DAO and Decentralized Finance: Regulators Are Getting Involved

Decentralized finance (DeFi) and decentralized autonomous organizations (DAOs) are today revolutionizing the image of traditional finance. Initially rigid, this new financial landscape aims to be free and accessible to anyone with internet access. Moreover, it generates unprecedented interest and currently does not adhere to any legal framework. Can we then affirm that it is the essence of user law?

Introduction

Decentralized finance is one of the innovations resulting from blockchain technology. It operates through smart contracts. The blockchain allows for the secure, definitive, and immutable storage and transmission of data, without a central control body. A smart contract, on the other hand, is a computer program that auto-executes all or part of the instructions set by its developer.

The use of decentralized finance is vast and limitless as it aims to facilitate multiple protocols through which users can engage in profitable or non-profitable transactions. However, this technology is not without risk and poses numerous challenges for regulators, investors, and financial markets.

Decentralized finance is a new and rapidly growing phenomenon. That is why it is important to detail its workings before taking stock of the current regulations.

The mechanisms of decentralized finance

Technological characteristics of decentralized finance

Decentralized finance (“DeFi”) enables anyone with internet access to exchange value, lend or borrow, and conduct financial transactions thanks to blockchain technology and the use of smart contracts. This finance is called decentralized due to the absence of centralized financial institutions to verify and approve user transactions. The technology serves finance since a financial operation will be materialized through a smart contract operating on the blockchain. In fact, the blockchain is a “technology for storing and transmitting information, transparent, secure, and functioning without a central control body“. This technology facilitates the development of protocols (Decentralized Application or “DApp“) DeFi on a public blockchain such as Ethereum.

The public nature of the blockchain is one of the features of DeFi, as it is open to all, for both reading and writing (this is referred to as “open source“). This criterion guarantees transparency, another fundamental principle of DeFi. All transactions are visible to everyone.

DApps are executed using smart contracts that correspond to computerized transaction protocols, executing the conditions of a contract. The use of smart contracts promotes the autonomy of this technology, which operates without external intervention. Moreover, once on the blockchain, smart contracts cannot be modified, and they execute automatically when the conditions are met.

The governance model is unprecedented; no classical body controls DeFi. This new organization takes the form of decentralized autonomous organizations (“Decentralized Autonomous Organization”) whose governance rules are set within smart contracts. Decisions are made by users according to, most often, the rule of the majority.

The last characteristic of DeFi is its quick adoption. In fact, one only needs an internet connection, to create a wallet (wallet) containing a cryptocurrency usable on these DApps (ether, DAI for the best-known) and a decentralized application such as Uniswap or Aave.

As of today, it is not required to meet customer identification requirements (“Know Your Customer“). If this were the case, the decentralized nature of the platform could be called into question.

This technology offers a multitude of financial services that rival the traditional systems known so far in the financial world. These innovations, while presenting advantages, are not without drawbacks. Let’s examine this through applications of DeFi.

Applications of decentralized finance and its risks

DeFi offers access to a multitude of services in finance and insurance under a new dimension. It is not a question here of listing the innovations that DeFi makes possible but rather highlighting the strengths and risks of applications against the traditional system.

The lending of digital assets is one of the financial services provided by DeFi platforms. Digital asset lending occurs peer-to-peer, meaning without the involvement of a financial intermediary, which traditionally plays the role of a trusted third party. The functioning of digital asset lending on these platforms follows this model: the lender provides an amount in the form of cryptocurrency that will form what is colloquially known as a liquidity reserve. The borrower can then borrow the available amount and, in exchange, will pay interest to the lender. The interest is accrued in real-time, which is still impossible in a traditional bank loan. However, the borrower can only borrow within the limits of the amounts available within the liquidity reserve.

In DeFi, it is possible to secure a loan with collateral, although this is not always mandatory. This is especially true in what are known as flash loans. This practice involves repaying the loan before the end of the transaction. In other words, the loan is repaid instantly. However, it carries security risks in the event of malicious attacks or bugs where the smart contract can be manipulated, and the lent amounts can be stolen.

