DeFi and MiCA: another missed opportunity

The MiCA has taken another step on the road to adoption: on October 10, as scheduled, Econ, the EU Parliament’s Committee on Monetary and Economic Affairs, approved the text fired by the Council of Europe a few days earlier.

In the last issue of The Cryptolawyer we addressed the lack of regulation on NFTs within the proposed European regulation on crypto assets, known as the MiCA.

The MiCA also misses DeFi

Another major omission from what was intended to be a general and comprehensive regulation of economic activities based on cryptographic techniques is the topic of DeFi, or decentralized finance.

In fact, in the text released in recent days by the Council of Europe, the definition of DAO (Decentralized Autonomous Organization) contained in paragraph 1, letter (1a) of the parliamentary draft submitted to the trialogue procedure, and identified a DAO as “a rule-based organizational system that is not controlled by any central authority and whose rules are entirely routed in its algorithm,” has disappeared from Article 3 of the proposed regulation.

This is one of the many reasons why one of the most popular comments about the now soon-to-be adopted European regulation is that it was born old: because it does not take charge of framing on more recent assets and developments in blockchain applications, such as precisely NFTs, DeFi, Web3 and algorithmic stablecoins.

On the other hand, it must be acknowledged that for a legislator or regulator accustomed to handling the more traditional categories and concepts of law, it may not be at all easy to write definitions and rules on a complex, multifaceted, and elusive topic as DeFi.

To set a boundary around the concept of decentralized finance is arduous even if the goal is not to provide a legal definition in the narrow sense.

In order to define what may or may not constitute an application of DeFi, on a practical and concrete level, at present, one cannot disregard the empirical identification of a number of characters that unite generally accepted applications that are considered to be applications of decentralized finance.

When we speak of DeFi, we commonly refer to services very similar to those offered by banking and financial intermediaries, but which have the character of being managed in a decentralized way, and therefore on a blockchain, and in an automated way, through the use of smart contracts.

Among the most popular services commonly qualified as decentralized finance tools are decentralized exchanges known as DEXs, or lending systems, or even so-called algorithmic stablecoins. 

Clearly, no limits can be placed on the creativity of innovators who can bring to life innovative services that are completely new and different or perhaps even partially the result of an appropriate mix & match of existing types of services.

The innovation of DAOs and DeFi

The “ingredients” that unite the different recipes underlying these services in general is that they are executed in a completely automated way, thanks to the use of particular algorithms, the setting and management of which does not report to an identified entity but follows mechanisms of widespread governance exercised in competition by the nodes that feed the blockchain, according to variously established criteria, which can attribute greater or lesser powers of influence, depending on predetermined characteristics.

All this gives rise to a DAO, thus a “distributed” and autonomous organization, which is not embodied in an individually identifiable entity.

Of course, at the basis of the birth of a DeFi activity there is always the initiative of a developer, or a group of developers, who create an original algorithm and set up the smart contracts that constitute, in essence, the engine of a given service.

The original algorithm, more or less fatally, then goes through adjustments and evolutions that are administered according to the predetermined governance criteria for that specific type of service.

This means that voting powers are given to tokens that can be variously modulated but, in practical terms, it is usually the case that developers hold tokens characterized by a preponderant voting right, at least on the most strategic decisions. Moreover, it is common for blockchain consensus mechanisms to aim to incentivize a progressive concentration of decision-making power in the hands of a small number of parties.

One of the consequences is that there is no clear and permanent dividing line between those actors who can be qualified as active managers of the DAO and those who, having a limited ability to influence its course, can be considered as mere “passive” token holders.

Now, services of this kind, compared to traditional finance, are appreciated because they can ensure the absence of particular limitations in access to the services themselves, anonymity, a significant reduction in transaction costs, extreme speed in the execution of services, and so on.

In terms of law, however, for the jurist, framing and handling these kinds of services can be a real nightmare. 

First of all, it constitutes a problem that as a rule there is no uniquely identifiable party to whom legal effects and responsibilities arising from the execution of the various operations can be attributed.

It is not necessarily the case that those who participate in a DAO can be traced to a physical or legal identity, but sometimes only to the public key of their token.

