In cryptoland, the fall tends to be regulators’ open season. As unprecedented as it’s been, 2020 is no exception to this trend. Tensions are high on both sides of the Atlantic: As markets were still processing the news of the United States Commodity Futures Trading Commission cracking down on derivatives exchange platform BitMEX, the Financial Conduct Authority, the British financial watchdog, moved to ban retail investors from using cryptocurrency derivatives altogether.

The densely packed news cycle has somewhat muffled the impact of another regulatory bomb that dropped a week earlier and is bound to have major lasting effects on the global financial system: The European Union’s proposed legislation for crypto-asset markets.

The far-reaching framework, designed to bestow regulatory clarity upon digital finance businesses serving residents of the European Economic Area, is bound to be especially consequential for two interconnected domains of the crypto industry that have dominated the narrative throughout much of 2020: stablecoins and decentralized finance applications. What gives?

Stablecoins as a threat to stability

At the moment, the draft, known as the “Regulation on Markets in Crypto-assets,” or MiCA, exists in the form of a proposal put forth by the European Commission, the EU’s executive branch. It is still bound to go through a rather lengthy legislative process before it becomes law, meaning that it might take months and even years before the new rules kick in.

The text makes it apparent that stablecoins, which are also called “asset-referenced tokens” and “e-money tokens” in the document, have been squarely at the top of European lawmakers’ minds: MiCA singles out this asset class and affords it a bespoke regulatory framework.

Under the proposed law, stablecoin issuers will have to be incorporated as a legal entity in one of the EU member states. Other requirements include provisions related to capital, investor rights, custody of assets, information disclosure and governance arrangements.

Albert Isola, the minister for digital and financial services of Gibraltar, explained to Cointelegraph that the reason for the European Commission’s heightened attention to stablecoins is the authority’s concern for the Eurozone’s financial stability:

Stablecoins are widely considered to potentially bring significant benefits as a digital method of payment, providing for greater financial inclusion and a more efficient method of transferring funds. They are also viewed as a potential risk to financial stability and integrity and could dilute the effectiveness of monetary policy. It would appear logical that the European Union may not welcome an entity other than the European Central Bank issuing Euro in an electronic format.

Isola mentioned that “disruptors,” such as the prospective stablecoin Libra, have the potential to significantly decentralize the control of currencies.

Seamus Donoghue, vice president for sales and business development at digital finance infrastructure provider Metaco, cited the impressive growth of the stablecoin market in recent months as a prerequisite for regulatory attention, which he called a “positive response”:

The USDC stablecoin’s market cap alone has grown 250% in 2020 from $520 million to $1.86 billion, with a significant acceleration in growth over the last two months. Bank regulators have no doubt also observed that although the asset class in the context of the traditional payments space remains relatively small, it has the potential to have a huge impact on regulated banks and payments incumbents.

The specter of Libra

Illustrating the depth of the top EU officials’ concern over preserving the union’s monetary sovereignty is the fact that, earlier in September, “finance ministers of Germany, France, Italy, Spain and the Netherlands issued a joint statement outlining that stablecoin operations in the European Union should be halted until legal, regulatory and oversight challenges had been addressed,” said Konstantin Richter, CEO and founder of the blockchain infrastructure company Blockdaemon.

Richter added that some of the more visible figures in European financial policy, such as the German minister of finance, Olaf Scholz, have advocated for the introduction of the regulatory framework.

Most experts who talked to Cointelegraph mentioned Facebook-backed stablecoin Libra as the point of departure in the EC’s thinking about the dangers and opportunities that asset-referenced tokens present.

MiCA opens with an explanatory memo that discusses how the crypto asset market is still too “modest in size” to pose a serious threat to financial stability; however, things can change, the framers admit, with the advent of “global stablecoins, which seek wider adoption by incorporating features aimed at stabilizing their value and by exploiting the network effects derived from the firms promoting these assets.” There has been a single stablecoin project to this date falling into the scope of this description: Libra.

Mattia Rattaggi, board chairman at FICAS AG — a Swiss-based crypto investment management firm — opined that stablecoins are the application of blockchain technology with the highest probability of big impact — something regulators are well aware of:

Stablecoins have grasped the attention of regulators over 12 months ago with the presentation of project Libra by Facebook and have since been closely monitored by the public and regulators around the world. Regulators are realizing that stablecoins are bound to increase efficiency in the payment system — particularly the international one — and promote financial inclusion.

Further hedging against the potential disruption of the Eurozone’s monetary stability, the MiCA proposal specifies even stricter compliance requirements for issuers of asset-referenced tokens deemed “significant.” The significance criteria include the size of the customer base, market cap, volume of transactions, and even “significance of the issuers’ cross-border activities and the interconnectedness with the financial system.”

Bad news for DeFi?

Stablecoins largely power another sprawling domain of crypto financial activity: a diverse array of applications and protocols that exist under the umbrella of decentralized finance. Given the stringency of the proposed requirements around asset-referenced tokens, it is plain to see how complicated things can get if, say, the bulk of liquidity locked in a certain decentralized protocol is denominated in a stablecoin that is not compliant by the MiCA standards.

Another major source of uncertainty is the requirement for all crypto-asset service providers, or CASPs, seeking authorization to operate in the EU to be legal entities with an office in one of the member states. Whether the European authorities will treat individual DeFi apps as CASPs remains an open (and central) question, but if this is the case, developer teams maintaining DeFi protocols might be forced to come up with workarounds that will stretch the notion of “decentralized” incredibly thin.

In their response to the proposed regulation, members of the International Association for Trusted Blockchain Applications expressed their concern that MiCA could effectively bar European residents from participating in DeFi markets.

Martin Worner, the chief operating officer and vice president of blockchain tooling provider Confio, believes that compliance issues could be resolved by implementing on-chain governance mechanisms tailored to specific jurisdictions’ regulatory frameworks:

[This could be] achieved within a self-sovereign framework where the institutions can develop compliant DeFi instruments, which work within their jurisdictions. Just as there are rules about businesses in different jurisdictions and how they do cross-border transfers, the same would apply on the blockchain.

Elsa Madrolle, international general manager at blockchain security company CoolBitX, told Cointelegraph that by the time MiCA becomes law, the DeFi landscape will have likely changed, much as the ICO landscape changed rapidly after the initial boom. By that time, “it will be quite clear what is required of DeFi projects to operate in the EU or seek out EU customers.”

Madrolle thinks that at that point, DeFi projects will fall into one of two categories — regulated and unregulated — and the big question will be whether the rest of the world will align itself with the European framework.

Nathan Catania, a partner at XReg Consulting — a regulatory and policy firm that has recently published a breakdown of the proposed regulatory framework — is hopeful that it is possible for regulators to reconcile MiCA requirements with not regulating DeFi out of existence. Catania said:

I believe that a project which is sufficiently decentralized and does not provide the service on a professional basis to a third party cannot be considered a CASP and there is still room for DeFi projects to exist.

Today, many DeFi protocols are far from being fully decentralized. The battles over how much decentralization is good enough are still ideological and are primarily fought inside the crypto bubble. It looks like the day when regulators join this debate will come, but with some very tangible implications for crypto businesses.