The Autorité des marchés financiers (AMF), the securities fee of France, revealed a abstract of responses obtained to a June 2023 dialogue paper on decentralized finance (DeFi), with nearly all of respondents favoring the concept of decentralization current on a spectrum and exhibiting assist for growing a regulatory framework for DeFi, together with elevated identification disclosures.

The AMF obtained 34 responses from varied gamers within the DeFi ecosystem (mission initiators, foundations, and blockchain organizations), in addition to centralized gamers from the digital asset sector and from conventional finance, resembling service suppliers, consultancy, and audit corporations.

The dialogue paper requested respondents to contemplate the next points: a definition of and a regulatory method to DeFi; the character (permissioned or permissionless) of blockchain protocols; points linked to good contracts; and governance-related issues.

“Overall, the responses raised the importance of developing a clear legal framework for DeFi and in this regard elaborated further upon several key concepts, such as the notion of ‘decentralization’ and references to ‘permissioned or permissionless blockchains,’” stated the AMF.

The paper started by outlining the basic challenge of what truly qualifies as ‘decentralized’ earlier than stepping into the equally thorny challenge of regulation.

Decentralization on a spectrum

The AMF famous that respondents appeared to agree on a few key factors associated to the definition of DeFi: first, that defining the idea could be important with the intention to set the boundaries of a regulatory framework, and second, that ranges of decentralization can range from one mission to a different and may thus be thought of alongside a sliding scale, or ‘spectrum,’ of decentralization.

This definitely appears a logical place to begin: eliminating the concept all DeFi is created equal and equally decentralized or the black-and-white interpretation that an entity is both decentralized or isn’t.

The truth is, some have argued that the complete notion of “decentralization” is a fantasy, and there are, in truth, solely completely different ranges of centralization—a semantic level that a number of respondents to the AMF dialogue paper clearly additionally made. In mentioning the consensus that decentralization is a spectrum, the regulator famous that the identical is true “conversely, of centralization.”

As well as, the AMF reported that some responses highlighted “the potential for a given project to evolve over time, where it may initially appear to be relatively centralised, but could evolve towards greater levels of decentralisation, particularly as it is further adopted by users, when its volume of activity increases, or as its governance becomes more open.”

This would possibly nicely be the case for some DeFi tasks, however once more, there are levels, and the notion of progressing to decentralization has been overplayed by some entities, such because the Ethereum blockchain and its founders.

With a view to work in direction of a extra goal measurement of the place a agency/mission lies on this centralization/decentralization spectrum, some respondents referred to the extent of automation of tasks, i.e., the extra these are topic to automated processes, the extra decentralized they could be.

Nevertheless, the AMF instructed that “the notion of automation would likely not be sufficient in itself to judge of the level of decentralisation, as other factors such as the layout, and distribution architecture of the network on which the project operates could also be taken into account.”

Typically, the concept emerged of manufacturing some type of ‘test of decentralization,’ which might take into consideration each technical features (resembling stage of automation, use of open-source code, permissioned or permissionless blockchain) and governance features (resembling absence of management of administrator keys over a protocol or good contract, absence of a central decision-making entity).

“Nonetheless, it appears difficult to reach a complete consensus among the responses obtained, with some respondents considering that some of the criteria mentioned should not necessarily be retained, while others consider them as central to the definition of DeFi,” stated the AMF.

Regardless of the difficulties in reaching a whole consensus, there was settlement that defining DeFi is a crucial process value making an attempt. With this in thoughts, the AMF extracted sure standards from the responses that would, at a minimal, be used to evaluate an entity’s stage of decentralization:

• From a technical standpoint, the extent of automation and autonomy of the protocol, the absence of administrator rights or keys (or rights or privileges of an identical nature), and an evaluation of the extent of transparency of the code used.
• From an operational viewpoint, the analysis might concentrate on the traits of the exercise, figuring out whether or not it’s supplied in an ‘open’ method (e.g., through a permissionless blockchain protocol that’s accessible to the general public) and that no custodial exercise is supplied through the protocol.
• From a governance viewpoint, standards could possibly be retained with the intention to determine conditions of ‘de facto’ or ‘de jure’ management over the protocol by builders or customers, contemplating as an illustration the degrees of distribution in governance tokens held, in addition to the efficient stage of participation of holders within the decision-making course of.

By way of the latter level, the AMF clarified that “it would seem clear however that, in order for an activity to be identified as decentralised, a protocol cannot in any case have a central authority (i.e. a legal entity, individual, or a group of individuals) responsible for the governance of the activity.”

After outlining responses associated to what decentralization truly is, the regulator put ahead the important thing findings associated to how DeFi must be regulated.

Reflections on regulation

Based on the AMF, respondents had been in favor of growing a regulatory framework for DeFi, most stressing the significance of clearly defining this to offer gamers with as a lot certainty as potential.