DeFi innovates by automating the role of market maker within decentralized exchange platforms. Each user can buy and sell digital assets at an algorithmically set price without going through a financial intermediary. This function is replaced by a smart contract. The buyer and seller are not connected, but they interact separately with the liquidity provider, which in this case is the smart contract.

Some decentralized platforms have implemented a system where fees are charged to compensate participants who provide liquidity. However, this system is sometimes insufficient to self-regulate the level of liquidity.

DeFi presents high risks, including the risks of loss of value, volatility, fraud, money laundering and terrorist financing, hacking, and bugs.

In the interest of protecting users and combating money laundering and terrorist financing, the question of regulating DeFi encourages blockchain actors to consider the topic. The challenge will be to reconcile the innovation of this technology with legal standards so as not to hinder the attractiveness of this technology.

Towards Progressive Regulation of Decentralized Finance?

Key players in decentralized finance as service providers for digital assets

As a reminder, law No. 2019-486 of May 22, 2019, relating to the growth and transformation of businesses, known as the PACTE Law, defines for the first time the status of service providers for digital assets (“PSAN”). The PSAN status should, in principle, be granted to any person providing one of the services provided for in sections 1° to 4° of article L.54-10-2 of the Monetary and Financial Code, such as custody services, the purchase or sale of digital assets in legal tender, the exchange of digital assets for other digital assets, and the operation of a digital asset trading platform.

To provide these services, service providers must necessarily register with the Financial Markets Authority (“AMF“) in accordance with article L. 54-10-3 of said Code. For providers offering services other than those mentioned in 1° to 4° of article L.54-10-2 of said Code, the provider may apply for an optional approval from the AMF.

The challenge of qualifying key players as PSAN is to subject these providers to obligations regarding anti-money laundering and counter-terrorism financing, as well as asset freezing provisions outlined in the Monetary and Financial Code. Moreover, in the case of optional approval, PSAN must have liability insurance, an internal control system, a secure IT system, and a conflict of interest management system. This regime serves to protect investors and the financial ecosystem.

It is noteworthy that the optional approval is rarely (if at all) sought today by players in the crypto sphere in France due to its burdensome nature. However, it does present a significant advantage: it largely anticipates the approval conditions of the upcoming European MICA regulation. Those approved in France will have near equivalence when MICA comes into effect, benefiting from the European passport (which does not exist under the current regime).

The recent update to the AMF position DOC 2020-07 of May 31, 2022, evolves the PSAN regime by potentially broadening the scope of this qualification to providers engaging in activities such as “staking” and lending digital assets (“lending“).

The engagement activity consists of immobilizing cryptocurrencies in a wallet for a certain duration in order to secure the operations of a blockchain network operating on a proof-of-stake protocol (“Proof-of-Stake“). This activity can schematically be likened to a savings account that earns interest.

Lending activity in DeFi has also developed very rapidly without it being able to fall within the common law conditions of bank lending.

For these two activities, the AMF specifies that they may be considered alternatively or cumulatively as a service on digital assets within the meaning of article L. 54-10-2 of the Monetary and Financial Code and a payment service within the meaning of article L. 314-1 of the same code. The AMF adopts a case-by-case approach, stating that those wishing to propose “these activities must conduct a thorough legal study to determine whether any of the aforementioned regimes (or both) apply to them“.

DeFi is giving rise to a new form of society in the digital space, which has no equivalent in current legal regulations. Experts decide to come together and define a legal regime for these decentralized autonomous organizations.

