Carlo Giuliano - DeFi or not DeFi: Where do we draw the line?

Okay, Carlo have give a try the other one.

Okay.

Okay. Amazing. Let's give a warm

let's give a warm of applause to Carlo.

Yeah. Thank you. Thank you.

The stage is yours.

Thank you. Thank you very much. Okay. So, I will not present myself. So, for for time manners, if you guys are curious, uh you can add me on linking later.

So, um I think it's useful to start asking ourselves what Defi is. I brought here a couple of definitions. One is from the bank of international settlement. The other is from the European Central Bank. Um, essentially DeFi is characterized by three core elements.

The first one is the offering of financial services. The second one is the absence of intermediaries. This is the main difference between DeFi and not only traditional finance but also CFI. Um so in traditional finance and CFI we have a legal entity offering the services. In DeFi the services are provided directly by protocols the centralized protocols.

And the third element is the the letter one. So the presence of um automation in form of smart contracts for example or in general blockchain technology. So um now what is the understanding of uh DeFi in our applicable law in Europe? Here we have a regulation called Mika. Mika is a regulation that is uh aiming at regulating um in a broad scope uh crypto assets uh directly uh targeting uh uh exchanging exchanges sorry and issuers of crypto assets.

Um Mika does not say much about defi. Uh we find the defi in reset 22. You find it written here. Uh essentially what the resital 22 says it's um defy falls outside the scope of our current regulation when it's fully decentralized. So when protocols or services are after offered in a fully decentralized manner while when there's a level of centralization even partial then the regulation still applies.

This makes a major difference because it's very complicated to offer DeFi like decentralized protocols and services uh still complying with Mika regulation. This is a game changer for all uh daxes and all uh all those who want to offer um services on crypto assets in a decentralized manner. We will discover a little bit more about this because we have a problem. Mika does not say what fully full decentralization is. What do we understand with full decentralization and what is the difference between partial decentralization and full decentralization?

So we somehow need to ask ourself a first attempt to attack decentralization. DeFi has been done by the Danish financial authority. um they essentially interpreted in a very restrictive manner the concept of DeFi or they interpreted in a very extensive manner the application of Mika regulation and essentially they said that in order to understand when a protocol is actually fully decentralized we need to uh do two a double assessment. The first one is on the um on the technicalities on the technology. So we need to have elements that um prove that the service is offered in a decentralized way and then we need to have an assessment of the governance.

So it's more like a legal assessment. So for example, we uh should not have any entity governing the protocol. We should have no person that has a special access or special rights according to how the smart contracts are structured and we should have no concentration of governance tokens. So as you can see um like checking all the uh assessments is not very easy. It's not very easy to have all the elements that uh the Danish financial authority requires for the centralization.

Um but we should also ask ourself what is a a cusp under Mika? What is an exchange under the Mika regulation? So here we find a definition. uh there's two elements that I uh um decided to to point out that are more relevant for our uh discussion. The first one is the concept of legal understanding legal undertaking.

Sorry. So to be regulated as a casp a crypto asset service provider under Mika you need to be a legal person on an undertaking. Watch out because this concept is very broad under European law. This means that even if even if you don't incorporate a company, still you can be considered um an undertaking under European law. Uh the second concept is the offering of crypto asset services.

If you do not offer a a service that is considered a crypto asset service, then you are not a crypto asset service provider. Right? So what are the crypto asset services under Mika? We have a list here. I will not go through one by one because we don't have the time.

Um but you find a typical services that are offered uh often by by by exchanges. So the exchange of crypto assets for example or like a managing of trading platforms but they can be relevant also for defy projects right. So um the thing is that the way the law is now structured um brings us uh necess necessarily to ask ourself every time we find a project to ask ourselves is it actually decentralized or is it not? It's not very clear. It's a case- by case analysis because we need to reach uh a sufficient level of decentralization in order to fall outside the scope of the regulation.

If we are not able to reach all those elements then we are only considered partially decentralized and therefore uh MIA does apply which is often a major project killer. It's a very often a project killer. Um this means that we need to ask oursel a few questions. I br I brought here some of the typical questions but there's a long list of questions that we need to ask ourselves to actually confirm that a project is decentralized. Um and we also need to remember that the law and the the the law maker and the financial authorities usually apply a general principle which is this one.

Same risks, same rules. It means that if you're offering services that bring to consumers risks that are typical of regulated services, for example, if you bring to consumers risks that are typical of investment firms. So for example, financial all the risk relating to you know financial investments then you should be regulated in the same way. So it's a very broad understanding of of the law. It's a broad application of the law that usually tries to keep in the scope of the law also defy projects.

I brought I brought to you a couple of examples. This is the first one. Um this is a DEX uh a DEX based on a automated market making model and in our DAX um the developers who designed the protocol decided to create the first pool uh adding BTC and ETH. And we are assuming for this example that the entire protocol is actually fully decentralized. Okay, it's fully decentralized.

But our developers created the first pool. Now question is are is this group of developers subject to Mika? Well, we should ask ourselves if the service that they are offering is a crypto asset service. I brought here the I outline uh like I pointed out the service that is more relevant, the exchange of crypto assets for other crypto assets. You find here the definition.

