Legal Issues Facing DAOs and DeFi Projects: An All Inclusive Guide
With the emergence of blockchain comes the development of new technologies such as Decentralized Autonomous Organizations (DAOs) and Decentralized Finance (DeFi). Almost all blockchain-based solutions guarantee efficient and effective organizational and financial governance without centralized authority. But this aspect of decentralization brings with it a variety of legal issues for DAOs and DeFi projects. There is no central authority to define or adjudicate boundaries which makes it difficult for the projects to define legal frameworks that cover compliance requirements they face.
In this post, we will identify the legal troubles for DAOs and DeFi and try to analyze these concepts of systems and technologies in relation to their legal facets. This is an important read for anyone looking to understand the legal issues surrounding decentralized systems, no matter their level of expertise.
What would be a DAO and DeFi?
One must note the function of DAOs and DeFi before heading to the legal complications. It can be helpful in addressing legal complications later on.
What is a DAO?
DAO stands for Decentralized Autonomous Organization, which means an organization ran by people as opposed to a single entity, unlike in traditional hierarchies. Such organizations operate on blockchain and is governed by “smart” contracts. Members of a DAO have a decentralised authority as opposed to simply being governed. Each member is given a governance token which they can utilize to vote on issues ranging from funds allocation to the overall future direction of the organization.
For instance, consider a scenario where a set of individuals use their AI to contribute towards a set goal or project. Rather than employing a chief executive officer and a board of directors, they create a DAO to make every choice vote based to enable complete contribution to decisions such as spending the funds, which projects are chosen and funding those projects. This decentralised style maximises transparency and practically eliminates the chances of incompetence and corruption.
This approach lacks central authority which causes legal complications such: who is held accountable in case something goes wrong. These inquiries are what legal specialists are struggling to respond to.
What is DeFi?
DeFi means Decentralized Finance. It refers to monetary activity on a blockchain that does not utilise a monetary intermediary like a bank or a broker. Instead of using a centralized institution, DeFi platforms utilize smart contracts to perform automated processes like lending, borrowing, and trading.
For example, let’s say you want to get a loan. In the traditional way, you would have to use a bank, give collateral, and wait for permission. With DeFi, all you have to do is get onto Aave or Compound, put some crypto down as collateral, and voila! You’ll get a loan instantly, only with the help of a computer program.
Nowadays, DeFi is becoming more popular because it offers an innovative way to include everyone into the financial world. However, it creates a lot of legal issues. How do you manage a system that is borderless and has no controlling body? What if there is a failure in a smart contract? These are just a handful of the obstacles that DeFi projects have to deal with today.
Lack of Clarity with Rules and Regulations for DAOs and DeFi.
One of the main legal controversies for DAOs and DeFi projects is the lack of clear rules. Different governments and regulatory bodies across the globe are finding it hard to keep pace with developments in the blockchain world.
Legal Framework for Smart Contracts.
Smart contracts serve as the foundation for DAOs and DeFi platforms. These contracts are executed automatically once the conditions stipulated within them are satisfied. Still, smart contracts are regarded as legal gray areas in several regions.
For instance, is there an accountable party in the case of a failed or exploited smart contract? Are the contracts binding in the legal sense? These questions bring to light the necessity for comprehensive legal systems to oversee smart contracts.
Questioning Overall, At Last Do DAOs Have to Register With Legal Establishments?
As of now, Most DAOs do not possess any legal standing and can conduct their operations without any formal legal standing. This absence of legal identity poses barriers to forming contracts, getting a bank account, or abiding by legal and taxation requirements.
Some DAOs have tried to tackle this problem by becoming registered legal entities like an LLC or a cooperative. This is indeed a solution to the problem, but these strategies can be very difficult and might compromise the reason behind why such an entity was formed.
Can DAO members be held legally accountable for its activities?
Another important question is whether members from the DAO group can be held legally accountable for specific actions within the organization. In normal companies, the liability is usually with the chief executive or directors. In a DAO, there is no upper level hence responsibility cannot be allocated.
For instance, in a situation where a DAO is being litigated for a breach of a contract, who would carry the burden? Would it be the members who took part and supported the vote or the developers who executed the smart contract? Most jurisdictions do not have answers to those questions.
