100% of Defi is illegal based on the Commodity Futures Trading Exchange’s (CFTC) reasoning in the recent Ooki Dao case, giving U.S. regulators the power to completely clamp down on DeFi. Unless the crypto industry wins in future court cases against the CFTC’s current legal arguments, U.S. authorities could kill DeFi.
CFTC Versus Ooki DAO
In September 2022, the CFTC sued Ooki DAO, a decentralized autonomous organization, alleging the DAO offered leveraged and margin trading products without registering as a Futures Commission Merchant (FCM) with the CFTC.
“In the CFTC’s interpretation, those who hold governance tokens and vote in a DAO should be held individually liable for illicit activity conducted by said DAO,” explains Kadan Stadelmann, CTO of the Komodo Platform blockchain. “Some analysts have questioned the sense in going after those governance token holders who vote, and not those who don’t.”
The Ooki DAO decision came on the back of another CFTC settlement with bZeroX, the company originally behind Ooki DAO, and its founders. They alleged the company offered leveraged and margin trading products to U.S. persons sans registration as a Designated Contract Market (DCM) or an FCM. bZeroX settled for a $250,000 fine.
By the time of the charges, bZeroX already operated as Ooki, a DAO with many operators. The CFTC, after having gone after the founders, simply went after the DAO, too.
“A key bZeroX objective in transferring control of the bZx Protocol (now the Ooki Protocol) to the bZx DAO (now the Ooki DAO) was to attempt to render the bZx DAO, by its decentralized nature, enforcement-proof. Put simply, the bZx Founders believed they had identified a way to violate the Act and Regulations, as well as other laws, without consequence … The bZx Founders were wrong, however. DAOs are not immune from enforcement and may not violate the law with impunity,” the complaint said.
“Commodities laws state you cannot engage in a transaction that involves a commodity, leverage, margin, or financing, except on a regulated CFTC registered exchange, with the exception of eligible contract participants,” points out Stadelmann. Ooki Dao, and any smart contract system for that matter, is not that type of exchange.
Who Violated The Law?
The developers wrote, deployed, and promoted software.
“Therefore, they might have also had limited control over the software after deployment,” notes Stadelmann. The CFTC equates these actions to being an FCM, which Ooki DAO arguably is not. A Futures Commodity Merchant acts as a counterparty and offers leverage, financing, and more.
Smart contract developers offer only software. “Depositors come to the software, and arguably act as counterparties offering each other leverage through the software,” explains Stadelmann.
The CFTC should perhaps be suing not the developers—who they could indeed argue aided and abetted law violations—but DAO participants, generally, including those who hold governance tokens for perhaps speculative purposes and do not vote.
DAO participants, it could be argued, are customers of the business, and not the business. People holding governance tokens look out for their own interests, not the interests of the business.
“They rely on the system, and get a say in it,” Stadelmann told me.
The CFTC instead wants to call a DAO a partnership in a commodities exchange.
The State of DeFi Regulation
At present, if a dapp uses digital assets not deemed securities or derivatives—basically, Bitcoin, Dogecoin, and Ethereum—the CFTC would not hold regulatory authority. In order to have authority, the dapp would need to offer leveraged services, liquid staking derivatives, etc., as was argued in the bZeroX and Ooki DAO cases. More clarity is needed as to when the CFTC is responsible for crypto oversight.
For instance, Uniswap, a decentralized exchange protocol (DEX), provides access to digital assets the CFTC could easily argue represent derivatives, including any liquid staking token. It could even be argued DAI represents a swap or derivative, since it derives its value from various collaterals.
Commodities swaps, which is any asset with a value based upon the value of another asset, are also regulated under commodities laws. For example, DAI is collateralized by various assets. Therefore, its value is based upon those assets or liquid staking derivatives, and could represent a commodity swap. Moreover, DEXs could offer DAO tokens and synthetic tokens, such as synthetic Tesla stock, etc.
CFTC’s Digital Commodities Consumer Protection Act
Further proof of the CFTC’s threat to DeFi comes in the form of the The Digital Commodities Consumer Protection Act (DCCPA), a proposed U.S. law to regulate digital asset trading, including cryptocurrencies. It places oversight under the authority of the CFTC. The bill, which has bipartisan support, is particularly unkind to DeFi. It did once have the backing of Sam Bankman-Fried, whose arrest and pending trial have presumably slowed down the bill’s adoption.
“Numerous problems exist with the bill,” believes Stadelmann. “Due to its original broad drafting, it is unclear if the bill could apply to software developers. The most recent draft, to be sure, delineates between central intermediaries and software developers, stating that if all you do is write and publish software, you’re not responsible for registering the facility. That helps, but it’s unclear which version will ultimately come to a vote.”
Further, if a developer markets said software, they might all the sudden fall under the purview of the CFTC, notes Stadelmann. “Only time will tell.”
The DCCPA targets entities which facilitate trades in digital commodities. That could qualify data aggregators and block explorers, since they arguably facilitate trading. There is, to be sure, a carve out in the bill for validators.
All DeFi Illegal
“In determining DAO voters were to be held individually, the CFTC cast a broad net,” said Stadelmann. “Clearly, decentralized governance—as we had already seen with the Tornado Cash case—does not protect a DAO against regulatory action.” What’s more, DAO voters can be held liable.
The CFTC argues whoever runs a platform could be held liable for violations of the law. In the bZeroX and Ooki DAO cases, it first went after developers, and then the later DAO participants. If the CFTC can go after Ooki DAO in such a manner, they could use the same exact arguments to declare virtually all of DeFi illegal. Most of DeFi—with the exception of perhaps only Automated Market Makers (AMM)—involves margin financing or leverage.
DeFi Versus U.S. Executive Branch
For now, the crypto industry must be content awaiting the coming judicial fight over where and when the CFTC has jurisdiction.
“American law remains facts and circumstances based with robust due process rights under the Constitution,” said Stadelmann.
This legal system features sophisticated judges, appellate courts, and expensive lawyers. Therefore, even if the content of the law is not fair, the process still entails some checks and balances. The judge hears, a jury decides, the people appeal, etc.
Therefore, although the CFTC believes it has the legal authority, it’s not easy for them to exercise. They have to bring individual cases, investigate and marshal facts, sue, and they might even lose cases. Case after case must be litigated.
“Meanwhile, the technology becomes more decentralized as capabilities like zero knowledge proofs and trustless front ends appear and become increasingly sophisticated,” an optimistic Stadelmann suggests. “Certainly, in order for DeFi to remain legal, work on the development and advocacy fronts are paramount.”