A class-action lawsuit against Uniswap spotlights gaps in DeFi regulation

Last week, a user of decentralized exchange protocol Uniswap filed a class-action lawsuit against Uniswap Labs, the startup that develops and maintains the protocol as well as its popular frontend website. 

Nessa Risley of North Carolina has alleged that Uniswap failed to adequately comply with know-your-customer(KYC) rules and failed to register as a broker-dealer with the Securities and Exchange Commission (SEC), actions which enabled scammers to execute pump and dump schemes on the Uniswap protocol, ultimately causing Risley and others to lose money. 

The complaint contends that if Uniswap Labs had registered with the SEC and met the burden of securities laws, investors would be better protected from fraudulent activity.

Cases like this often never reach oral arguments inside a courtroom. But potential outcomes aside, what’s interesting about this case is that it spotlights fundamental questions about decentralized finance (DeFi) platforms that regulators have yet to address. 

Are DeFi platforms subject to securities laws?

The Risley case alleges that Uniswap is operating as an unlicensed broker-dealer and isn’t abiding by securities laws — and that this has harmed investors. 

But what exactly are the developers of DeFi platforms legally required to do? There is no federal regulatory regime for crypto exchanges, centralized or decentralized. There’s no guidance that says a centralized platform like Coinbase has to register as a securities exchange, let alone Uniswap. SEC chair Gary Gensler and Senator Elizabeth Warren have both called for a new federal framework for regulating crypto exchanges. 

Confusion and debate over which crypto tokens should be considered securities, and in turn which platforms should be considered securities brokers, has been a fixture in crypto for years. Centralized exchanges have generally tried to steer clear of listing tokens with obvious security-like features. Last June, Uniswap Labs itself restricted access to certain tokens through its website, explaining that it was due to an “evolving regulatory landscape.”

It’s possible that the SEC could take an enforcement approach to establish guidance on the issue. The agency hasn’t yet explicitly taken aim at DeFi platforms for listing unregistered securities.

But last August, Gensler said in a speech that he believed “we have a crypto market now where many tokens may be unregistered securities.”

He also told The Block in September that the 1934 Securities Exchange Act “painted with a broad brush as to what’s a security,” indicating it could include popular DeFi activities like staking and lending.

Who’s in charge?

Even if the SEC were to decide that  Uniswap or other DeFi platforms are violating securities laws, the next difficult question is who to serve papers to. 

The system is set up to regulate intermediaries, explains Anthony Tu-Sekine, head of Seward and Kissel’s blockchain and cryptocurrency law group. That means brokers, stock exchanges and transfer agents rather than the end-users. But the whole point of DeFi, at least in theory, is to cut out the middleman.

According to Tu-Sekine, many DeFi platforms potentially engage in conduct that is regulated. But if there is a regulatory burden, it’s not clear who would have to apply for those licenses, he said.

The new class-action lawsuit points the finger at Universal Navigation Inc., the legal entity name of Uniswap Labs, as well as Uniswap creator (and CEO of Uniswap Labs) Hayden Adams and investment firms Paradigm, Andreesen Horowitz and Union Square Ventures. 

But while those not familiar with DeFi may assume that Uniswap Labs runs Uniswap, it’s not that simple.

Adams invented the Uniswap protocol, which is a decentralized protocol in that it lives on the Ethereum blockchain. He and others set up Uniswap Labs as the primary hub for messaging around the protocol. It acts as its marketer, it retains a team of developers to work on the protocol and it manages an easier-to-navigate front end to create a simpler way to interact with the protocol.

But Uniswap Labs can’t change the code any more than any other team of developers can. Other, non-Uniswap Labs affiliate developers can also augment or even replicate the protocol. For example, a developer by the name of Chef Nomi forked the network to create rival platform Sushiswap. 

And users don’t need to use the Uniswap Labs interface, called the frontend, to interact with the protocol. There are alternative Uniswap frontends out there, and with enough know-how, it’s possible to use Uniswap to trade coins that Uniswap Labs has de-listed. 

Regulators and court systems haven’t yet figured out how to deal with the relationship between a decentralized protocol and those who develop and maintain it — mostly because they haven’t had to. Lawsuits like this increase the pressure because if they do go to court, rulings could come down that the SEC doesn’t agree with.

For his part, Gensler has said the term DeFi is "a bit of a misnomer,” and suggested that finding regulatory targets wouldn’t necessarily be so difficult. These platforms "facilitate something that might be decentralized in some aspects but highly centralized in other aspects," he said in August.

"There's still a core group of folks that are not only writing the software, like the open-source software, but they often have governance and fees," said Gensler. "There's some incentive structure for those promoters and sponsors in the middle of this."