Decentralized Finance (“DeFi“) aims to transform the financial industry by giving customers access to financial services without the need to involve financial institutions. DeFi protocols replicate established financial business models, including lending, borrowing and trading, within a fully decentralized ecosystem powered by smart contracts. One of the most significant innovations introduced by DeFi, which may also change the dynamics of traditional markets and trading venues, is automated market making.AMM“) Protocols. AMM protocols were originally developed to provide liquidity on decentralized crypto exchanges, but can also find application in other market areas. This article addresses the issues of regulation of AMM in the context of European law.
What are AMM protocols?
In traditional financial markets, market makers play a central role in improving market liquidity. Market makers are financial institutions or traders trading on their own account who continuously buy and sell assets traded on a trading venue at quoted prices. Market making ensures that investors can trade faster and more efficiently in the market and increases the liquidity of the assets traded. Market makers make their profits from the bid-ask spread, which is the difference between buying and selling prices.
AMM protocols apply the same principle of market making in a DeFi environment. These protocols leverage the power of smart contracts and algorithms to facilitate the exchange of crypto assets. They replace the traditional role of market makers with a “peer-to-pool” mechanism where each investor can trade against a common pool of assets, called the liquidity pool.
What is a liquidity pool?
Liquidity pools serve as the foundation of DeFi exchanges, allowing users to trade assets instantly and efficiently. In a liquidity pool, users deposit a pair of assets in a smart contract. For example, an investor could contribute a single unit of a cryptocurrency, such as 1 Ether (ETH), into a liquidity pool (ETH-USDT) along with an equivalent amount of a stablecoin such as Tether (USDT).
The price of each asset within the liquidity pool is dynamically calculated by the AMM protocol, which is based on a mathematical formula. The formula continually adjusts the price of each asset to maintain a constant ratio between the value of the assets held in the pool.
For example, if the set ratio between ETH and USDT in the pool is “k”, and an investor buys ETH and deposits USDT into the pool, the value of ETH will increase while the value of USDT will decrease. This mechanism ensures that the ratio between these two assets is always equal to k.
Investors who contribute assets to the pool are called liquidity providers. They are entitled to a share of the liquidity pool proportional to their contribution and represented by liquidity pool tokens. Liquidity providers earn a corresponding portion of the fees collected from investors who trade against the pool. Paying the fees incentivizes users to deposit assets into the pool, thereby increasing market liquidity.
Are AMM protocols regulated under MiCAR?
An open question under EU law is whether and to what extent AMM protocols are regulated by the Market in Crypto-Assets Regulation (EU) No. 2023/1114 (“My car“), which establishes a common framework for crypto asset service providers and issuers in the EU.
In addition to the services offered by centralized platforms, MiCAR also applies to crypto asset services, some of which are provided in a decentralized manner. If cryptoasset services are provided in a fully decentralized manner and without intermediaries, they do not fall within the scope of MiCAR.
Since AMM protocols typically operate in a fully decentralized environment, they are unlikely to fall within the scope of MiCAR. However, the precise criteria that trigger the application of MiCAR in the case of “partial” centralization of services or when an “intermediary” is involved in the process are less defined and leave room for regulatory interpretation.
AMM protocols under MiFID2 and the DLT pilot regime
MiCAR does not extend its scope to tokens that are considered financial instruments under Directive 2104/59/EU (“MiFID 2“). These tokens remain subject to the existing MiFID2 regulatory framework.
In 2019, the European Securities and Markets Authority (“ESMA“) addressed the issue of managing trading platforms for financial instruments issued on distributed ledger technology (“DLT“) (ESMA50-157-1391).
ESMA noted that platforms trading crypto-assets that are considered financial instruments with a central order book and/or “matching orders under other trading models” are likely to be considered multilateral systems under MiFID 2 and should therefore be regulated as multilateral trading facilities (“MTFs“), organized trading establishments (“OTFs“) or regulated markets.
Regarding decentralized business models, ESMA acknowledged that the lack of a clearly identified operator and the reliance on self-executing pieces of code raise specific issues that need to be addressed. At the same time, ESMA recognized that decentralized trading venues could mitigate some risks of traditional trading venues, such as counterparty risk.
AMM protocols are implemented in accordance with Regulation (EU) 2022/858 (the “Regulation on the DLT pilot regime“), which introduces a pilot regime for market infrastructures based on DLT. The term DLT-MTF used in the DLT Pilot Regime Regulation is essentially based on the MiFID2 term of MTF and does not provide any further explanation on decentralized AMM protocols.
Managing regulatory uncertainty: the classification of AMM protocols
AMM protocols are a major innovation in the DeFi space. The integration of AMM systems could also help traditional trading venues improve the liquidity offered to investors without relying on traditional order book systems, market makers, auctions or other matching protocols.
From a regulatory perspective, MiCAR does not apply to AMM protocols that operate in a fully decentralized manner. This approach will result in different regulatory treatment for crypto exchanges operating on the basis of centralized/semi-decentralized models, as opposed to fully decentralized platforms.
As for crypto assets that are considered financial instruments, such as security tokens, the regulatory framework remains unclear in the absence of further guidance from EMSA. A key question is whether and to what extent AMM protocols are designed to “match” orders to buy or sell DLT financial instruments and what role, if any, intermediaries or other operators play in facilitating the matching or settlement of these orders. AMM protocols that trade DLT securities may require a license to operate as a DLT MTF under the DLT Pilot Regime. However, identifying the legal entity or person that would be subject to such a licensing requirement is a complex challenge in a DeFi environment due to the decentralized nature of these platforms.
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