Llama Legal: DeFi Yield Optimizers
The legal status of DeFi yield optimizers under the EU crypto regulatory framework
TL;DR
For yield-optimizing protocols, achieving an exemption under MiCA requires a genuine approach to decentralization, characterized by limiting the control of influential individuals and fostering automated ongoing relationships with users. Additionally, adopting legal models that support full decentralization, such as permissionless access for external contributors and multiple, non-centralized front-ends, is crucial for reinforcing a decentralized structure.
Yield optimizers would not fulfill the primary requirement for being classified as Undertakings for Collective Investment (UCIs) since their operational framework does allow token holders significant discretionary control over daily vault activities. Changes to these vaults are typically subject to approval either by unanimous consent or a significant majority vote, further distancing them from the UCI categorization.
Despite the current absence of crypto tokens from MiFID II's specific financial instrument categories, yield optimizers may not be entirely exempt from its regulations. Guidelines for the qualification of crypto-assets as financial instruments are expected by ESMA by the end of 2024. Yet, their universal accessibility, offering strategies equally to all without exclusive benefits for certain token holders, might provide a valid reason to exclude these yield strategies from being categorized as investment advice.
Regulatory Framework
The legal status of yield optimizers/aggregators under EU laws and regulations is a developing area, reflecting the broader evolution of authorities’ perception of decentralized finance. The Markets in Crypto-Assets Regulation (MiCA), which came into force in June 2023, establishes uniform EU market rules for crypto assets, including those not covered by existing financial services legislation. It is designed to supplement the current EU regulatory framework, including the Markets in Financial Instruments Directive II (MiFID II) and the Alternative Investment Fund Managers Directive (AIFMD). MiCA specifically excludes from its scope financial instruments as defined by MiFID, as well as deposits, structured deposits, and e-money. Therefore, crypto assets that qualify as financial instruments under MiFID do not fall within the scope of MiCA.
The purpose of the presented analysis is to assess the probability of qualification of optimizers as licensed entities under numerous EU legal acts.
Operational specifics
The working mechanism of DeFi yield optimizers/aggregators involves pooling investors’ crypto assets into vaults and investing them in a portfolio of yield-paying products and services using pre-programmed and automatically executed strategies. Their role is akin to that of digital fund administration, orchestrating investor portfolios to capitalize on DeFi opportunities for enhanced profit generation. Employed automated strategies may include lending assets to earn interest, participating in liquidity pools, staking tokens to secure a blockchain network, or utilizing other DeFi mechanics. These platforms vary mainly in the blockchains they support, the specific smart contracts they utilize, and the fees and interest rates they charge.
Tokenized vaults in the context of ERC-4626 represent a significant development in the standardized implementation of vaults in the DeFi ecosystem. Standardized methods for depositing and withdrawing assets from the vault have been introduced. Once users deposit their tokens in a vault, they receive a vault-specific token representing their share in the vault. ERC-4626 offers a consistent method for calculating the share of the vault's assets that each token represents. From a legal perspective, the proposed interface for vaults holding fungible assets on the Ethereum blockchain facilitates uniformity and interoperability among different DeFi protocols.
Definition
The European Commission, through its Directorate General for Financial Stability Financial Services and Capital Markets Union (FISMA), has been actively engaging in consultations to shape the future regulation of DeFi in Europe. In the FISMA consultation paper, portfolio management is viewed as one of the main DeFi financial services where customers are allowed “to integrate pools of assets - so-called ‘vaults’ - governed and managed by predetermined rules encoded publicly into smart contracts”.
The French financial markets regulator AMF shared its preliminary thinking on the regulatory issues concerning the emerging DeFi ecosystem. Among the studied categories of activities and services, the AMF recognizes aggregator‐type activities as protocols that are able to read activity across several protocols, aiming to offer better liquidity and / or pricing by aggregating data. Instances can include creating efficiencies across AMM or DEX type protocols by seeking to provide better asset or price allocation, while others may look to bridge gaps in rates across lending or staking protocols that can occur due to inefficiencies.
The current version of MiCA lacks a specific definition for DeFi. By December 30, 2024, following consultations with the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA), the EU Commission is expected to submit a report. This report will assess the evolution of decentralized finance in the crypto-asset markets and determine the suitable regulatory approach for decentralized crypto-asset systems. This includes evaluating the need and practicality of regulating decentralized finance. Additionally, the report will explore the necessity and feasibility of regulating crypto-asset lending and borrowing. It is anticipated that this report will provide precise definitions of distinct DeFi activities.
