More than MiCA: EU’s Governing of Smart Contracts Will Need Even More Legislation

• After passing the MiCA legislation, EU lawmakers are moving on to the next regulatory frontier.
• A recent report by the ESMA highlights the risks posed by DeFi smart contracts.
• Without oversight, DeFi protocols could threaten consumers and financial stability.

When the EU passed the Markets in Crypto Assets (MiCA) legislation earlier this year, it was a major milestone in the regulation of cryptocurrencies. Although MiCA covers a lot, it doesn’t cover everything, as huge swathes of the DeFi space remain unaffected by the new rules.

As the EU considers its next move post-MiCA, early signs point toward smart contracts and their role in decentralized finance being the next regulatory frontier.

MiCA Just the Start for EU Crypto Regulation

In one sense, the Markets in Crypto Assets (MiCA) regulation is a sweeping piece of legislation that covers most major cryptocurrencies and the businesses that deal with them. But at the same time, it has little to say on other associated technologies, such as DeFi protocols.

Looking ahead, the EU has already signaled its intention to bring more of the crypto sector within its regulatory perimeter.

For instance, in a research paper published on Wednesday, October 11, the European Securities and Markets Authority (ESMA) delves into the world of Ethereum smart contracts and what they could mean for the European markets.

Smart Contract Risks Up Next on the Regulatory Agenda

Pointing out that the prevalence of smart contracts has steadily increased despite the fluctuations in the price of ETH, the ESMA argued that they pose a number of consumer and financial stability risks.

On the consumer front, the regulator takes issue with the high prevalence of pseudonymous developers in the DeFi space. 

Unlike regulated entities, DeFi platforms governed by smart contracts are often built and deployed without their creators ever disclosing their identities. Over the years, this tradition of secrecy has allowed malicious DeFi developers to get away with numerous rug pulls and scams.

In terms of financial stability, the ESMA cautioned that smart contracts composability and the “stacked” nature of many DeFi protocols create dependencies among protocols. In turn, this leads to the risk of contagion, whereby the failure of a single protocol could trigger a domino effect leading to a larger financial crisis.

“These risks are yet to receive adequate attention from supervisors and regulators,” the authority noted.

“As DeFi grows and its linkages with traditional finance broaden, it is becoming increasingly important for authorities to assess these risks,” the report added. 

A MiCA for DeFi? What Next for EU Crypto Regulation?

Ultimately, regulation can never keep up with the pace of innovation. With new technologies being developed all the time, lawmakers will always be one step behind.

And while the Congressional impasse that has thus far frozen all attempts to pass MiCA equivalent regulation in the US has been damaging to the American crypto sector, rushing through legislation that isn’t fit for purpose wouldn’t serve the EU well either.

However, the ESMA’s latest publication shows that EU regulators have, at the very least, identified the DeFi sector as a strong candidate for their next big legislative push.

Already, the European Data Act proposed in March is the first piece of EU legislation that attempts to define a smart contract. Going forward, research like the ESMA’s will lay the groundwork for potential DeFi regulation in the future.

Suggesting potential policy initiatives the EU could take, the ESMA cited the European Commission’s call for “a public observatory of DeFi activity operated by a public authority.” Such an authority could carry out investigations and issue opinions and public warnings about specific DeFi protocols, the report noted.

To create a new regulator, the EU would need to achieve broad consensus among member states, and the necessary legislation could take years to formulate. But with the DeFi sector growing by the day and becoming ever more entwined with the world of traditional finance, leaving it unchecked would run counter to the EU’s established regulatory model.