US SEC lawsuit targets Uniswap

The U.S. Securities and Exchange Commission (SEC) issued a warning to UniSwap Labs on Wednesday, saying it may file an enforcement lawsuit against the company. UniSwap Labs is the initiator of the decentralized trading protocol UniSwap Protocol, which is the leading protocol in the DeFi field. Since its launch five and a half years ago, its trading volume has exceeded US$2 trillion, accounting for 55.5% of the total trading volume of the decentralized trading market.

The warning was issued in the form of a Wells notice, which represents an informal reminder that the SEC will send to the companies involved before formally filing a lawsuit, providing the companies with a last chance to refute the allegations. Of course, receiving a Wells notice does not mean that the SEC will definitely file a lawsuit. In short, this is the last chance to defend, and the recipient can provide evidence and arguments to the SEC in an attempt to convince the SEC not to take action. If the SEC decides to proceed, it will file a formal lawsuit and issue a "civil complaint." But in general, the Wells process is just a formality. Rumor has it that the agency has been investigating UniSwap for quite some time, and the SEC is seeking to launch a comprehensive crackdown on the cryptocurrency industry.

"The SEC does not comment on the existence of a potential investigation," a spokesman for the agency said in an interview.

At present, the specific nature of the SEC's charges against UniSwap Labs is not yet known - although the company built the eponymous protocol UniSwap Protocol, it is not the core controller of the protocol. Judging from the SEC's previous lawsuits against high-profile cryptocurrency companies such as Coinbase, the nature of the lawsuit is likely to be illegal offering of unregistered securities to the public, or failure to register as a broker or compliant exchange.

The facts have also been confirmed to a certain extent. At a press conference on Wednesday afternoon, UniSwap COO Mary-Catherine Read and Chief Legal Officer Marvin Amory told reporters that the content of the Wells notice focused on UniSwap as an unregistered securities broker and an unregistered securities exchange, but it was not clear whether UniSwap’s native token UNI was implicated as a potential security in the SEC notice.

The lawsuit UniSwap faces comes at a delicate time, as the cryptocurrency industry is complaining about the SEC. The industry generally believes that the SEC is overly arbitrary in dealing with issues in the crypto field, taking enforcement actions without clear rules, and not taking into account the uniqueness of cryptocurrencies based on blockchain and decentralization. SEC Chairman Gary Gensler countered that existing securities laws are clear, and the cryptocurrency industry sought special treatment but did not comply with the law - a view shared by the White House, especially Gensler's powerful ally, Democratic Senator Elizabeth Warren.

Of course, historically, the SEC has had a lot of clashes with the cryptocurrency industry, with several high-profile lawsuits, Coinbase and Ripple being the case, focusing on the SEC’s jurisdiction over digital assets and how the Supreme Court’s 1946 test for the definition of securities should be applied to cryptocurrencies.

These lawsuits are ongoing, with mixed results. Both sides have had the upper hand at one point, but recent rulings have shown that the SEC, as a regulator, still has a relatively leading advantage in law. However, in this lawsuit, given the uniqueness of DeFi technology and UniSwap Labs' legal victory in a class action lawsuit last year, the outcome of the UniSwap case is still unpredictable.

In terms of significance, since the outbreak of DeFi in the summer of 2020, DeFi has become a crucial segment of the crypto market, and the leading UniSwap protocol has completed more than 2 trillion US dollars in transactions. The mainstream financial community is also paying more and more attention to its underlying technology. Therefore, the outcome of the lawsuit between the US SEC and UniSwap Labs has far-reaching impact.

Unlike traditional brokers or cryptocurrency exchanges, DeFi platforms do not have a central institution as a counterparty or an institution to match buyers and sellers for transactions. Instead, they rely on automated protocols that are purely supervised by code, which set basic requirements such as trading rules and collateral.

In the case of UniSwap Labs, founder Hayden Adams wrote the original underlying code that provides the basis for the protocol, and the company provides users with an interface for trading certain crypto tokens. The protocol itself is open source and has been referenced by many other projects in the DeFi field. Based on the open source Uniswap code, users can directly participate in market transactions without any middlemen under the premise of self-custody of their property.

This particularity is particularly important for UniSwap Labs' defense. In fact, UniSwap already has relatively rich experience in responding to lawsuits. As early as April 9, 2022, the US law firm Kim & Serritella and Barton announced the initiation of a securities class action lawsuit, accusing Uniswap Labs and defendants such as Paradigm and a16z of violating securities laws and issuing and selling unregistered securities in the form of digital tokens on the UniSwap platform, including Uniswap's governance token UNI.

The lawsuit argues that UniSwap should be held liable for harmed investors. In the case, the plaintiff uses a car analogy, arguing that Adams’ mechanism actually created a dangerous self-driving vehicle that went out of control.