Exposure to MiCA
The Regulation should apply to natural and legal persons and certain other undertakings and to the crypto-asset services and activities performed, provided, or controlled, directly or indirectly, by them, including when part of such activities or services is performed in a decentralized manner. Recital 22 excludes from the application field of MiCA crypto-asset services that are provided in a fully decentralized manner without any intermediary.
On the contrary, following FATF arguments, creators, owners and operators, or some other persons who maintain control or sufficient influence in the DeFi arrangements, even if those arrangements seem decentralized, may fall under the definition of a Virtual Asset Service Provider (VASP) where they are providing or actively facilitating VASP services. This holds true regardless of the involvement of other parties or if parts of the service are automated. Owners or operators are often identifiable by their connection to the activities being performed.
For yield-optimizing protocols that adopt a prudent approach towards decentralization, there is the potential to qualify for an exemption under MiCA. De facto decentralization implies the functional limitation of individuals with significant control or sufficient influence over assets or over aspects of the service’s protocol, and the existence of an ongoing business relationship between themselves and users, even if this is exercised through a smart contract or in some cases voting protocols.
Effective models that lend legal credibility to the concept of full decentralization include the implementation of permissionless access for third-party contributors. This approach allows external parties to assume critical operational roles, thereby diluting centralized control. Additionally, the existence of multiple front-ends for interacting with the protocol, coupled with the absence of a centralized access point or a dedicated team responsible for their deployment and maintenance, further reinforces the decentralized structure.
Moreover, in terms of governance, it is essential to ensure true decentralization. This can be achieved through strategies such as imposing a cap on governance token holdings to prevent voting power concentration within a small group. Additionally, empowering subDAOs (decentralized autonomous organizations) with specific authorities over certain types of decisions can distribute control more evenly. Encouraging active participation among token holders through incentivization strategies also contributes to a more democratized and widespread decision-making process.
Exposure to UCITS
When considering that vaults partially invest in assets that may be classified as financial instruments, it raises a pertinent question: do these investments represent a form of collective management activity with exposure to financial instruments, essentially constituting operations involving Undertakings for Collective Investment (UCIs)?
Undertakings for collective investment in transferable securities (UCITS) get their legal standing defined in Directive 2009/65/EC. UCITS means an undertaking:
with the sole object of collective investment in transferable securities or in other liquid financial assets referred to in Article 50(1) of capital raised from the public and which operate on the principle of risk-spreading; and
with units which are, at the request of holders, repurchased or redeemed, directly or indirectly, out of those undertakings’ assets.
Transferable securities within the meaning of Article 4(44) of MiFID II are those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
shares in companies and other securities equivalent to shares in companies, partnerships, or other entities, and depositary receipts in respect of shares;
bonds or other forms of securitized debt, including depositary receipts in respect of such securities;
any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities, or other indices or measures;
Further elaboration on the criterion for the UCI constitution is provided in ESMA’s Guidelines on key concepts of the AIFMD. The cumulative presence of all conditions determines the formation of a UCI:
the undertaking does not have a general commercial or industrial purpose;
the undertaking pools together capital raised from its investors for the purpose of investment with a view to generating a pooled return for those investors; and
the unitholders or shareholders of the undertaking – as a collective group – have no day-to-day discretion or control. The fact that one or more but not all of the aforementioned unitholders or shareholders are granted day-to-day discretion or control should not be taken to show that the undertaking is not a collective investment undertaking.
On the contrary, the optimizer will not be categorized as a UCI if it does not satisfy at least one of the above-described conditions.
general commercial or industrial purpose
Pursuant to ESMA definition, general commercial or industrial purpose is the purpose of pursuing a business strategy which includes characteristics such as running predominantly
i) a commercial activity, involving the purchase, sale, and/or exchange of goods or commodities and/or the supply of non-financial services, or
ii) an industrial activity, involving the production of goods or construction of properties, or
iii) a combination thereof.