“A consensus seemed to emerge in responses on the subject of a regulatory approach that would have the same objectives as the regulation applicable to traditional financial markets, i.e. thereby proposing an approach under the ‘same activity, same risk, same regulatory outcome’ principle,” stated the report.

Fortuitously, that is primarily the method to DeFi regulation additionally proposed by the Financial institution for Worldwide Settlements (BIS), the U.Ok. Financial institution of England (BOE), and the EU Markets in Crypto Property (MiCA) regulation, to which France is topic (or can be when it absolutely comes into power by the top of the 12 months).

For that reason, the AMF instructed that “the principle of ‘same activities, same risks, same regulatory outcomes’, widely supported in the responses received from respondents, should be applied unambiguously, while taking into account the emerging features brought about by these new activities.”

Some trade gamers did level out that this method could be extra applicable the place the actions and dangers of DeFi are much like these of centralized finance (CeFi), however as we’ve already seen, the road between DeFi and CeFi is hazy at greatest, and non-existent at worst, so maybe this level is moot.

To deal with particular regulatory challenges posed by DeFi, respondents additionally instructed that imposing sure obligations could be applicable, resembling disclosing the dangers incurred and a mechanism for certifying the code and auditing good contracts. Respondents additionally instructed imposing requirements on protocol governance, the transparency of the code, cybersecurity, and in relation to anti-money laundering and counter-terrorist financing (AML/CFT) measures.

Permission and governance

The dialogue paper additionally touched on a number of different subjects associated to DeFi, together with an analysis of permissioned and permissionless blockchain protocols.

Permissioned blockchains prohibit entry to sure customers who want approval to take part, whereas permissionless blockchains permit anybody to affix and take part with out approval. The primary distinction is that permissioned blockchains management who can entry and contribute, whereas permissionless blockchains are open to everybody.

“A number of respondents indicated that DeFi could only be considered in the context of permissionless blockchains,” stated the AMF.

This appears a logical suggestion, as any permissioned blockchain raises the query of who the permissioned persons are, who approves of becoming a member of, and in the event that they qualify as a centralized group/entity.

As soon as the standing of a DeFi mission or entity is established, the following main challenge turns into governance.

A key dialogue level was the ‘pseudonymity‘ of the blockchain, which can contribute to a less transparent governance of DeFi protocols, of which the AMF noted that “responses affirmed the inherent nature of pseudonymity in public and permissionless blockchains (due to their freely accessible nature).”

It went on to report how “the majority of respondents indicated that the issue of participant identification would however be fundamental to the establishment of a regulatory framework, in particular to enable the application of AML/CFT and Know Your Client rules, which are fundamental aspects that serve to maintain the integrity of the financial system.”

The admission from DeFi “industry players”—a demographic not always known for its embracing of transparency and self-identification—that some form of mandated identification would be a necessary part of any appropriate regulation makes for pleasant reading for those in the industry that favors operating openly, in compliance and within the law.

To achieve this, the AMF’s dialogue paper instructed introducing a centralized digital identification that will allow the direct identification of contributors on the blockchain stage.

This answer would add additional transparency to the general public blockchain, however raises the query of feasibility, particularly which authority (or authorities) could be accountable for implementing it, on condition that public blockchains can function in a worldwide and cross-border method.

Debates and deliberate follow-up

The AMF concluded by noting its appreciation to those that participated and setting out its subsequent steps.

“The AMF wishes to thank the respondents to its paper, and intends to continue the discussion with all stakeholders involved, with a view to supporting the emergence of a regulatory framework conducive to the balanced development of decentralised finance,” stated the regulator.

“Through this form of dialogue with the ecosystem, the responses brought to the paper have helped to further develop and refine the understanding of decentralised finance, in the context of discussions around the emergence of a possible regulatory framework.”

The AMF stated it could proceed to assist the event of a coordinated regulatory method to DeFi, notably given the cross-border nature of its actions, to allow “a level playing field between jurisdictions.”

On this regard, the French finance watchdog was eager to attract consideration to European and worldwide initiatives on this space.

“At the European level, following the entry into force of the MiCA regulation, the European Commission will produce a report on assessing the development of decentralised finance and of the appropriate regulatory treatment of decentralised crypto-asset systems, as well as an assessment of the necessity and feasibility of regulating decentralised finance,” stated the AMF.

It additionally pointed to the work being finished on the worldwide stage by the Worldwide Group of Securities Commissions (IOSCO)—of which the AMF is an lively member—the Monetary Stability Board (FSB), the Financial institution for Worldwide Settlements (BIS), and the Group for Financial Cooperation and Growth (OECD), all of which have revealed reviews offering concerns and proposals on DeFi.

The AMF rounded off by reiterating that “as indicated in the discussion paper, the next few years will prove to be crucial for DeFi, with a dual challenge: building secure and transparent mechanisms that enable the ecosystem to thrive, while ensuring better protection for investors.”

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