Ad hoc regulation of decentralized autonomous organizations

DeFi is flourishing with decentralized autonomous organizations (“Decentralized Autonomous Organization” or “DAO”) on the blockchain. These are digital structures established on the blockchain. Their function is to organize the governance of a project present in DeFi. Each member of the DAO holds tokens and by this right gains voting or governance rights. The characteristics and operational rules of these DAOs are specified within a smart contract. In Europe, they do not fall under any legislation, unlike the United States where the Securities and Exchange Commission (“SEC“) took early interest in the question considering they could take the form of a Limited Liability Company (“LLC”). In the United States, the state of Wyoming is one of the first states to adopt a law concerning and defining the conditions of existence for DAO-type LLCs. A year after the enactment of this law, the balance sheet is rather positive as several DAO LLCs have been established in that state.

The growth of these digital structures on the blockchain and the resulting legal questions have prompted a group of independent experts, the Coalition of Automated Legal Applications (“COALA”), to draft a Model Law for decentralized autonomous organizations (“Law”). This Law aims to address functional and legal queries and to set up a uniform legal framework at the international level.

The first question to consider is to understand why it is not possible to assimilate them to companies of common law. The technical specificities make this solution impossible, but the committee suggests relying on the concepts of functional and regulatory equivalence. These concepts will allow adapting the common law characteristics of a company to the technical specificities of DAOs. The most significant illustration from this Law is the recognition of legal personality for DAOs by simply registering it on the blockchain without the need to re-register with a commercial court clerk.

Furthermore, the Law provides that a DAO should be considered a limited liability company. The members of the DAO do not engage their personal liability for the debts of the DAO. Finally, the Law specifies concepts specific to the DAO such as the concept of hard fork or the maintenance of legal personality in the event of a hack of the platform. However, its effectiveness will have to be assessed upon its application in the states.

In France, the deputy Pierre Person is also looking into the fate of DAOs in his personal report published on June 8. Proposal 22 reiterates the idea put forward by this committee to allow DAOs “to obtain legal personality to recognize their legal existence and give them the power to establish contractual relationships just like other legal entities. Develop a regulatory framework to take their governance into account, ensure their financial stability notably to protect their members and guarantee cybersecurity“. This report demonstrates the interest in DeFi and the necessity to evolve corporate law without compromising innovation.

To date, the lack of legal structuring of a DAO can lead to a risk of qualification as a de facto partnership and consequently impose all the legal and tax issues resulting from this on the founders. However, French law offers certain possibilities for the legal structuring of DAOs, such as the establishment of a limited liability company, a foundation, or an association. These three structures present advantages and disadvantages but remain ill-suited to the specific operation of DAOs. The authors of Cryptoast have pondered the ideal structure to set up for a DAO under French law. They advocate combining several structures to address the different aspects of the DAO, for instance by establishing a simplified joint-stock company to organize relationships among the founding members, an association to hold the protocol and assets, and finally to frame the interaction between these two structures by drafting a service provision contract.

In a recent report published in June 2022, the World Economic Forum (“WEF”) speaks on DAOs. This report aims to demystify the concept of DAO by presenting the main principles, the challenges, and the risks faced by these new structures and to serve as a basis for reflection for the development of regulation in this area. This report reminds us that due to the rapid pace at which this technology is evolving, it is crucial for public authorities and regulators to closely monitor this sector.

In conclusion, it seems necessary to build a regulatory framework in Europe that takes into account foreign experiences and published reports in order to confer a new place to DAOs.

Conclusion

DeFi is a young and constantly evolving sector, making it still difficult to understand all its contours due to the multitude of possible protocols and governance structures. Furthermore, the highly anticipated European Regulation “MiCA” has unfortunately remained silent on the subject. However, some argue that this Regulation is not the right instrument to regulate DeFi and that it would be better to set up think tanks to govern it. In our view, and at this stage, the regulation of DeFi must remain flexible and adaptable as this sector is intended to be in constant evolution.

La Rédaction C.

L'équipe éditoriale de Cointribune unit ses voix pour s’exprimer sur des thématiques propres aux cryptomonnaies, à l'investissement, au métaverse et aux NFT, tout en s’efforçant de répondre au mieux à vos interrogations.