Given the features of the vaults, it is safe to assume that they do not meet the criteria for a commercial-oriented setup. The core purpose of vaults is to maximize yield for users by automating and optimizing investment strategies. They do not offer non-financial services, nor develop industrial activity.
raising capital
The conditions for pooling investors’ assets imply carrying out “commercial activity of taking direct or indirect steps … to procure the transfer or commitment of capital by one or more investors to the undertaking for the purpose of investing it in accordance with a defined investment policy” (ESMA, VII.Guidelines on ‘raising capital’). No distinction shall be made between the activity taking place only once, on several occasions, or on an ongoing basis; or subscription-based transfer or commitment of capital.
Vaults are used as the primary means to collect user assets without express limitations on the number of users who can interact with the smart contract(s). Typically the system is designed to accommodate a wide range of users without restricting their number or capacity.
As a result, the raising capital prong would be satisfied, noting also that the exception for a pre-existing group cannot be applied. Due to the open model of the vaults, оne cannot claim that the capital is invested in an undertaking by a member of a pre-existing group, for the investment of whose private wealth the undertaking has been exclusively established.
defined investment policy
ESMA provides a comprehensive framework for understanding what constitutes such a policy for undertakings engaged in pooling capital to generate returns for investors. The following criteria, either individually or collectively, signify the presence of a defined investment policy.
established and fixed at the latest when investors' commitments become binding;
documented and either included in or referenced in the undertaking's rules or instruments of incorporation;
existence of a legally enforceable obligation on the undertaking or its managing legal person to adhere to this investment policy, including any modifications.
presence of investment guidelines, including but not limited to asset categories, investment strategies, geographical focus, leverage limits, minimum holding periods, and other risk diversification measures.
The investment guidelines shall be distinct from general business strategies pursued for commercial or industrial purposes, reinforcing the focus on specific investment criteria. Another critical aspect is that leaving full discretion to make investment decisions to the legal person managing an undertaking should not be used as a means to circumvent the provisions of the AIFMD. ESMA addresses it as a safeguard against potential abuses of discretionary power, ensuring that the defined investment policy remains the guiding principle for all investment decisions.
The investment policies of yield optimizers are incorporated in their official documentation, including details on fee structures, strategy limitations, types of investments, and automation aspects. Strategies may be overseen by a Guardian and the strategist, ensuring optimal performance and responsiveness to critical situations. A specified investment guideline, as Yearn’s, allows up to 20 strategies per vault with each having a capital cap. These guidelines are designed to avoid over-allocating funds to a strategy that no longer increases APY. Automated functions like harvest() and earn() are used to manage these investments.
Another good example is stringent SAFU (Secure Asset Fund for Users) practices followed by some protocols to ensure the safety and security of the investments. Rules for new farms to be vaulted, a manual testing procedure for new vaults, and criteria for strategy upgrades are integral parts of the SAFU practices. The guidelines also cover aspects like contract verification, liquidity requirements, and protection against potential abuses of smart contract functionality.
The public declaration of policies, as outlined above, would constitute the establishment of a clearly defined investment policy. The processes involved in proposing strategies on a governance forum, voting, and their subsequent implementation via a set of smart contracts should be carefully considered. This approach represents a departure from traditional methods of documenting and enforcing rules at a later stage, highlighting a more dynamic and interactive process.
day-to-day discretion or control
The assertion that only a subset of the mentioned unitholders or shareholders are endowed with day-to-day discretion or control should not automatically imply that the enterprise does not qualify as a collective investment undertaking. Instead, it indicates that decisions made unanimously by the shareholders or their participation in other facets of the company's daily management could constitute an exemption from the UCI regime.
A typical vetting process for strategies is a crucial part of ensuring the safety, efficiency, and effectiveness of the yield-optimizing protocol. The process begins with a new strategy proposal filed by anyone from the DeFi community, not necessarily a protocol token holder. A standard proposal includes detailed information about the strategy's mechanics, expected returns, associated risks, and how it aligns with the protocol's overall objectives.
Once the strategy is proposed, it enters a phase of community review and discussion conducted on the governance forums. During this phase, community members, including developers, strategists, and other stakeholders, critically evaluate the proposal. They discuss its merits, potential risks, and any possible improvements or optimizations. In the next phases, technical evaluation, code review, and risk assessment are performed. Often, strategies undergo simulation and testing in a controlled environment.
After thorough vetting, the strategy is put up for a community vote where the majority of votes should be cast in favor of the strategy to be approved. Approved strategies are then implemented into the protocol’s ecosystem by deploying smart contracts, allocating resources, and integrating the strategy with the optimizer's existing protocols.
