Is the SEC Targeting Uniswap and Ethereum’s DeFi sector?

Posted on Sep 30, 2021 | BLOG


How are decentralized and centralized exchanges different?
Is Uniswap decentralized or transparent?
The Howey Test and Crypto
SEC increasingly targets DeFi
How can the SEC vs Uniswap impact the DeFi space and Ethereum?


Uniswap Labs (UNI), lead developer of Uniswap, one of the world’s largest decentralized cryptocurrency exchanges, is under investigation by the U.S. Securities and Exchange Commission (SEC), according to the Wall Street Journal.

While the SEC and Uniswap declined to comment, anonymous sources say that the securities regulator is looking into the leading Ethereum DEX’s marketing and investor services. This could be due to a number of actions undertaken by Uniswap that have raised industry eyebrows about how decentralized and transparent the protocol actually is.

For example, Uniswap made waves in 2020 when it airdropped 400 of its UNI governance tokens to every user who interacted with its platform.

In 2021, the automated market maker (AMM) also unveiled its Uniswap V3 version, which greatly improved on its second iteration, and was also its first version to be licensed for reuse. Developers had to apply for a license to repurpose the latest software. This was seen as a direct response to the exploitation of its intellectual property by copycat projects such as SushiSwap.

It’s possible that the SEC could interpret these actions as being consistent with the actions of a company that is unlawfully offering securities, which is what Ripple is currently being accused of.

The SEC Uniswap rumors come on the back of an increasing focus by global regulators on the decentralized finance (DeFi) industry, as well as targeted comments by Gary Gensler, the SEC chairman on DeFi.

How are decentralized and centralized exchanges different? 

Uniswap is an Ethereum-based cryptocurrency exchange that is automated and uses its own governance token, UNI. It pushes through as much as $1.5 billion in transactions a day, collecting a small trading fee each time.

Unlike centralized exchanges such as Binance or Coinbase, Uniswap is decentralized. This means that it is not owned or operated by a single entity, but governed by holders of UNI, which vote on important decisions.  This currently protects it against regulations.

Decentralized exchanges have no single owner to hold funds, so they don’t directly operate as a third party like centralized exchanges. Instead, Uniswap creates an automated liquidity pool. Its users contribute their money to a pool for that particular cryptocurrency or token, and this fund is used to execute all trades on the platform.

This removes the wait time that typically exists for a user to find someone on the other end of their trade, be it buyer or seller. This also benefits the liquidity provider, as they receive a fair fraction of the trading fees for the transactions of their particular pool.

This lack of direct interaction with third parties creates a barrier of anonymity for users, as they do not have to personally give or receive funds with the DEX, Uniswap. Only a wallet is required for users to interact with other Uniswap users, meaning no personal information is required.

DEXs also provide a larger range of coins than their centralized counterparts. For example, Uniswap supports thousands of Ethereum-based ERC-20 tokens.

On the other hand, centralized exchanges require you to place your funds into their control. This means that they will operate as a broker to complete your exchange, be it swapping or for fiat, then give you permission to withdraw them once the transaction is complete.

Centralized exchanges are required to record and provide personal information to comply with anti-money laundering (AML) regulations like the FATF Travel Rule. This is an easy task to complete for centralized exchanges. On the other hand, DEXs do not have the same capacity to identify users, report and record transactions, and send them to the federal government.

Is Uniswap decentralized or transparent? 

This begs the question, is Uniswap truly decentralized, and if not, should it be regulated?

Uniswap is unusual in that it is one of the major DEXs operated and based in the United States, where the SEC has jurisdiction. Yet the DeFi space is currently not regulated in the U.S.

DeFi operates on 2 core tenets: decentralization and transparency. Many detractors have voiced their doubts whether Uniswap meets any of these 2 requirements. 

