On October 18, 2022, the European Commission published a report, titled Information Frictions and Public Policies: Approaching the Regulation and Supervision of Decentralized Finance (“DeFi”) (the “Report”). The Report discusses the need to adapt existing policy frameworks to account for the change brought about by DeFi to the underlying information structure upon which financial services are provided. Unlike traditional finance, DeFi applications provide financial services based on blockchain technology, i.e., without requiring any intermediary agent and instead relying on automated protocols that are encoded in public digital contracts universally accessible and maintained by an open pool of pseudonymous miners.
The Report analyzes the opportunities and risks associated with DeFi applications. On one hand, the Report acknowledges the openness, transparency, innovation, financial inclusion and avoidance of market manipulation that DeFi brings about. On the other hand, the Report notes DeFi’s potential risks of attracting illicit activity derived from pseudonymity and limited control over the process, generating new sources of financial instabilities and enforceability. The Report emphasizes that these risks do not necessarily require external public intervention. Rather, the majority of risks are continuously being addressed through solutions produced within the DeFi ecosystem itself.
The Report also highlights the distinct privacy protection approaches followed by traditional finance vs. DeFi, where the former relies on a trusted third party to hide information from public access and the latter “segments between public activity and strictly not-accessible private identity.”
Separately, on October 5, 2022, the Council of the European Union issued an updated draft of its “Markets in Crypto-Assets” regulation, which aims to protect investors and preserve financial stability.