– Written by Angelo Messore, Francesco Dagnino and Carlo Giuliano

Decentralized Finance (“DeFi”) seeks to transform the financial industry by granting customers access to financial services with no 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. Among the most significant innovations introduced by DeFi, which may also reshape the dynamics of traditional markets and trading venues, are Automated Market Making (“AMM”) protocols. Initially designed to provide liquidity on decentralized crypto exchanges, AMM protocols can also find applications in other market domains. This article delves into the issues concerning the regulation of AMM within the context of European law.

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What are AMM protocols?

In traditional financial markets market makers play a pivotal role in enhancing market liquidity. Market makers are financial institutions or traders acting on their own account that continuously buy and sell assets traded on a trading venue at quoted prices. Market making ensures that investors can trade more swiftly and efficiently on the market and can boost the liquidity of traded assets. Market makers earn their profits from the bid-ask spread, which represents the difference between buying and selling prices.

AMM protocols apply the same principle of market making in a DeFi environment. These protocols harness 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 every investor can trade against a shared pool of assets, known as the liquidity pool.

What is a liquidity pool?

Liquidity pools serve as the bedrock of DeFi exchanges, enabling users to trade assets instantly and efficiently. In a liquidity pool users deposit a pair of assets into a smart contract. For example, an investor might contribute a single unit of cryptocurrency, such as 1 Ether (ETH), alongside an equivalent amount of a stablecoin like Tether (USDT), into a liquidity pool (ETH-USDT).

The price of each asset within the liquidity pool is dynamically computed by the AMM protocol, which is driven by a mathematical formula. The formula continuously adjusts the price of each asset to maintain a constant ratio between the value of the assets held within the pool.

For instance, if the stipulated ratio between ETH and USDT in the pool is ‘k’, when an investor purchases ETH and deposits USDT into the pool, the value of ETH rises while the value of USDT decreases. This mechanism ensures that the ratio between these two assets is always equal to k.

Investors who contribute assets to the pool are known as liquidity providers. They are entitled to a share of the liquidity pool that is proportional to their contribution and is represented by liquidity pool tokens. Liquidity providers earn a corresponding portion of the fees collected from investors trading against the pool. The payment of the fees creates an incentive for users to deposit assets into the pool thereby enhancing market liquidity.

Are AMM protocols regulated under MiCAR?

An open question under EU law is whether and to what extent AMM protocols are regulated under the Market in Crytpo-Assets Regulation (EU) No. 2023/1114 (“MiCAR”), which introduces a common framework for cryptoasset service providers and issuers in the EU.

In addition to services offered by centralized platforms, MiCAR applies also to crypto-asset services that are partly performed in a decentralized manner. When cryptoasset services are provided in a fully decentralized manner without any intermediary, they do not fall within the scope of MiCAR.

Given that AMM protocols are normally operated in a fully decentralized environment, they are likely to fall outside the scope of MiCAR. Yet the exact criteria triggering the application of the MiCAR in case of “partial” centralization of the services, or if an “intermediary” is involved in the process, remain less defined, leaving room for regulatory interpretation.

AMM protocols under the MiFID2 and the DLT Pilot Regime

MiCAR does not extend its scope to tokens qualifying as financial instruments in accordance with Directive 2104/59/EU (“MiFID 2”). These tokens remain subject to the existing regulatory framework outlined in the MiFID2.

In 2019, the European Securities and Markets Authority (“ESMA”) addressed the issue concerning the management of trading platforms for financial instruments issued on distributed ledger technology (“DLT”) (ESMA50-157-1391).

ESMA noted that platforms trading crypto-assets qualifying as financial instruments with a central order book and/or “matching orders under other trading models” are likely to qualify as multilateral systems in accordance with the MiFID 2 and should therefore be regulated as multilateral trading facilities (“MTFs”), organized trading facilities (“OTFs”) or regulated markets.

With respect to 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 would 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 risks.

AMM protocols are not considered under Regulation (EU) 2022/858 (the “DLT Pilot Regime Regulation”) which introduces a pilot regime for market infrastructures based on DLT. The notion of DLT MTF that is used in the DLT Pilot Regime Regulation is essentially based on the MiFID2 notion of MTF and does not offer any further elucidation regarding decentralized AMM protocols.

Navigating regulatory uncertainties: the classification of AMM protocols

AMM protocols stand out as a major innovation within the realm of DeFi. The integration of AMM systems could also help traditional trading venues enhancing the liquidity offered to investors without relying on traditional order book systems, market makers, auctions or other matching protocols.

From a regulatory standpoint, the MiCAR will not apply to AMM protocols operating in a fully decentralized manner. This approach will lead to a different regulatory treatment of crypto exchanges operating on the basis of centralized / semi-decentralized models, as opposed to fully decentralized platforms.

As to crypto-assets qualifying as financial instruments, such as security tokens, the regulatory framework remains unclear in the absence of further guidance by EMSA. A central question is whether and to what extent AMM protocols are designed to “match orders” to buy or sell DLT financial instruments and the role, if any, played by intermediaries or other operators in facilitating the matching or settling of these orders. AMM protocols trading DLT securities could require a license to operate as DLT MTF under the DLT Pilot Regime. However, identifying the entity or person that would be subject to such licensing obligation is a complex challenge in a DeFi environment due to the decentralized nature of these platforms.

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