Blogs from September, 2024

The CFTC’s Case Against Uniswap: Dissent, Innovation, and the Call for Clearer Rules

R Tamara de Silva

On September 4, 2024 the U.S. Commodity Futures Trading Commission (CFTC) published an order settling charges against Universal Navigation Inc. d/b/a Uniswap Labs, a domestic U.S. company. Uniswap Labs is the developer of the decentralized finance (DeFi) platform Uniswap.

The enforcement action centers on Uniswap’s offering of leveraged and margined digital asset transactions involving Bitcoin and Ether to retail investors who did not qualify as eligible contract participants (non-ECPs).[1] According to the CFTC, these trades violated Section 4(a) of the Commodity Exchange Act (CEA) by bypassing regulated exchanges and failing to meet specific exemptions required for such transactions.

Background

Through the Uniswap platform, users could trade in various liquidity pools, which are collections of digital assets locked in a smart contract. How this works is when users deposit their tokens into these pools, they help ensure there is enough liquidity—meaning there are sufficient assets for others to buy and sell easily. In return for providing their tokens, users earn a small fee each time a trade is made using the pool. This system allows decentralized platforms like Uniswap to function without relying on traditional intermediaries, such as banks or brokers, to facilitate trades. Instead, the smart contract handles the transactions automatically.

Among the assets traded on Uniswap were certain Leveraged Tokens developed by a third party unaffiliated with Uniswap Labs. These tokens, such as BTC 2x Flexible Leverage Index (BTC2XFLI) and ETH 2x Flexible Leverage Index (ETH2XFLI), allowed users to gain roughly double (2:1) the price movement of Bitcoin or Ethereum. For example, if the price of Ethereum rose by 10%, someone holding the ETH2XFLI token could see a 20% return.

However, these tokens did not involve actual delivery of Bitcoin or Ethereum within 28 days.[2] Additionally, the platform did not restrict access to these leveraged tokens, allowing non-sophisticated retail users to trade them, leading to regulatory concerns under the Commodity Exchange Act.

Overview of the Enforcement Action

Between March 2021 and September 2023, Uniswap Labs enabled users to trade a variety of digital assets, including leveraged tokens. These tokens provided users with approximately 2:1 leveraged exposure to Bitcoin and Ether. Uniswap did not prevent non ECPs from accessing the leveraged tokens.

Uniswap Labs itself did not act as a liquidity provider or collect trading fees from these transactions, but it facilitated the trades through its platform.

In the settlement order, the CFTC concludes that these transactions violate Section 4(a) of the CEA. The leveraged tokens did not meet the legal exceptions that would have exempted them from regulation, nor did they satisfy the 28-day delivery requirement for such transactions. As part of its settlement with the CFTC, Uniswap Labs agreed to pay a $175,000 civil monetary penalty. This penalty was reduced due to Uniswap’s cooperation and remediation efforts. The settlement also includes a cease-and-desist order, ensuring that Uniswap complies with the CEA moving forward.

The settlement order is remarkable because of the powerful dissenting opinions of two CFTC Commissioners.

Commissioner Mersinger’s Dissent

Commissioner Summer K. Mersinger dissented from the enforcement action, expressing strong concerns about the CFTC’s approach to regulating DeFi. In her dissenting opinion, Commissioner Mersinger argues that the CFTC’s reliance on enforcement actions, without first providing clear regulatory guidance tailored to DeFi, is deeply flawed.

1. Regulation Through Enforcement

Commissioner Mersinger criticizes the Commission for applying outdated rules designed for centralized financial institutions to decentralized platforms like Uniswap. She argues that using enforcement to regulate without establishing clear guidelines will likely drive responsible DeFi innovators out of the U.S., harming innovation and economic growth.

2. Penalizing Compliance Efforts

Ms. Mersinger notes that Uniswap had proactively blocked the tokens at issue after a previous CFTC enforcement action. Despite this, the CFTC still brought charges based on the period before the tokens were blocked, which Mersinger saw as counterproductive. She warnes that such actions could discourage other DeFi platforms from taking steps toward compliance, fearing that past actions could still lead to penalties.

3. Misaligned Priorities

The Commissioner also questions the CFTC’s resource allocation. Uniswap Labs neither extended credit nor collected fees on the trades in question, and no fraud or market harm was alleged. Pursuing cases with no clear harm, she argues, diverts resources from addressing actual fraud, such as “Pig Butchering” scams that defraud retail investors on a massive scale.

4. Chilling Innovation

Commissioner Mersinger warns that holding DeFi platforms liable for all activities on their protocols, without clear standards, risks driving DeFi innovation offshore. She argues that this approach contradicts the CFTC’s stated mission to promote responsible innovation.

5. Call for Rulemaking

Finally, Commissioner Mersinger advocates for formal rulemaking to provide transparent, clear guidance to DeFi platforms. She emphasizes that the CFTC’s reliance on enforcement actions undermines its mission to support innovation while protecting markets.

Commissioner Pham’s Dissent

Commissioner Caroline D. Pham alsodissented, raising concerns about the legal and procedural basis of the action.

