Who’s Afraid Of (Suing) DeFi Entities? Spoiler: Tougher Than It Seems.

Last week’s financial news mentioned an investors’ failed attempt to file a class action against Uniswap
UNI
, a decentralized cryptocurrency exchange and automated protocol, which facilitates peer-to-peer trading based on blockchain technology.

DeFi, short for Decentralized Finance, refers to a set of financial services and applications built on blockchain technology that aim to recreate traditional financial systems and services in a decentralized manner. Blockchain technology is used in DeFi to create trustless and automated systems for various financial activities, such as lending, borrowing, trading, and much more.

For many, the decentralized, transparent, trustless, and automated nature of the blockchain heralded the brewing of a financial revolution to dismantle the foundations of traditional finance. In their utopic vision, the financial system could become an open one where users, not corporations, hold the keys to their financial futures. DeFi has sought to rebuild finance from scratch without its conventional gatekeepers which have rendered traditional financial systems inefficient, opaque and exclusionary. DeFi’s proposed antidote has been an architectural overhaul, redesigning financial systems around transparency, security, anonymity, and – most importantly – decentralization. From lending platforms to derivatives markets, DeFi applications promise to slash costs and frictions while providing programmable financial services to anyone with an internet connection.

Yet, DeFi’s purported benefits come saddled with largely unaddressed risks for average users. Without oversight, DeFi ecosystems could become breeding grounds for scams and manipulation. Code exploits or engineering oversights may leave user funds frozen or pilfered. Prices of volatile crypto assets swing wildly, oblivious to wipeout risks for amateur traders. For non-technical users, smart contract code may prove indecipherable, meaning DeFi platforms could conceal anything.

But the starkest risk stems from DeFi’s own DNA. Its decentralized premise eschews centralized authorities overseeing markets or intermediaries backing transactions. In other words – users have no recourse against losses. No regulator can penalize abuses of power or clawback vanished funds. In a much-anticipated ruling, several days ago, Southern District of New York Judge Katherine Polk Failla has confirmed this regulatory hands-off approach. In the ruling, Judge Failla dismissed a lawsuit against leading decentralized exchange Uniswap Labs and other related parties, shielding the platform and its deep-pocketed investors from potentially massive liability over alleged “scam tokens” traded on their decentralized protocol.

The suit stemmed from major losses suffered by investors who poured money into dubious tokens that were traded on decentralized protocols and listed on Uniswap. When the tokens collapsed, angry investors looked to recoup their money. But in the decentralized world of crypto, the token issuers remain anonymous – leaving investors with no clear entity to target. Looking for a legal avenue to direct their case at, the allegedly scammed traders set their sights on the next best target: the very people responsible for creating Uniswap. The investors, who hoped that the court would address current gaps in cryptocurrency regulation, argued that while Uniswap calls itself decentralized, surely the real people behind it and the Venture Capital (VC) funds that bankrolled them could and should be held responsible for enabling these alleged scams.

In dismissing the suit outright, Judge Failla declined to plug the perceived regulatory gap.. Her nuanced ruling provided a first sketch of how courts may view decentralized systems within existing laws. For Uniswap and its investors, including powerhouse VC firm Andreessen Horowitz, the victory was a sweet relief. The hugely popular exchange dodged what could have been crippling liabilities. But DeFi developers saw even more at stake in this potentially precedent-setting case. The ruling touched on one of the fundamental tensions surrounding technology generally and crypto specifically: the battle between freewheeling technological innovation and the impulse to regulate new technologies. New DeFi platforms emerge constantly, with features evolving swiftly to outpace regulatory oversight. And while strict regulations could stifle DeFi innovation entirely, in their absence users are left in an extremely vulnerable position.

This concern has offered a rich foundation for scholars – like us – who are researching the legality of DeFi business models. In recent studies, we explored decentralized credit scoring models powered by cutting-edge FinTech, which have been evolving in the last decade. We uncovered a thriving ecosystem of DeFi platforms, facilitated by digital wallets, crypto assets, non-fungible tokens (NFTs) and smart contracts, that offer novel approaches to gauging the trustworthiness of crypto wallets and their owners. These scores aim to democratize finance by identifying safe counterparties, aligning with decentralization principles. But in pursuing this vision of financial inclusion, DeFi credit architects have entered legally ambiguous territory. Our research surfaced alarming fairness risks posed by these experimental scoring models, which lack oversight and remain untested in courts.

These risks stem from a collision of two cultures: the loose sensibilities of crypto avant-garde supporters versus the regimented rigor of credit rating veterans. DeFi developers dismissed the old rules of credit scoring as oppressive obstacles to inclusion and progress. But their creative efforts to code financial opportunity from scratch ended up repeating the sins of history. Revelations of coded inequality and structural exclusion highlight that DeFi may end up recreating some of the very flaws of traditional finance it aims to remedy. For now, decentralized credit experiments, as well as other DeFi ventures, operate in a glaring regulatory void, one that Judge Failla’s ruling not only acknowledges, but also declined to fill.

As decentralized platforms expand beyond finance into autonomous organizations, foundational governance and liability questions remain unsettled, as exemplified in the recent Uniswap case. In her ruling, Judge Failla declined to extend securities laws to cover the alleged conduct, pointedly noting “Plaintiffs’ concerns are better addressed to Congress.” We join Judge Failla in urging lawmakers to heed this guidance. Lawmakers should take a nuanced approach that provides regulatory clarity and effective consumer protection while avoiding limitations that stifle fintech innovation. This balanced approach entails advancing legislative definitions, standards and norms that address issues in the DeFi space while allowing the industry to continue developing. Regulatory wisdom, not regulatory restraint, is key to fostering DeFi’s rise responsibly. Done right, oversight can spur innovation, not stifle it.

This Op-Ed was co-authored with Yafit Lev-Aretz, a law professor at the Zicklin School of Business, Baruch College, CUNY.