Unhosted wallets face severe restrictions in the EU

In fact, there is reason to celebrate. The BTC ban was not tabled again by the EU Parliament this week. A proof-of-work ban as part of the so-called MiCA regulation is practically off the table, we reported. Now the next wave of possible bans or at least massive restrictions on DeFi applications and unhosted wallets in the European Union is looming.

The same committee that negotiated the MiCa regulation is now debating the identity disclosure requirements for crypto transactions. The ECON Committee of the EU Parliament is specifically concerned with the Transfer of Funds Regulation, or TRF for short. This is based on the international FATF Travel Rule, which defines standards for combating money laundering.

Red alert for DeFi in the EU

Already next Thursday, March 31st, there will be further votes on the crypto-related anti-money laundering regulation in the ECON committee. The fact that the so-called TRF provides for stricter disclosure requirements for crypto transactions is not new. However, BTC-ECHO, german outlet, now has leaked documents that provide for particularly tough measures. Crypto insiders like DeFi expert Patrick Hansen of Unstoppable Finance are alarmed:

Even if some subjunctive moods are included in the working drafts, in an emergency they can lead to the DeFi sector in the EU being severely weakened. Nothing is final yet, but the likelihood of significant cuts in decentralized finance applications is significantly higher than with the averted BTC ban. In contrast to the highly controversial BTC ban, which did not have a majority in the EU Parliament, Commission or Council of Ministers, the drastic measures of the Transfer of Funds Regulation look different. Applications with so-called unhosted wallets could be particularly affected by the regulation.

The attack on unhosted wallets

If you want to keep your private keys yourself, you can use a so-called unhosted wallet. Also common terms are non-custodial wallet or self-hosted wallet. With these wallets, the crypto investor himself bears full responsibility. This means that he is independent of intermediaries who take over custody and also control it. The latter would in turn be referred to as a hosted or custodial wallet. Motives for unhosted wallets are above all the use of DeFi applications, protection of one’s own privacy, fear of stock exchange hacks or possible state intervention in one’s own crypto assets.

If the new or revised paragraphs in the TRF have their way, transactions between unhosted wallets and crypto service providers in the EU could no longer be legally possible without excessive bureaucracy. Crypto companies had already expected severe cuts, but the revised paragraphs 22a, 29a, 33a and 44a are significantly more threatening for the DeFi sector than previously expected.

Transfer of Funds Regulation ignores blockchain technology

Among other things, crypto service providers should not only collect the personal data of users of their own wallets, but also verify them in a complex manner, regardless of the amount (paragraph 22a). Transactions over 1,000 euros should also require an additional report to the competent supervisory authority (paragraph 33a).

In plain language, this would mean that if you connect, for example, your non-custodial Metamask wallet to an NFT platform or DeFi platform, you will initiate verification processes that are comparable to opening a brokerage account and beyond. Politicians seem to have completely forgotten that all transactions are already recorded in the respective blockchain. Instead, additional, sometimes expensive and time-consuming identification procedures are provided by the operators.

Nobody can currently explain how crypto service providers who work with unhosted wallets could implement this in a meaningful way. The result could be that businesses are economically forced to stop transactions with unhosted wallets. Automation, as provided for by smart contracts, is thus taken ad absurdum. It would no longer be possible to fully exploit the advantages of blockchain technology.

Is there even a ban on unhosted wallets?

In addition to the complete dissolution of privacy, the TRF working document provides for a possible tightening of the measures already after 12 months of the TRF coming into force (paragraph 44a). To put it simply, a reassessment should take place after 12 months in order to then issue even stricter requirements if necessary. The concern here is that the current TRF draft is only an intermediate step towards ultimately banning unhosted wallets entirely.

In perspective, the question arises to what extent peer-to-peer transactions between unhosted wallets will still be attractive in the future. Finally, there is a risk that you can no longer use them for commercial purposes.

If the “red flags” in the TRF working document were to pass the voting process in their current form, this would not only cause massive damage to crypto companies, but would also ignore and limit the logic and potential use of blockchain technology. After all, no attempt is made to regulate air traffic in Germany with the road traffic regulations.