1. Lack of Evidence on Product Characteristics

Commissioner Pham points out that there was insufficient evidence in the record describing the characteristics of the "leveraged tokens" at issue. Without this information, she argues, it was impossible to determine whether the CFTC even had jurisdiction over these products.

2. Overly Broad Legal Interpretation

Ms. Pham criticizes the CFTC’s reasoning as overly simplistic. She argues that simply labeling a token as "leveraged" does not automatically bring it under the CFTC’s jurisdiction. She raises concerns about the far-reaching implications of this logic, suggesting that if applied broadly, it could disrupt even routine commodity transactions in the broader economy.

3. Violation of the Administrative Procedure Act (APA)

Commissioner Pham argues that the CFTC violates the APA by creating new legal interpretations without engaging in formal rulemaking. She emphasizes that major regulatory changes should be handled transparently, with public input, rather than through enforcement actions.

4. Regulatory Overreach

The Commissioner asks if the CFTC would have taken this approach in anything other than DeFi. She poses the hypothetical of cows being purchased using financing and asks if the delivery of said cows took 29 days and not 28 days-would the farmers have to have completed the transaction on a regulated futures exchange and not a stockyard?

5. Stifling Innovation

Commissioner Pham views the enforcement action as regulatory overreaction. Stating that DeFi represents a transformative shift in market structure and urging regulators to take a more thoughtful, forward-looking approach that balances protections with the need to promote innovation.

6. Jurisdictional Turf War

Ms. Pham suggests that the CFTC’s action may have been driven by a desire to claim jurisdiction over DeFi ahead of the Securities and Exchange Commission (SEC). She urges the CFTC to focus on addressing fraud and manipulation, rather than expanding its jurisdiction through enforcement.

Broader Regulatory Implications

The CFTC’s enforcement action taken against ZeroEx, Inc., the developer of the 0x Protocol and Matcha DEX aggregator, followed a similar path. Much like Uniswap, ZeroEx’s Matcha interface allowed retail users to trade digital assets, including leveraged tokens that provided approximately 2:1 exposure to Bitcoin and Ether, in violation of Section 4(a) of the CEA. The CFTC found that ZeroEx’s peer-to-peer trading system enabled retail customers, who were not ECPs, to engage in leveraged transactions without requisite protections or regulatory oversight.

The parallels between these enforcement actions show the CFTC’s consistent approach: targeting platforms facilitating off-exchange transactions involving retail users and requiring them to conform to the centralized regulatory model, even though DeFi protocols fundamentally operate in a decentralized manner. The CFTC’s recent actions demonstrate that it is targeting DeFi protocols, whether or not instances of fraud have occurred.

From a regulatory risk perspective, this also suggests that only larger hedge funds and institutional investors (ECPs) may be able to engage with DeFi platforms. This, in turn, could serve as a disincentive for DeFi platforms to ever allow US customers or as in the case of Uniswap, domicile in the United States. There are many other law firms that facilitate their US customers using centralized crypto exchanges that are prohibited to US customers counseling selective foreign registration, the establishment of holding companies to mask beneficial ownership, and VPNs. The ethics of this legal advice is another matter and beyond scope of this article.

A nagging and broader question though remains unanswered by the enforcement actions taken against DeFi since 2022: How do you make something decentralized, centralized?

DeFi protocols, by their very design, are decentralized and operate through smart contracts that execute peer-to-peer transactions. In contrast, centralized commodity exchanges are highly regulated entities that rely on intermediaries, like brokers and clearinghouses, to ensure regulatory compliance, manage risk, and supervise transactions. The centralized structure of traditional exchanges allows for clear lines of accountability, while DeFi protocols distribute control across a network of users, complicating efforts to apply traditional regulatory models.

Put another way, in what way(s) are DeFi protocols like centralized financial exchanges? Instead of a case by case discovery of the answer to this question through enforcement actions, wouldn’t clearer guidance be better for all sides? DeFi is about disintermediation, and removing the layers of intermediaries found in traditional finance. While registering may seem like a straightforward expectation, enforcing requirements like know-your-customer (KYC) programs presents a serious challenge for many DeFi protocols for the simple reason-who will be tasked to perform this and other functions?

Conclusion

Commissioners Mersinger and Pham both voiced strong dissent regarding the CFTC’s enforcement action against Uniswap Labs. Commissioner Mersinger warned that the CFTC’s reliance on enforcement actions, rather than clear regulatory guidance, could stifle DeFi innovation and misallocate regulatory resources. Commissioner Pham raised significant legal concerns, questioning the CFTC’s jurisdiction over the leveraged tokens and criticizing the agency’s failure to engage in proper rulemaking.

This case, much like the ZeroEx enforcement action, illustrates the tension between the important function of regulators to protect the public and the integrity of the financial markets while not driving DeFi completely away from the US and US customers. If the latter were to happen, the CFTC may be less able to protect US customers. It is time for more holistic guidance, and informed rulemaking to create a framework that fosters both innovation and compliance.

One of the persistent flaws of regulation by enforcement is that it deprives parties of truly fair notice of the what the regulations are so that they can avoid non-compliance.