UniSwap Labs also responded to this, arguing that the technology it developed is neutral - the company has no control over the operations performed by other third parties using the technology.

The judge apparently agreed with this view. On August 29, 2023, the case came to an end. Court documents from the United States District Court for the Southern District of New York show that the UniSwap platform is capable and in many cases operates legally; there is no transaction between the plaintiff and the UniSwap platform and protocol; current securities laws do not seem to cover the liability of the DeFi protocol itself for using it to defraud others.

The judge held that the plaintiffs were harmed by fraudulent token issuers who used UniSwap’s core contract to scramble for funds, and that UniSwap created the platform in which the fraudulent token issuers committed fraud, which did not mean that Uniswap was liable for the fraud and the resulting damages, at least under U.S. securities law.

In the SEC's lawsuit against Coinbase last month, although the judge refused to dismiss the company's allegations of providing illegal securities, it ruled that the decentralized wallet provided by Coinbase could not be considered a broker under the jurisdiction of the Securities and Exchange Commission. This ruling also provides a strong example for UniSwap, because it also mainly operates through wallets and DAPPs. But it is worth noting that the ruling did not include the display interface that the company has permission to control, which has highlighted tokens that were later identified as securities by the US SEC in the past.

Overall, citing the opinion of Web3 lawyers, the SEC's lawsuit against the company still faces many challenges. First, transactions based on the UniSwap protocol are difficult to be subject to securities law. In the previous Risley vs. UniSwap Labs case, the presiding judge clearly stated that due to the neutrality of the company, transactions on Uniswap are not subject to securities law, and proposed that "the determination of whether it is a security or not is best determined by Congress."

Secondly, compared with many cryptocurrencies that can be traded directly, UniSwap is based on an open source protocol, and the applications and wallets involved do not meet the legal definition of a securities exchange or broker according to the original rules.

Finally, UniSwap’s own token UNI is a governance token and only a single-function token. It does not meet the legal definition of any type of securities, including the definition of an “investment contract.”

In addition, since the developer of TornadoCash was imprisoned, UniSwap itself has also been walking on thin ice. According to BlockBeats, UniSwap has taken a fully compliant approach in team operations: all American executives, employee recruitment and welfare policies that fully comply with US laws, and a legal approach to the separation of open source protocols and development entities.

Perhaps it is for this reason that UniSwap is confident in its compliance. In an open letter, the founder of UniSwap clearly stated that he believed in the legitimacy of the products provided by the company and believed that the company was on the right side of history. He also expressed dissatisfaction with the unclear SEC rules, questioned the SEC's regulatory capabilities using FTX as an example, and even stated at the end of the letter that he would not give up the lawsuit and might appeal to the Supreme Court, which shows his determination to fight.

A person familiar with UniSwap Labs’ case said the company was prepared to fight a “worthy fight” in court, and said the company’s choice to take root in New York City rather than operate overseas in broad daylight was a direct reflection of its legitimacy.

Although it seems to be arguing on its own merits, UNI is still under severe pressure due to the impact of the lawsuit. According to market data, under the influence of the news, the price of UNI has fallen from $14 to the current $9.38, a 24-hour plunge of more than 16.88%. Coincidentally, just one day before the SEC issued a warning, the UniSwap team/early investor-related wallet sold 15,000 UNIs on the chain at an average price of $11.18. Even though this is a drop in the bucket compared to the market value, it still caused some concerns among some people.

From the SEC's perspective, it is doubtful why it filed a lawsuit without sufficient certainty. Some people believe that this is just a display of confrontation. After all, the conflict between the SEC and the industry has already broken out. With the election approaching, the SEC may also be under more political pressure. The passage of the Bitcoin ETF has been criticized by many opponents, so it is eager to have a targeted incident to prove its professional position. With the top centralized trading platforms already locked up, it will extend its tentacles into the decentralized field.

But on the other hand, according to industry analysts, the two new rules passed by the SEC on February 6 this year seem to have made the lawsuit confusing again.

The final rule states that market participants who perform certain dealer roles, particularly those that assume a significant liquidity-providing role in the market, must register with the SEC, become a member of a self-regulatory organization (SRO), and comply with federal securities laws and regulatory obligations. According to the final rule, “any person who engages in the activities described in the rule is a ‘dealer’ or ‘dealer in government securities’ and, absent an exception or exemption, is required to: register with the Commission under Section 15(a) or Section 15C, as applicable; become a member of an SRO; and comply with federal securities laws and regulatory obligations and applicable SRO and Treasury Department rules and requirements.”

According to the content, whether the automated market makers in Defi and the largest liquidity providers in a certain trading pair are included is still worth discussing. If so, it means that UniSwap and even Defi will face challenges in new directions. But on the positive side, if UniSwap wins this time, it will clear key obstacles for Defi and become the cornerstone for the encryption field to move towards large-scale application.

Success or failure, perhaps, depends on this one move.