As you can see, um the main concept of this service is that you are allowing your clients to exchange crypto assets by using your own crypto. So you use your own crypto exchanging with clients so they can exchange crypto for crypto. This is typical for an exchange. But hey, it can work here as well, right? Because our group of developers created the first pool using their own crypto so that users interacting with the protocol are actually exchanging their crypto assets with the crypto assets used by the developers to create the pool.

This means that Mika could apply maybe yes. Uh what if they do not create the pool? Then we assume that the protocol is fully decentralized. question is are users considered um you know subject to mika because users create the pools probably no because users are not are not not acting on a professional basis so they're not targeting clients they're they're acting on their own okay I brought a second example is a DAO um in this example we are imagine a DAO where the three uh developers founders hold 40% of the governance tokens uh allowing them to propose, to vote, to do almost everything. And we imagine that this DAO is offering crypto asset services like a trading platform for example.

Now the question is, is the DAO um subject to Mika? Well, being a DAO does not automatically mean that the law thinks you act in a decentralized manner. We need to ask herself if the project is actually decentralized. In this case, we need to analyze certain aspects. I brought here the main the more relevant um we need especially to ask ourself if the DAO the the governance of the DAO actually um allows us to to to confirm that is the centralized.

Usually you we use certain um uh like certain criterias like the Nakamoto coefficient. So this is essentially with the Nakamoto coefficient we are asking ourself how many you like how many persons how many actors you need to reach a certain decision. How many persons you need to ch amend the protocol to to vote to to confirm um a certain amendment of the protocol. So applied to Dows this mean understanding how many people you need how many voters you need to take action if it's just a small amount of people bam this is probably the centralized uh centralized sorry so you applied Mika and again this could be a major project killer the hot case is the online interfaces this is an example that is brought by the financial Danish financial authority uh online interfaces are essentially the front end that allow users to interact more easily with the centralized protocols. You know, you as a user can act you you can interact with smart contracts directly, but the majority of users cannot do that.

So, you have interfaces that allow you to interact with the DEX. Is the interface possibly a sign of a crypto asset service under Mika? Well, according to the Danish authority, yes. According to the Danish authority, these two services, execution of orders and receiving and transmitting of orders are the typical services that are offered through online platforms. Um to be honest, I disagree with this opinion.

uh I believe execution of orders it's very unlikely because usually you don't you don't give your crypto to the online platform so that the online platform execute the orders but you sign yourself the transactions directly uh you know interacting with this with a smart contract. So it's very unlikely receiving and transmitting of orders. This is more tricky because this is a service in which um you receive the orders of the users and then you just tell the entity that is offering the service uh about the order and then the contract is between the entity and and the and the consumer. This is more disputed according to conso. So the Italian financial authority uh they gave a communication in 1999 regarding um websites.

Back then uh it was more more uh like web two of course um and it was relating to financial services. Essentially, consub said you do not have uh this um you do not have this uh receiving and transmitting of order service when the when the platform is actually inter only um functioning as a as an interface um that is essentially just a UI for the for the user. So the user is entering in the contract directly with the with the financial provider. Um so you don't have a relationship between the provider of financial services and the and and the website. So the website is not for example selecting the financial the providers of financial services that that that it wants to conclude the transaction with.

But um still this was a very specific case. So I I I think this this argument can be still um not not necessarily applicable here because you don't have a provider of financial services. You don't have a provider of services in the case of DeFi but the person is interacting directly with a smart contract. In general though I believe and the major uh players in the industry believe that online interfaces actually function merely as um as a UI system you know so like it's just a front end that allows you to more easily interact with the smart contract but the smart contract is the offerer of the service. You sign the transaction using I don't know your MetaMask directly on the smart contract.

Uh but I still would say watch out because this is not a clear point and um authorities like conso could still go after you if you offer an online platform. So let's use let's focus now uh on the risk perspective because we said defy protocols when fully decentralized can fall outside the scope of mika. This does not mean that they do not bring risks to consumers. actually risks can be even higher than regulated um services. Uh we have here some typical risks for consumers.

I don't know relating to technology, finance, you know, risks connected to frauds and so on and so forth. What does it mean? It means that when we see it's a service that is so, you know, risky for the users, we need to somehow regulate it. I think and this is like the the conclusion of of of my speech. I think that regulating DeFi under the current regulation, it's not bringing anywhere.

It's actually bringing probably to more risk because we will never see software companies applying for Mika licensing. It's literally impossible and this will be a total killer of DeFi in Europe at least if we will regulate it under the current regulations. probably the solution would be or I hope it will be um a targeted regulation. This could be in MikA 2 or a different regulation um that is um taking into account the particularities of D5 protocols. So for example, auditing certifications and all this stuff that allow um protocols to act still in a decentralized manner but without being subject to the typical obligations that are required by Mika which is focused on exchanges.

Probably our regulator still doesn't really understand the difference between a decentralized protocol and a centralized exchange. Yeah. So that's that's it. If you have more questions about it or you want to discuss like weird nerdy stuff, I'm I'm here. You find me here.

I can also share the slides with you guys if you are curious about it. Thank you.