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The End Of The Wild West For Decentralized Crypto Trading

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Decentralized Finance (DeFi) has been billed as Web3’s revolutionary response to the concentration of financial and political power in Web2. Decentralization also seemed to open an escape hatch for centralized crypto exchanges (CEXs) from the American regulators’ vast broadside against digital assets. 

At the same time, the deficiencies of the structure of Decentralized Autonomous Organizations (DAOs) have come out in stark relief, with the dissolution of Hector Network and Parrot Protocol, challenging much-touted Web3 governance structures to deliver promised innovation.

Ooki is not Okay

The founders of certain U.S.-based DAOs offering trading services hoped to avoid the wrath of regulators on the warpath with the DAO loophole. The trick was to remove all identifiable people and addresses and give up decision-making power to the user community. The founders would be obliged to stand in the shadows, collecting fees.

NOT SO FAST! The case of Ooki DAO (Ooki) definitively shut down hopes that they could avoid legal and regulatory exposure, setting various notable precedents.  

The larger DAO community was closely watching the case because it was the first time regulators had gone after a DAO and its token-holders. If you were thinking of setting up a DAO in the U.S., think again.

DAO Personhood & Collective Liability

The head of the CFTC’s enforcement division, Ian McGinley, declared, “The founders created the Ooki DAO with an evasive purpose, and with the explicit goal of operating an illegal trading platform without legal accountability. This decision should serve as a wake-up call to anyone who believes they can circumvent the law by adopting a DAO structure, intending to insulate themselves from law enforcement and ultimately putting the public at risk.” 

The CFTC’s novel theory was that all tokenholders who voted for the operation should be held liable for federal crimes.

One vital aspect of the court ruling against Ooki was the determination that the DAO is legally considered a person under the Commodities Exchange Act and subject to the same laws as any other organization. Arguments made by defenders of the crypto collective that a DAO is no more than a technological tool fell on deaf ears.

Why did Ooki become a DAO? 

Before Ooki’s existence, its founders ran a decentralized platform called bZeroX protocol, which offered leverage and margin trading services between 2019 and 2021. In November 2021, the protocol was hacked and drained of $55 million, after suffering two smaller hacks in 2020. 

Perhaps sensing that a law enforcement response could result from all the media attention, the founders switched from a centralized protocol to an “unwrapped” DAO structure, meaning the entity had no legally recognized structure. Later, they changed the name to Ooki. 

Unfortunately, one of the co-founders made Ooki seem like low-hanging fruit for the CFTC by explicitly admitting that they were trying to insulate themselves from future legal repercussions:

It’s really exciting. We’re going to be really preparing for the new regulatory environment by ensuring bZx is future-proof. So many people across the industry right now are getting legal notices and lawmakers are trying to decide whether they want DeFi companies to register as virtual asset service providers or not – and really what we’re going to do is take all the steps possible to make sure that when regulators ask us to comply, that we have nothing we can really do because we’ve given it all to the community.

Pro Tip: Don’t spell out an illegal game plan in a public forum. Wulf A. Kaal, an economist and law professor at the University of St. Thomas, said in a call with #DisruptionBanking, that Ooki’s mistake was not having a “legal wrapper.” 

[The founders of Ooki] had a nebulous understanding of what DAO means. Of course, that’s the risk you take, especially if it’s a finance-related DAO.” He added, “I wouldn’t touch a DAO in the US without a legal wrapper.” 

Ooki loses by choosing not to play

Ooki did not respond to or even acknowledge the suit brought by the CFTC, much less launch a defense. The judge called this “strategic nonparticipation.” This lack of any response calls into question whether the governance model of Ooki was effective as a DAO. It’s a good bet that no Ooki member wanted to stick their neck out.

The CFTC confronted a challenge even to serve the lawsuit because Ooki didn’t have a business address. On December 12, 2022, U.S. District Judge William H. Orrick stated in an order that there was no point in indicting all Ooki DAO token-holders, but that the CFTC needed to serve at least one identifiable token-holder.

