REGULATION OF DECENTRALIZED SYSTEMS: A STUDY OF UNISWAP.

• Author: Kim, Jamie

TABLE OF CONTENTS I. INTRODUCTION 335 II. BACKGROUND 339 A. Decentralized Exchanges 339 B. Uniswap 341 C. The DAO 346 D. EtherDelta 347 III. FAILURE TO REGISTER AS A SECURITY OR EXCHANGE 349 A. Is the UNI Token a Security? 349 1. Investors in UNI Invested Money 350 2. In a Common Enterprise 351 3. With a Reasonable Expectation of Profits 351 4. Derived from the Managerial Efforts of Others 352 B. Is Uniswap an Exchange? 356 C. Past SEC Enforcement Actions 358 1. Under Securities Act [section][section] 5(a) and (c) 360 2. Under Exchange Act [section] 5 363 IV. CONCLUSION 366 APPENDIX 368 I. INTRODUCTION

Decentralized finance ("DeFi") is an umbrella term for blockchainbased decentralized applications that offer automated, unregulated alternatives to traditional financial services. DeFi projects are powered by self-executing protocols known as "smart contracts," (1) which are written and deployed by software developers on public platforms like the Ethereum blockchain. (2) Smart contracts carry out pre-specified agreements between disparate, anonymous parties without relying on central intermediaries like banks or other traditional financial institutions. (3) Today, anyone in the world with an internet connection and a cryptocurrency "wallet" (4) can engage in a variety of financial transactions using cryptocurrencies, such as lending, borrowing, trading, paying, saving, and insuring. (5)

Smart contract developers began to build DeFi applications on the Ethereum blockchain network around late 2017. (6) Since then, the number, and transactional volume, of Ethereum-based applications have grown exponentially. (7) In May of 2020, the volume of assets deposited as collateral on Ethereum-based DeFi platforms (a common metric known as "total value locked" ("TVL")), (8) was less than $9 billion. (9) Just one year later, in May of 2021, TVL on Ethereum was more than $85 billion. (10) In November of 2021, TVL on Ethereum reached an all-time high of more than $110 billion. (11)

DeFi's sudden growth is testing the ability and authority of government actors to regulate activity on peer-to-peer networks. At issue is whether and how "legacy" financial regulations--which presupposed the presence of institutional intermediaries--now apply to DeFi projects powered by code. (12) In 2018, the Securities and Exchange Commission ("SEC") warned that the use of blockchain technology or automated smart contracts would not exempt token issuers or exchanges from complying with federal securities laws. (13) But the SEC did not clarify how its rules would apply to decentralized protocols, and so far, the agency has been slow to bring enforcement actions. (14) Scholarly attention on this subject is sparse. Previous articles have proposed new frameworks for regulating the DeFi industry, (15) but have not analyzed how existing regulations may apply to today's leading protocols.

This Note answers the question of whether the SEC has a legal basis to charge Uniswap, a peer-to-peer cryptocurrency trading platform, for violating the Securities Act of 1933 ("Securities Act") and the Securities and Exchange Act of 1934 ("Exchange Act"). (16) Uniswap is one of the largest decentralized exchanges (17) by trading volume today, (18) completing roughly $2.6 billion in cryptocurrency asset trades per day. (19) Uniswap's native token, UNI, is also the twentieth most valuable cryptocurrency in the world, with a market capitalization of around $10 billion dollars. (20) Because of its size and stature, Uniswap's status under federal securities laws is likely to implicate not only other noncustodial exchanges, but also the DeFi industry as a whole. (21)

The following analysis will address whether Uniswap and UNI qualify as an "exchange" and "security" under federal securities regulations. (22) To examine whether the UNI token is a security, the analysis will compare Uniswap to DAO, a decentralized investment fund (23) whose token (DAO) was classified as a security by the SEC in July of 2017. (24) To assess whether Uniswap is an exchange, this Note will examine the SEC's case against the founder of EtherDelta, who was charged in November of 2018 with operating an unregistered securities exchange. (25) This Note will also consider eighty-two (82) crypto-related SEC enforcement actions (26) in order to assess the likelihood of the SEC bringing charges against Uniswap.