Another problem is territoriality: a situation in which liability is spread across all nodes in a blockchain, even assuming that the dilemma of identifying the parties to whom the legal imputation of effects and liability should be attributed is resolved, it may not be easy to identify the jurisdiction to which one can turn to enforce, if any, rights and obligations.

How does one regulate a DAO?

Then there is another crucial issue, for those who put themselves in the jurist’s shoes: that of proper delimitation of obligations and regulation of the relationships that bind the participants of a DAO.

Indeed, in most cases, there is no contractual regulation, in the commonly understood sense, for the regulation of the relationships among the various participants.

The “contract” is in the algorithm underlying smart contracts, which, however, do not always and not necessarily qualify as contracts in the legal sense, despite their name.

More than ever, in this case, “the code is the law.” 

A rule that, however, is dynamic: it can change over time and sometimes, precisely because it is embedded in the programming code, if not properly explicated, may not be intelligible.

The law struggles to deal with these challenges, which correspond to managing and solving possible problems, but it sometimes tries.

The state of Wyoming, for example, passed a DAO law in July 2021.

The move made by the US legislature takes the form of the creation of corporate figures, specific and dedicated in which a DAO can be incorporated, in the form of a particular type of corporation, called a DAO LLC, or, Decentralized Autonomous Organization Limited Liability Company.

The use of this corporate model is aimed at delimiting the liability of partners (i.e., certain members of the DAO who qualify as partners), thus avoiding the individual and personal liability of all mere token holders indiscriminately.

With respect to this model, moreover, there has also been speculation that it would be possible to set up a DAO in corporate form in Germany under an old treaty between the US and federal Germany (i.e., the Treaty of Amity, Commerce and Navigation), which dates back to 1954. 

The German model for the regulation of DAOs

According to German author Byien Mienert, in fact, as a result of the provisions of this treaty, a DAO LLC should be automatically recognized in Germany as well and in the same way as an LLC.

Hence, the model could be employed, through a sort of legal osmosis, in every state of the Union, on the basis of the principle affirmed by Article 49 TFEU, which stipulates that member states are prohibited from restricting the freedom of establishment of nationals of other member states (so-called primary right of establishment) and similar restrictions on the opening of agencies, branches or subsidiaries (so-called secondary right of establishment).

Which, in effect, would solve one of the crucial problems discussed above: the incorporation of the DAO within a corporate vehicle substantially comparable to a corporation, endowed with its own legal subjectivity and asset autonomy from its individual members would allow a clear delimitation of responsibilities within the organization thus created.

This would allow the mere holders of the tokens lacking specific decision-making powers to be relieved of the patrimonial consequences related to actions that are essentially beyond their control, especially in cases where the smart contract system has a high degree of autonomy.

Such a corporate structure would avert the risk that, in the absence of a clear frame of reference, the organization that gives rise to a DAO would take on the characteristics of a de facto company and the consequent unlimited liability of the de facto partners.

MiCA, DAOs and Italy

The scenario is of extreme interest, even if one has to reckon with possible difficulties in giving practical implementation to such a scheme in the legal system of some member states, including in particular certainly Italy (this has already been discussed in a previous issue of The Cryptolawyer).

It is also important to consider that the mere incorporation of a DAO within a legal entity, which through its representative bodies has not only the power but also the obligation and responsibility to intervene in the functioning of algorithms and smart contracts, modifying them when necessary, obviously has a decisive impact on the very concept of decentralization and autonomy.

There remain on the table the other problems alluded to.

Nevertheless, the virtue and lesson of this theoretical reconstruction is that it does not matter how difficult the legal framing of a novel phenomenon may be.

With the right open-mindedness and understanding of the phenomenon and its practical purposes, it is always possible to provide a situation and establish an appropriate and balanced framework of discipline.

On the other hand, the law has always been trailing in the wake of business conduct and practices and is forced to package a posteriori the discipline of events that have never before been manifested.

What is certainly inadequate is the approach of those who expect to be able to bring never-before-seen phenomena back into existing legal categories and rules at all costs, because this kind of operation is not necessarily always possible.

Source: https://en.cryptonomist.ch/2022/10/13/defi-mica-another-missed-opportunity/