A report prepared for the executive branch of the European Union recommends a suite of light-touch regulations for decentralized finance that has industry observers cheering.
The report published this week stands in stark contrast to several presented to the White House earlier this year. Those reports recommended that the United States take several measures to mitigate the volatility and fraud present in crypto markets, but made little mention of the potential benefits of the technology, disappointing its supporters.
“One thing is clear: EU is light years ahead of the US on DeFi,” Marc Goldich, general counsel at Proximity Labs, tweeted.
Gabriel Shapiro, general counsel at Delphi Labs, agrees.
“This sounds really promising,” he wrote on Twitter. “At this rate, Europe is going eat the U.S.’s lunch when it comes to crypto, web3 and DeFi.”
The report is expected to inform the European Union’s debate on decentralized finance as well as legislation that may be drafted next year, according to Patrick Hansen, director of EU strategy and policy at Circle, the issuer of the USDC stablecoin.
The report makes four policy recommendations: regulating traditional finance entities that jump into DeFi; incentivizing voluntary regulatory compliance among DeFi protocols; creating a “public observatory” that analyzes on-chain data and issues warnings or recommendations based on that data; and regulating oracles, the technology that brings real-world data on-chain.
Most notable, however, is the general tone of the report. It asserts that DeFi and traditional finance are fundamentally different and must be regulated as such, and cites the anonymity provided by blockchain technology as a “feature and not a bug.”
“The US is out here saying don’t treat DeFi differently than CeFi. The EU is authoring an absolute f!@#ing masterclass on why DeFi is fundamentally different and needs its own thoughtful regulatory structure,” Adam Sternbach, general counsel at Tessera and former counsel to New Jersey Gov. Phil Murphy, wrote. “We are not the same. And not in a good way.”
‘Policing the Policed’
In a section titled “policing the policed,” the report suggests regulating the DeFi activity of “legal entities falling under current supervisory and regulatory mandates.”
The report notes that entities already regulated in traditional markets should be easy to identify on-chain. But it recommends laws to compel them to furnish a list of all the wallet addresses they own in order to limit their opportunity to conceal the flow of their assets.
Integration between on- and off-chain finance might benefit the latter, the report continues, given the transparency inherent in the former.
“The transparency of DeFi public activity also bears favorable outcomes for regulators,” the report reads, “as it grants them additional means to verify proper reporting.”
Given its anonymous and permissionless nature, DeFi might be difficult to regulate via traditional means, according to the report.
The author recommends regulations that “entities and protocols voluntarily seek to comply with … in order to obtain a public stamp of approval and other potential benefits.”
Among DeFi entities – as opposed to permissionless protocols – regulations might include liability, identification and capital requirements.
For permissionless protocols, “regulators could require that counter-cyclical mechanisms be embedded into a protocol” or that only certain whitelisted persons can access the protocol. To incentivize compliance, the EU could offer “privileged access to central bank facilities,” for example.
Taking a cue from traditional markets, in which financial institutions’ activity is actively monitored, the report also suggests government monitoring of on-chain activity.
“With enough credibility, documented warnings of flash crashes and strong protocol vulnerabilities could be effective in steering market activity away from risky and inefficient segments of the DeFi ecosystem,” the author wrote.
Finally, it calls for the regulation of oracles, the technology that provides blockchains with off-chain data, such as the weather, or the real-time price of a real-world commodity.
In addition to public oracles, the European Union should consider
“establishing standardized frameworks for specific data production, processes and APIs” as well as “security standards and disclosure guidelines,” the author suggests.
Whether the European Commission, the EU’s executive branch, will heed the report remains to be seen. Nevertheless, aggressive enforcement from U.S. regulatory agencies, such as the Securities and Exchange Commission, has set a low bar for governments to clear in order to win praise from the crypto community.
“A regulatory framework about blockchain-based constructs [is] emerging in the EU,” Firat Cengiz, senior lecturer of law at the University of Liverpool, tweeted. “Although it is not possible to see the full picture yet, the general approach seems quite liberal and supportive of innovation.”
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