DeFi’s portability wins over TradFin’s siloed approach
Decentralized Finance (DeFi) continues to present opportunities for innovation across financial services and the Web3 landscape. While crypto still struggles with a stigma of volatility, DeFi has earned a more promising reputation as a financial alternative powered by blockchain-based protocols.
Decentralization, transparency, and fewer permissions (in short, a completely open financial system) can promote innovation in everything from lending and borrowing to asset management. The result: an explosion of projects over the last few years that have embraced the inclusion, predictability and perhaps most underrated, the portability that DeFi brings.
The total value locked (TVL) in DeFi projects was around $59.7 billion in the first quarter of 2024. More confidence has attracted more interest and led to further liquidity—as well as increased risk.
Operation Shutdown
In 2023, the Commodity Futures Trading Commission fined three DeFi companies up to a quarter of a million dollars each over regulatory failures, signaling a federal crackdown in the broader industry and uncertainty for those operating in it.
Challenges are also emerging in the European Union. According to Cointelegraph, new regulations under the Crypto-Assets Regulation (MiCA) could be trying to force DeFi protocols into a more hybrid position with licensing and Know Your Customer (KYC) requirements.
Failure to establish a proper legal footing in your DeFi project can lead to hefty fines, project shutdowns, or even worse, jail time. The latter is uncommon, but the regulatory gray zones of DeFi governance pose a significant risk. So, it’s crucial to understand and mitigate the challenges by nailing the legal structuring.
Defining your project
Getting the foundations right is the first step in achieving legal compliance and establishing resilience within your project. So, start by answering the most obvious question: what are you trying to build?
Whether your project is a lending platform, prediction market, or decentralized exchange (DEX), understanding its scope, functionality, and audience lays the groundwork for navigating the legal landscape.
Some DeFi projects have inherently more legal risks than others, particularly those that operate close to traditional securities. For example, a user-friendly, non-custodial platform enabling basic token swaps might face fewer regulatory hurdles than a complex exchange offering cross-chain functionality.
Some still overlook the fact that complex legal issues can arise in Decentralized Autonomous Organizations (DAOs), token offerings, and KYC/AML requirements. However, operating in the decentralized sphere doesn’t mean a free pass from regulation. The quicker you understand this, the better.
Understanding token needs
In 2021, the US Securities and Exchange Commission (SEC) brought forward a case against Blockchain Credit Partners over the alleged sale of unregistered tokens worth $30 million. The case was eventually settled, and Blockchain Credit Partners didn’t have to admit guilt—but it cost them almost $13 million.
Token issuance and token release can result in costly, complex litigation if you ignore the legal framework. It all depends on the legal status and characteristics of the tokens you choose to distribute (and the distribution process itself).
There are many ways to categorize tokens, but practically speaking, they fall into three status categories: security tokens, utility tokens and stablecoins. Security tokens often face stricter scrutiny in a legal sense, as they’re most aligned with traditional securities. However, other types of tokens occasionally raise red flags at the SEC as well.
One way to navigate the regulatory complexities is to create a legal entity that sits between tokens and assets. Token Special Purpose Vehicles (SPV) can add a degree of separation, but that’s not necessarily enough because they still need to comply with regulations.
The legal standing of tokens and issuance also varies by jurisdiction, so it’s essential to choose wisely. Issuing and distributing tokens in jurisdictions with unclear regulations will add to further complexities.
The bottom line is that tokens that aren’t structured correctly are high risk and run into various legal problems, which is simply off-putting for investors. In today’s regulatory climate, getting a legal opinion on your tokens is probably worth the investment.
Understanding the scale of decentralization
In 2022, MakerDAO members turned out in record numbers to vote against a proposal to centralize the platform’s governance. The degree of decentralization within your DeFi project will shape everything from its governance strategies (like permissionless vs. multisig voting) to token distribution processes.
Decentralization would suggest fewer legal hurdles, and most members support it, but the complex nature of DeFi governance mechanisms can actually lead to operational challenges and SEC interest.
Key to this context is The Howey Test, the US legal framework that determines whether a transaction should be regulated. It also applies to cryptocurrencies and DeFi tokens, defining whether they are classed as securities.
The ongoing saga between the SEC and Uniswap serves a cautionary tale. Regulators have threatened the exchange with court and leveraged the Howey Test within their arguments. CoinDesk ominously warned that this was an “opening attack against DeFi,” suggesting this debate is far from over.
Regulators will keep on coming, so you need to be adaptable and strike a balance that facilitates both decentralization and compliance. Remember, as MakerDAO demonstrated, decentralization could also evolve based on community decisions.
Structuring your governance the right way
Governance is the cornerstone of DeFi, driving transparency and decision-making. As an essential component of your legal framework, understanding and implementing effective governance is critical to navigating the legal challenges of your DeFi project.
Decentralized Autonomous Organizations (DAOs) are the most common governance strategy in the DeFi world. They rely on token-holder votes within a blockchain to enable input from diverse investors in stark contrast to traditional decision-making. The fact that we’ve gone from 4,000 DAOs in 2022 to 12,000 this year (by DeepDAO’s records) shows that they’re doing something right.
However, DAOs live in a gray zone as they don’t operate alongside a legal entity like a company or foundation. Consequently, you need to build a proper structure to protect members and enable decision-making. Otherwise, the DAO could be deemed a general partnership, making everyone involved legally responsible. What’s more, depending on the structure of your DAO and token distribution, it could be subject to securities regulation if it meets the SEC’s Howey Test criteria, meaning more red tape.
Legal wrappers – the practice of conducting all or some activities of a DAO through an incorporated or registered legal entity – have been touted as the solution as they provide a recognized legal framework to the DAO. They wrap a sort of legal blanket around your DAO, shielding its members from legal and financial challenges and ensuring limited liability. The most in-vogue types of wrappers appear to be DAO LLCs, which jurisdictions like the Marshall Islands have embraced because they add a corporate familiarity to an otherwise alien concept.
Indeed, DAOs crucially require limited liability. However, legal wrappers are still a relatively novel concept that faces challenges. An LLC structure is also inherently flawed as it slaps a more rigid layer on top of your decentralized decision-making arm. This limits its abilities without addressing the key issue, prompting us to think a multi-pronged approach is better.
Enter: the entity stack
DAOs will continue challenging existing legal systems, and LLCs may not be a viable, long-term solution. Only a creative collaboration of entities, or an entity stack, can help navigate this minefield.
An entity stack consists of two or three entities, such as a foundation, token issuer, and operational company, that work together to unlock the interplay of operational and governance abilities across your DeFi project. It’s another relatively new concept and not necessarily a silver bullet to DeFi's legal woes, but it's certainly more legally sound than the single legal wrapper.
But how does this help with your DeFi project’s legal structuring? By separating the functionalities of your DAO, you create a more modular and atomized system that allows more clarity between sections and less collective risk.
There are also particular jurisdictions where this model can reap more benefits. Jurisdictions like the Cayman Islands, Panama, and the British Virgin Islands offer favorable solutions for token distribution and other aspects of DAO operations, making them a solid option for starting a DeFi project.
Leveraging an entity stack in these jurisdictions boosts regulatory compliance and, most importantly, reduces legal risks. It can protect the DAO and its members while championing the full potential of decentralized governance—and that’s something we should all be striving for.
You don’t have to navigate Web3's jurisdictional complexities alone. At Otonomos, we specialize in helping you unlock multi-jurisdictional access while delivering the best decentralization.
