a MiCA license.

As the European Commission scrutinizes the decentralized finance landscape, there's anticipation of new regulatory frameworks looming over DeFi protocols in Europe.

Under the Markets in Crypto-Assets (MiCA) regulations governing digital assets in the region, the European Commission is obligated to produce a report by December 30, 2024, scrutinizing the decentralized finance market and contemplating specific regulations tailored for the sector.

"In anticipation of this report, we've initiated various measures. For instance, we're conducting a study on embedded supervision. However, no policy decisions have been finalized yet," clarified a spokesperson from the Commission in communication.

The forthcoming report is aimed at exploring how decentralized systems, particularly those devoid of a discernible issuer or service provider, should be regulated. Maxim Galash, CEO of CoinChange Financials, elaborated that a pivotal aspect of this evaluation will focus on regulating activities like crypto-asset lending and borrowing, which are central to the DeFi landscape.

DeFi epitomizes a departure from conventional centralized financial systems towards peer-to-peer finance facilitated by decentralized technologies harnessed on blockchain networks. Unlike traditional finance laws that often hinge on regulating central entities such as banks or financial services providers, decentralized systems function without such intermediaries.

The prospect of new regulations has sparked apprehensions about the legal viability of certain crypto projects. Rune Christensen, co-founder of MakerDAO, raised concerns that the rules might subject some DeFi interfaces, like decentralized exchanges, to licensing requirements.

"This could render DeFi frontends on standard internet domains, as we know them today, infeasible. Only fully decentralized, locally downloaded frontends or fully KYC-compliant online frontends would be permissible. Disappointing," he lamented on X (formerly Twitter).

Similarly, Nathan Catania, a partner at XReg Consulting, posits that an eventual DeFi regulation could encompass all non-fully decentralized applications, including DeFi frontends. Catania underscores that the MiCA regulation lacks a definitive definition of decentralization, suggesting that the scope of DeFi regulations will heavily hinge on the criteria employed to ascertain the concept.

"Even protocols that aren't decentralized enough could be viewed as offering CASP services such as crypto-assets exchange. In terms of frontends, there are also services like reception and transmission of orders on behalf of third parties. Therefore, it may boil down to how stringent regulators wish to be in implementing this," he explained.

In the MiCA regulation, a Crypto-Asset Service Provider (CASP) encompasses any entity offering services related to digital assets to third parties, encompassing exchange services, transfer services, and custodian wallets, among others.

Catania highlights that one of the pivotal factors regulators might consider in assessing the level of decentralization is whether a professional service is being rendered.

"A frontend merely providing users an interface to access DeFi without exerting control over users' funds and not charging a fee is less likely to be at risk than one that imposes a fee. Even then, legal and technical intricacies need to be examined to ascertain whether such activities should be licensed under MiCA," he emphasized.

Another potential avenue for DeFi regulation could be through the Financial Action Task Force (FATF).

According to Galash from Coinchange, the FATF proposes that in certain scenarios, individuals or entities exercising control or substantial influence over DeFi setups may be classified as Virtual Asset Service Providers (VASPs). "This classification applies even if the setups appear decentralized, underscoring the complexity of defining and regulating DeFi activities," Galash elucidated.

Based on data from DefiLlama, the total value locked (TVL) in DeFi protocols has witnessed a remarkable surge over the past four years, surging from $570 million in April 2020 to $96.7 billion currently, marking a staggering 16,865% growth during the period.

"The fundamental question revolves around whether the DeFi setup is merely a technological construct or if there's an overseeing party influencing user value," concluded Catania.