By taking into consideration the strategy approval process, the token holders can be viewed as having real discretionary power on the investment resolutions achieved via a decision-making quorum that allows them to put the approved strategies in play. The demonstrated allocation of rights and obligations effectuates a strong involvement in the day-to-day management of the vaults, ergo discounts the discretionary power conditions.
In summary, the typical configuration of a yield optimizer does not meet the initial criterion of the UCI test. There are substantial grounds to disregard the third prerequisite, particularly when token holders within a specific DeFi protocol maintain discretionary control over the daily operations of the vaults. Ideally, modifications to any vault should be ratified either unanimously or by a substantial majority quorum.
Exposure to MiFID II
By disclosing and granting public access to their investment strategies, yield optimizers could be construed as offering investment advice or related financial services, which may fall under the scope of the Directive.
Investment advice within the meaning of MiFID II is the provision of personal recommendations to a client, either upon its request or at the initiative of the investment firm, in respect of one or more transactions relating to financial instruments. MiFID II Delegated Regulation further clarifies in Art. 9 that a personal recommendation shall be considered a recommendation that is made to a person in his capacity as an investor or potential investor, or in his capacity as an agent for an investor or potential investor.
These recommendations are distinguished by their tailored suitability for an individual or their alignment with the specific circumstances of the person receiving the advice. According to the Delegated Regulation a personal recommendation includes guidance that suggests the acquisition or disposal of financial instruments (e.g. buying, selling, subscribing for, exchanging, redeeming, holding, or underwriting) or the decision to exercise or refrain from exercising rights conferred by a specific financial instrument. Crucially, for a recommendation to qualify as a “personal recommendation” under these legal terms, it must be directed towards a specific individual or a group defined by their unique circumstances. If, however, the recommendation is disseminated indiscriminately to the general public, it can be assumed it does not fall under the category of a “personal recommendation”.
While the yield strategies are open to the public, allowing anyone to review and understand the approaches taken, it cannot be claimed that there are restrictions on access to strategy details or particular investors’ eligibility criteria. It is reasonable to infer that if a recommendation is not tailored to a specific investor (or a group of investors with similar characteristics) and does not consider the unique circumstances or characteristics of the investors, it does not qualify as investment advice on similar grounds.
MiFID II defines that advice should be delivered either upon request or as an initiative of the investment firm, identified as any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.
To this date in Europe, DAOs commonly involved in various aspects of yield optimizers' operations, have not been recognized as legal entities. Given the absence of a tailored legal and regulatory framework for DAOs, it remains a contentious issue whether a DAO could be considered an investment firm within the context of MiFID. Furthermore, due to distinct structural, organizational, and functional characteristics of DAOs, there is a strong basis to argue that they might qualify for the exemptions intended for fully decentralized entities or protocols under MiCA.
Annex I of MiFID comprehensively enumerates different categories of financial instruments. The type of advice discussed previously could relate to various instruments such as transferable securities, money-market Instruments, units in collective investment undertakings, among others, as specified by the Directive. However, crypto tokens intrinsic to the operations of yield-optimizing protocols are not explicitly included in this categorization. A definitive clarification from the relevant authority is anticipated. By December 30, 2024, the ESMA is expected to issue guidelines detailing the conditions and criteria for classifying crypto-assets as financial instruments.
In summary, the absence of crypto tokens from the current detailed categorization of financial instruments in MiFID II does not automatically exempt optimizers from its applicability. However, a potential basis for exempting yield strategies from being classified as investment advice is their universal accessibility. The fact that these strategies are available to the general public without any preferential treatment or exclusive offerings to specific token holders could be a significant factor in this context.
Disclaimer: This report on the legal status of DeFi yield optimizers is provided for informational purposes only and does not constitute legal advice. The content herein is a general overview and should not be relied upon as a definitive guide to the legal or regulatory status of DeFi yield optimizers. This review does not advocate for or against any specific protocol, nor does it represent a binding legal opinion on the regulatory status of yield optimization practices that may be referenced by one or multiple protocols.
The information provided in this report is not intended to be a substitute for legal or professional advice. Readers are cautioned not to act upon any information contained in this report without seeking professional legal counsel specific to their situation. The author(s) and publisher(s) of this report disclaim any liability for any actions taken based on the contents of this report.
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