Uniswap issued 150 million UNI tokens in an airdrop in 2020, with 60% going to its community and 40% going to Uniswap’s team and investors. The UNI tokens are used to make community decisions according to a quorum’s voting. Uniswap’s tokens are supposed to be vested over 4 years, yet no schedule has been released.  Moreover, the team’s tokens are not locked in a smart contract. Rather, they are completely liquid and stored at regular ETH addresses, which means they can be used at any time.

It’s certainly worrying for a decentralized project to have 40% of its voting power concentrated in the hands of its creators and friends. It may be too close for comfort to the 51% mark required to push through majority votes.

Finally, Uniswap Labs pushed through the protocol’s V3 update without any opposition or submitting it to the community for a governance vote. Therefore, users have expressed doubts on how the company impacts the protocol’s developments, especially considering its control over the platform’s user interface as well as access to tokens.

This lack of transparency and decentralization might have triggered the SEC’s attention and made it review Uniswap’s operations. The SEC may review it against U.S. legislation like the so-called “Howey Test”, a cursed term that crypto companies in the U.S. try to avoid at all cost.

The Howey Test and Crypto

The Howey Test comes from the SEC vs Howey (1946) case, which defined what constituted a security according to these criteria:

“…If there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”

In that case, the transaction must be disclosed and is subject to registration requirements under the Securities Act of 1933 and the SEC.

Based on Uniswap’s centralized behavior surrounding its UNI token, it is likely that the SEC may feel that it has a securities case against Uniswap. This could have a devastating impact on its continued legality of operations as well as the regulation of other DEXs. As the biggest Ethereum DEX, such actions will severely hurt the network activity and price of Ethereum due to lower demand.

SEC increasingly targets DeFi

The SEC is infamous for its skirmishes with the crypto industry and its reluctance to allow a Bitcoin ETF. Therefore some crypto entities view it with hostility and blame its interventions for holding back the crypto market’s mainstream adoption.

Uniswap’s investigation could be the beginning of more stringent stateside cryptocurrency regulation. During the 2021 Aspen Security Forum, SEC Chair Gary Gensler spoke at length about his personal worries regarding cryptocurrency, and more specifically, DEX platforms. 

Gensler pointed out three of his concerns with cryptocurrency and its future in the financial sector. These include:

  • Consumer and investor protection
  • Ensuring financial stability
  • Guarding against illicit activity

The first two concerns can be addressed by exchanges and token creators, as they share these same concerns. However, it’s difficult for DEX exchanges to protect against “illicit activity”; DeFi software creators do not make it easy to identify users. It’s certainly possible that DEX developers could already be implicated in wrongdoings. 

How can the SEC vs Uniswap impact the DeFi space and Ethereum?

The DeFi, DEX and NFT sectors have driven the stellar rise of Ethereum since 2020. Ethereum, the world’s second biggest cryptocurrency, went from under $100 to over $4,000 in value. This can due to a greater need for Ethereum for the purposes of staking, yield farming and acquisition of ERC20 tokens offered by hundreds of new projects.

The SEC’s investigation against Uniswap is still unconfirmed and could just be industry “FUD”. However, it does raise several questions about the nature of Uniswap’s operations that will likely affect players in the DeFi Space, forcing them to get their houses in order to fortify them against potential sanctioning by regulators.

Many projects take a rather lax approach to regulations as they figure that their decentralized nature and community governance exclude them from current regulations. It’s clear that things are not as simple as that.

Could DEX’s  be considered responsible for their provided assets, making anything traded on their platform a “security” and create a whole new set of licensing and reporting requirements? While this is unlikely, this will temporarily restrict the DeFi space in the U.S. In turn, it will cause the U.S. to fall further behind in the global blockchain arms race, leading to an exodus of their best projects for greener pastures.

To their credit, Uniswap Labs stated to The Wall Street Journal, that they are “committed to complying with the laws and regulations governing our industry and to providing information to regulators that will assist them with any inquiry.”

What this entails yet, is uncertain at present. It will certainly take more than lip service, and could very well show the way for the DeFi industry to stay in the good graces of regulators.