Obstacles for Compliance with DAOs and DeFi.
At the same time, compliance is another legal hurdle for DAOs and DeFi projects. Because the systems is decentralized, abiding by current financial rules and regulation is a challenge.
Kyc and AML Compliance
For a customer KYC (Know Your Customer) and Anti Money Laundering (AML) policies, users of any financial services are expected to provide their identity details and transactions of certain amounts are monitored. The problem is that many defi platforms are pseudonymous which is problematic in policing.
For instance, DeFi lending platforms such as these do not have KYC policies that can be abused, thus exposing themselves to money laundering activities. Such cases of non-compliance result in a lot of attention from regulatory authorities and legal complications for the company.
Are Other DeFi Protocols Legal Financial Institutions?
Assessing DeFi protocols for legal qualification has always been a gray area – are they financial institutions as defined in law? If they are, then they have to operate within strict legal bounds pertaining to licensing and reporting.
With regard to particular DeFi platforms, the USA SEC has taken a strong position. As a result, they have been embroiled in a lot of litigation, and such fights have added stress and burden of compliance on DeFi projects.
What Global Regulators Have To Say
Global regulators are showing interest in DeFi as well, like FATF. FATF has set rules that VASPs must follow AML and KYC measures. The main issue presents in these steps is the implementation on distributed platforms.
Taxation Questions for DeFi and DAOs
Taxing DeFi and DAOs is also a slippery slope. These systems, by their very nature being decentralized, and cross border in functionality, make compliance and reporting a challenge.
How Are DeFi Transactions Taxed?
Tax laws related to lending, borrowing, yield farming in DeFi can be quite complicated. These transactions often differ as there might be different laws in place in different countries.
For instance, in the US, the IRS classifies crypto as property, meaning every transaction could potentially be taxed in the form of capital gains tax. Because of this, DeFi users may find it difficult to comply with certain laws.
Are DAO Members Liable for Tax Reporting?
Similarly, members of a DAO also might have some tax duties to attend to. For instance, if the DAO makes profit, it might need to distribute it to members and those distributions would incur income tax obligations. However, the ambiguity of the laws makes it challenging.
Obstacles related to enforcement of cross border taxation are exacerbated with the vertical nature of DAOs and DeFi. It increases the difficulty of monitoring transactions across borders and obtaining tax compliance, especially with anonymous users.
Security and Consumer Protection Laws
Consumer security is an important concern in a DeFi project. With the decentralized structure of DAOs, it becomes extremely difficult to hold anyone responsible in the event of fraud or hacking.
Who is to blame for hacks and rug pulls done to DeFi?
Hackers tend to mainly focus on DeFi platforms and as a result a lot of money is lost. In some instances, developers have left projects with user’s money in hand, which is referred as ‘rug pulling.’
Determining the responsible party for these losses poses signficant legal obstacles. Are the developers, the users, or the platform at fault? Unfortunately, it seems that victims have little power with such laws in place.
Legal Action For the Case Of Lost Funds
On the same note, who is legally liable for losing money on a smart contract that failed? Traditional systems require a financial institution to have provisions for covering losses through insurance and other means. However, most DeFi platforms tend to function without such cover.
Coverage in DeFi and Rights Users Possess
There are some platforms in DeFi are trying to provide insurance coverage against losses. But the challenge is that their legal status is unknown and when it comes to disputes, users will not have sufficient rights.
In DAOs and DeFi how is Intellectual Property IP possessed?
Intellectual property is yet another challenge for DAOs and Defi projects. Many blockchain projects are of open source nature which poses distinct legal risks.
Can DAO Own Patents or Copyrights?
DAOs are usually worked on as open source projects, which means that their code is available for anybody to use and edit. But this begs the question, what about intellectual property? Can a DAO own patents or copyrights? If it can, how is enforcement done?
Legal Challenges in Open-Source and DeFi Projects
All open source DeFi projects face the same problem. Where a project that uses code from another open source project, who possesses intellectual property? What if a DAO programmed that code into their system? What would happen if a DAO breaches copyright laws?
Future of DeFi and DAO Regulations
How these legal hurdles are dealt with by authorities tends to dictate, to a large extent, the future of both DAOs and DeFi projects. Upcoming Global Regulations Countries are now starting to come up with regulations for blockchain technologies such as within the Europian Union’s (EU), where the Markets in crypto-Assets (MiCA) regulation aims to construct a one-size-fits-all policy for crypto assets.
