I see you're using 2.0, it's best to say explictly if you want a 2.0
answer as the current version is still 1.0 (2.0 is still in draft)

I don't think you need to keep copying nodes and build copies of the
tree, you want to recursively walk over the existing tree not copy
branches of it:

<x>

    <define name="DEF1">
        <reg name="REG1"/>
    </define>

    <define name="DEF2">
        <reg name="REG2"/>
        <ref name="DEF1"/>
    </define>

     <block name="block1">
          <reg name="REG3"/>
          <ref name="DEF2"/>
     </block>

</x>






<xsl:stylesheet version="2.0"
              xmlns:xsl="http://www.w3.org/1999/XSL/Transform">

<xsl:key name="r" match="define" use="@name"/>

<xsl:template match="x">
 <xsl:apply-templates select="block"/>
</xsl:template>

<xsl:template match="reg">
Register: <xsl:value-of select="@name"/>
</xsl:template>

<xsl:template match="ref">
 <xsl:apply-templates select="key('r',@name)"/>
</xsl:template>

</xsl:stylesheet>



$ saxon8 ref.xml ref.xsl
<?xml version="1.0" encoding="UTF-8"?>

Register: REG3


Register: REG2


Register: REG1

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