2. BACKGROUND

   1. Decentralized Exchanges

      Cryptocurrency exchanges facilitate the buying and selling of cryptocurrency assets for other cryptocurrency assets or fiat currencies like USD. There are two types of cryptocurrency exchanges. Centralized exchanges ("CEXes") like Coinbase function as trusted intermediaries: they take custody of users' funds and ensure that their orders are fulfilled. (27) Decentralized exchanges ("DEXes") like Uniswap provide platforms for buyers and sellers to transact directly. (28) They route cryptocurrency assets between two users' cryptocurrency wallets without taking custody of either users' funds, (29) thereby reducing the risk of third-party censorship or control. (30)

      There is no single, universally accepted definition of "decentralization." Many applications that are nominally decentralized are actually hybrids of centralized ("off-chain") and decentralized ("on-chain") elements. (31) For example, on one of the first DEXes to be widely used, trades were matched on order books stored on central servers (offchain) before being executed on-chain on Ethereum. (32) Subsequent DEXes eliminated off-chain order books by matching trades directly on the blockchain. (33) These DEXes host reserves ("liquidity pools") against which users can trade at market prices at any time. (34) When trade orders are received, smart contracts instantly settle the transactions on the blockchain without waiting for a counterparty to take the order. (35)

      The most popular DEXes today rely on smart contracts called Automated Market Makers ("AMMs") to set buy and sell prices for the tokens they allow users to trade. (36) Bancor, a DEX founded in 2017, (37) has been credited with popularizing AMMs. (38) Bancor's original AMMs adjusted prices for a given token based on the ratio of Bancor's reserve of the token and the token's total circulating supply. (39) Subsequent AMMs set token prices using a different algorithm that compared the ratio of two tokens in a token reserve. (40) By initially combining the tokens in each liquidity pool to amounts that produced equal value, the AMM formula could automatically set the token price based on the relative sizes of the two token reserves and the sizes of incoming trades. (41)

      Over the past year, DEXes have grown considerably in both size and importance. In June of 2020, a sudden surge of activity on Uniswap and other DEXes caused aggregate trading volumes on decentralized exchanges to increase from $1.8 billion to $4.8 billion in less than one month. (42) Since then, DEX trading volumes have continued to rise, surpassing $18 billion in November of 2020, $60 billion in January of 2021, and $161 billion in May of 2021. (43) The leading DEXes today are less than five years old (44) and their protocols are still being updated. (45)

   2. Uniswap

      Uniswap is a platform that facilitates trades of digital tokens. It is widely considered the leading DEX, often controlling more than half of total DEX trading volumes (46) and accounting for more than three-quarters of all DEX users on Ethereum. (47) Uniswap's recent growth has raised questions about its status under federal securities regulations. (48) Unlike its centralized counterpart, Coinbase, which has taken steps to acquire a broker-dealer license and other licenses, (49) Uniswap has not registered any aspect of its ecosystem with the SEC. The native token, UNI, is not registered as a "security," and the trading platform itself is not licensed as an "exchange" or otherwise exempted from federal registration requirements.

      Uniswap's original protocol was developed by 24-year-old programmer Hayden Adams (50) and deployed on Ethereum in November of 2018. (51) The V1 protocol was written to allow instant, on-chain settlement of token-to-token transactions. (52) For every pair of tradable tokens, there is an exchange "contract" and a liquidity pool. (53) The latter is simply a reserve of the two tokens that is combined in amounts that produce equal value. (54) When users submit orders to trade, token prices are determined dynamically using Uniswap's AMM formula (x*y=k). (55) With each trade, liquidity providers ("LPs") whose tokens make up the liquidity pool collect fees in proportion to their shares of the reserve. (56)

      In May of 2020, an updated protocol known as Uniswap V2 was launched by Uniswap Labs. (57) Unlike Uniswap V1, which only allowed swaps of ERC20 tokens and Ether ("ETH"), Uniswap V2 enabled trades of any ERC20 token for another. (58) About one year after the launch of V2, (59) Uniswap V3 added several features to offer greater flexibility for both liquidity providers and traders. (60) One feature known as concentrated liquidity allows LPs to designate specific price ranges within which to offer liquidity. (61) By concentrating their capital (i.e., tokens) in price ranges at which they prefer to sell, LPs can multiply their potential yields.

      The current version of Uniswap consists of the Uniswap V3 smart contract protocol and a web interface that can be accessed online. (62) Trading on Uniswap does not require sign-up. There are no accounts, deposits, or withdrawals (hence, no Know-Your-Customer ("KYC") procedures). (63) To trade, the user simply connects her wallet, chooses a token pair (e.g., ETH to UNI, or UNI to DAI), and enters the volume she intends to sell. (64) Uniswap displays the tokens' exchange rate and the amount of the liquidity provider fee. (65) When the user clicks to trade, the Uniswap smart contract routes the tokens between her cryptocurrency wallet and the corresponding...