Preparing for Legal Changes
Legal Changes on the Horizon DAOs and DeFi platforms need to pay attention to regulations coming, and how they can adapt. This could mean changes such as getting registered as legal entities, putting into place compliance policies, or engaging pro actively with regulators to help shape the policies.
Is it likely anymore for DeFi to shift policy?
One possible effect of more regulations is that DeFi may be able to become more consolidated, or rather controlled.
For instance, the platforms that users utilize may have to implement KYC and AML procedures which can increase the risk of the loss of anonymity and decentralization.
How Governments Are Regulating Decentralized Finance
Governments across the globe have varying approaches towards the regulation of DAOs and DeFi initiatives. While some choose to embrace these innovations, others choose to treat them as a potential danger to financial stability and move towards cracking down on them.
The United States
In the US, most regulators such as the SEC and the Commodity Futures Trading Commission (CFTC) are quite active when it comes to DeFi regulation. For example, the SEC has already designated certain tokens as securities, which means that there are strict rules regarding their registration and disclosure. The CFTC, on the other hand, has dealt with the trading of derivatives and futures on DeFi platforms.
Nevertheless, the absence of sufficient policies has led to uncertainty among project founders. Many are demanding an approach that is less favorable towards consumers, and which also facilitates innovation.
The European Union
The EU has approached the blockchain regulation problem in a more structured way. In 2020, it has passed the Markets in Crypto-Assets (MiCA) regulation, which is aimed at providing a single regulation for crypto assets for all member states. MiCA has provisions for operating DeFi platforms, that require them to comply with AML and KYC directives.
Even though MiCA is an important step towards regulatory improvement, the fact that it can burden smaller businesses with compliance issues within the scope of DeFi does make other critics question whether true innovation can be achieved at all.
India
When it comes to blockchain regulation, India’s stance has always been very slow. The government’s concern on the one hand is balanced by its interest on the other hand as it is actively looking for DeFi solutions. In 2022, the RBI issued a warning against private cryptocurrencies due to risks posed to financial systems and lack of proper consumer regulations.
On the other hand, India appears equally keen on formulating a central bank digital currency CBDC as this may simplify the problem for wider adoption of blockchain technology in other parts of the country.
One Concrete Example and Case Studies
To understand more deeply the issues with law and governance of DAOs and other DeFi projects, studying real-life projects is of great help.
The DAO Hack
A hack of The DAO was executed in 2016 and was called “The DAO” after the organization which lost its token. It led to the loss of more than $50 million of Ethereum tokens. This hacked brought into the mainstream attention the worrying weaknesses of smart contracts and posed shocking issues about the legal standing of DAOs.
Instead, the Ethereum community mined the Ethereum blockchain offsetting the damage done by the hack. This decision to hard fork was far from consensus however. The arguments against it were mostly rooted in the idea that it went against the philosophy of irreversible blockchain technology. Defenders of this position deemed it an appropriate measure to secure funds for those who were harmed.
Uniswap and Regulatory Scrutiny
Uniswap is among the biggest DeFi platforms in the world. It feels the blunt of scrutiny from regulators everywhere. In 2021, the SEC opened a case with investigation on Uniswap Labs, the company that owns the platform, due to unregistered securities and compliance issues with financial regulations.
The case illustrates the difficulty of regulating platforms that are decentralized and operate with no central supervision.
Conclusion
The legal challenges for DAOs and DeFi projects are considerable, but they are far from impossible to overcome. There is the problem of uncertainty surrounding legal regulations as well as difficulty in meeting compliance requirements, but each of these systems exists within a fluid and transforming legal framework.
Provided that there is advance thinking and anticipating in combination with cooperation from regulators, it is very possible that DAOs and DeFi platforms will meet the challenges and keep on making more innovative solutions. The realm of DeFi and governance, epitomized by DAOs, is expanding and with it, the focus on maintaining control alongside protecting new ideas becomes just as crucial.
These paramount legal issues have to be dealt with immediately so that we can envision a reality where DAOs and DeFi projects coexist without restrictions together with users and economic stability.