From a regulatory point of view, the area of decentralized finance is still unexplored territory. The EU crypto regulation, the Markets in Crypto Assets (MiCA), does not yet cover the sector. Nevertheless, the decision-makers in Brussels are of course concerned with the increasing popularity of the services related to Uniswap and the like, which increased again after the fall of FTX. In a position paper, the Commission has already ventured first thoughts. Renowned DeFi experts have now taken this approach in one go common document on. Overall, the nine-page letter contains six proposals that, from the point of view of the experts, combine both “consumer protection and innovations” for the European decentralized financial sector.
1.) Legal recognition of DAOs
A core concern of the authors deals with the legal status of DAOs. These fundamentally open up a new decentralized organizational structure in which central authorities become obsolete. Thus, they are an important element in the DeFi world. However, DAOs are not yet recognized as legal entities, which limits the legal options of the decentralized organizations. The paper calls for clarity in European law. Hagen Weiss, legal adviser at the commercial law firm Dentons and co-author of the position paper, told that this would be best done by means of your own regulation.
2.) Standardized API data framework for oracles
In order to facilitate the exchange of information in the European DeFi market, the authors advocate the introduction of a standardized API data framework for oracles. These first feed a blockchain with the external data that is then verified by the technology. With the help of a uniform API repository (a repository for programming interfaces), for example, DeFi applications could be developed much faster and made more interoperable across the EU.
The “main focus must be on the high security standards that already exist at the beginning” so that the digital security infrastructure is not endangered, says Weiss.
3.) SoulBound token as DeFi proof of identity
Furthermore, the authors call for the recording of so-called “SoulBound Tokens” (SBT) in the MiCA and the eIDAS regulation. The term first emerged in May 2022 around a publication by Ethereum co-founder Vitalik Buterin. Basically, the identity of the user in the respective network can be tokenized in compliance with data protection. Consequently, the SBTs are not transferable to other persons.
4.) Compliance: Voluntary through incentives
How do you guarantee that the participants in a decentralized financial market also adhere to the relevant rules that a central authority such as the European Union sets? The authors rely on the concept of voluntariness through the creation of incentives. However, these would have to be worked out in more detail, says Weiss. A consideration would be something like:
The public sector could release “badges” or reports on specific networks, and then use on-chain tools to show which protocols are (currently) the safest from an investor and market protection perspective.
In this way, a standard could crystallize with increasing activity, the legal adviser continued.
5.) Compliance through public oversight
The issue of supervision must also be reconsidered. The aim here is to find individual solutions for various DeFi applications. In addition, one must take advantage of the “radical transparency” of the sector. Weiss calls this approach “embedded supervision”. Regulators would use this authority to launch public inquiries, express opinions and issue warnings.
6.) Use of Licensed Oracles
In general, the document places high hopes in oracles for DeFi regulation, for example with regulatory requirements. A core element must therefore be the “authenticity” of the imported data. Therefore, the authors propose the licensing of oracles, preferably using their own set of rules. Liability claims, for example, could then be regulated therein.
The use of so-called KYC-NFTs, which are assigned according to a publicly accessible framework, would be conceivable. Users could then use these tokens to operate in the DeFi sector. Here, too, the data protection regulations would have to be complied with, says Weiss.