The lawsuit was sent through the chatbot on the DAO’s website, a move that the court upheld, over objections from the crypto industry. Additionally, the judge ordered the CFTC to serve it on Tom Bean and Kyle Kistner, the original founders of the bZeroX protocol.

This was odd since the CFTC had already settled charges with Bean and Kistner, imposing a $250,000 fine on them. An attorney representing Bean and Kistner informed the court that the duo were no longer tied to Ooki.  

The attorney, Jason Gottlieb, of Morgan Cohen, wrote, “Bean and Kistner no longer have any involvement with the governance of the Ooki DAO. Accordingly, Bean and Kistner are not authorized to accept service on behalf of ‘the Ooki DAO’ ‐‐ nor could they be.” 

It didn’t matter.

The Judge Rules 

Judge Orrick ordered Ooki to pay $643,542 for operating an illegal trading platform, banned the platform from trading, and obligated the hosting service to take down the website and remove all associated content from the internet.

The question remains if the ruling is specific to the circumstances of Ooki, whose founders left no doubt about their intentions, or if the case is a harbinger of things to come in the DAO ecosystem. 

The Ooki case sets a new precedent that anyone who holds a DAO’s tokens and votes in a DAO decision can be held personally liable by regulators. Imagine if the Justice Department indicted union members for the illegal acts perpetrated by the union or held a random NRA member personally liable for the financial crimes of the executives. 

Certainly, the case could be made that Ooki forced the hand of regulators, but given the CFTC’s increased activity in the space, there will likely be more enforcement actions.  

Implications for DAOs

DAOs across the globe may be well-advised to consider to the precedent set by the Ooki case because regulators in other countries may follow the CFTC’s lead in how to regulate DAOs that operate in their jurisdictions. 

However, many jurisdictions are taking a different approach than the USA, and entrepreneurs in the space are watching closely to see which jurisdiction is going to provide the least headache for those in pursuit of innovation in the space. 

Professor Kaal said the hostility of U.S. regulators, “leads to jurisdictional arbitrage — over time it harms the US as a place to do business. There are free trade zones and city-states offering — to create legal environments for DAOs. [Local authorities are] offering to optimize association rules. [They will allow us to] write the DAO wrapper laws, making it optimal for us… No one I know would do anything in the US, until there’s regulatory clarity. No one would touch it. They go to Switzerland, Dubai, Costa Rica...”

#DisruptionBanking wrote about Swiss cities experimenting with digital assets and blockchain technology here. At the end of the day, corporate governance is the question that keeps coming up in Web3 and the DAO ecosystem, and that includes security. Ooki had poor security, like many DeFi platforms, and the governance model, based on fungible tokens, may not be the most effective if regulators plan to target those who vote.

Again, regulators refuse to clarify the rules of the game, opting for enforcement measures instead. And yet again, recent bills aiming to clarify the status and role of digital assets and regulators have left out DeFi, claiming that the CFTC and the SEC need to conduct “further joint study.”

Those planning to found and develop governing structures for DAOs would be well-advised to avoid the U.S., opting instead for the forward-thinking city-states and island nations who, in the words of Professor Kaal, “see the DAOs coming as a new way of doing business.”

The path forward for Web3 innovation is filled with uncertainty, and recent cases of the Mango Markets hack, which we wrote about here, as well as Hector Network, and Parrot Protocol, have illustrated how the purportedly ultra-democratic DAO governance structure can deliver decisions that are highly unpopular with the user community.

When asked how far away this dynamic governance model is, Professor Kaal says the innovation won’t come from DeFi, calling it “a get-rich-quick scheme.” He adds, “It’s the old Wall Street game. I’m talking about an organic grassroots community – like Reddit – by posting they become DAOs, evolutionarily. Elon Musk is doing this with X – without the monetization aspect – that’s exactly the right thing but you need to build it in a community setting, but people need to be able to earn a living in a community setting.” 

The problem is complex, but creative entrepreneurs around the globe are intent on solving it. We will be watching this space.

Author: Tim Tolka, writer, journalist, and BI researcher

The editorial team at #DisruptionBanking has taken all precautions to ensure that no persons or organizations have been adversely affected or offered any sort of financial advice in this article. This article is most definitely not financial advice.

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