Decentralized finance (‘DeFi’) has become a major use case for blockchains over the past several months. Users have loaded billions of dollars onto DeFi platforms, causing the secondary market prices of DeFi-related digital assets to skyrocket, and leading to severe network congestion on blockchains hosting DeFi activities.
This surge in DeFi activity naturally raises comparisons to the 2017-2018 initial coin offering (‘ICO’) bubble, in which speculative use cases garnered huge investments by blockchain users, causing similarly extreme swings in digital asset prices. And, like in 2017-2018, DeFi projects raise a mixture of novel and familiar legal questions.
This part A of the post provides a high-level overview of DeFi by focusing on one particular DeFi project, Sushiswap. In Part B, the post will explore legal and compliance considerations that are made particularly salient by the unique characteristics of DeFi projects, but which reflect long-standing laws that have been repeatedly enforced in the context of digital assets. Finally, the post will make several other observations about the state of blockchains in a DeFi world more generally.
I. DeFi Defined
DeFi refers to a type of blockchain project designed to enable relatively complex financial activities, like secured lending and leveraged trading, using only blockchains and smart contracts—with minimal or no involvement with typical intermediaries. These types of products and services are provided by the existing financial system and have been for decades or even centuries. DeFi projects, however, purport to eliminate reliance on financial institutions or intermediaries, and so seek to rebuild some of these basic functionalities—and introduce new ones—using mostly what is available on-chain. This results in a few characteristics that are novel even from the relatively recent perspective of the 2017-2018 ICO boom, let alone from the perspective of the traditional financial system: automation through smart contracts, anonymity and community governance.
A. Automation Through Smart Contracts
DeFi projects generally facilitate transactions involving blockchain-native digital assets, not fiat currencies, minimizing the direct need for connections to banks or other fiat on-/off-ramps. This characteristic is what enables much of the core functionality of DeFi projects. Digital assets can integrate directly into smart contracts—software that generally runs on a blockchain—which can be used to automate and simplify certain activities that are performed manually in traditional markets or offered in closed platforms by existing financial institutions. ICOs also made use of smart contracts, typically to automate the distribution of ICO tokens to participants who funded the respective token issuers, but DeFi projects deploy smart contracts for a much wider range of uses.
For example, several DeFi projects enable users to convert a volatile digital asset into a less volatile one, such as a stablecoin pegged to the value of a fiat currency. Every aspect of this activity is either automated (eg, conversions between the volatile digital asset and the stablecoin are facilitated automatically, without the need for an intermediary to approve, or halt, the conversion) or accomplished by providing incentives available to anyone willing to perform the transaction through interactions with smart contracts (eg, users can earn arbitrage profits by trading mismatches between the stablecoin and the fiat peg, which at scale helps restore and maintain the peg). Like ICOs, these DeFi projects use smart contracts to automate the performance of on-chain financial activities to eliminate the need for traditional intermediaries. But these projects do so in more sophisticated ways, enabling participants to manage volatility and shift risk with precision. These activities are also similar in certain respects to those offered by financial institutions, such as securitizations, though lacking in the legal protections and regulatory oversight that apply to traditional markets.
Because smart contracts are central to the functioning of DeFi platforms, problems with smart contract code, like bugs and unexamined vulnerabilities, can destroy projects and place user funds at risk. Drawing inspiration from the open source software community, smart contract auditors, who review a project’s code and verify the project will work as intended, have sprung up to provide quality control to the DeFi community. One preliminary lesson about DeFi is that in the absence of traditional gatekeepers, like the regulated financial institutions that support existing capital markets, unofficial gatekeepers will emerge to fill this gap. Nonetheless, many of the fastest-moving DeFi projects do not commission audits before launch—users are simply encouraged to do their own research. We elaborate on this dynamic below.
Also unlike in existing financial infrastructure, developers and users can participate in DeFi on an anonymous basis. This difference is especially stark given that DeFi platforms founded by anonymous teams can attract billions of dollars of user value on-platform, but users—not to mention regulators and law enforcement—may have trouble identifying a product team or founder if there are violations of the law. Of course, methods exist to link individual users on blockchains by analyzing blockchain transactions and leveraging publicly available data and so, depending on the given blockchain project and how it is used, anonymity may not be absolute. Below, we discuss the way that Sushiswap experienced explosive growth before eventually demonstrating the pitfalls around fully anonymous, highly-capitalized platforms.
C. Community Governance
Finally, as suggested in the above examples, participation by users is a critical source of value for DeFi projects. DeFi projects not only rely on users to enforce some of the basic economics of their platforms, such as through the arbitrage mechanism described above, but many also allow and affirmatively want a broad base of users to participate in longer-term governance of the platform itself.
DeFi governance is typically effected through ‘governance tokens’, which permit holders to vote on governance decisions for the platform and may also offer additional functionality like early access to new features. Some platforms also award governance tokens in exchange for users performing services that are valuable to the platform. Governance tokens may be available to trade on digital asset exchanges, which may cause their prices to increase, and in turn attract more users and increased participation. Some have argued that the decision of a few large DeFi platforms to start distributing governance tokens in this way, and the resulting feedback loop, helped spark significant interest in DeFi projects. But it has also opened the door to platforms offering governance tokens with dubious usefulness, or as one industry commentator phrased it, ‘liquidity first, purpose later’.
DeFi users can participate in governance in an even more fundamental way, through forks. Because DeFi platforms are composed entirely of open source smart contracts, users who disagree with decisions made on a given platform can simply ‘fork’ it by copying that platform’s code and making their desired changes. Though obviously a more dramatic and rarer governance mechanism than token holder voting, the threat of forks is an ever-present check against platform insiders or large holders of governance tokens making controversial platform governance decisions. It is also, as discovered by Sushiswap, a way to create explosive user growth for new DeFi platforms at the expense of existing platforms.
II. Sushiswap Unwrapped
The Sushiswap saga begins with Uniswap, one of the decentralized digital asset exchanges (‘DEXs’) that power DeFi. DEXs are digital asset exchanges that facilitate trades without custodying users’ digital assets. Like other DeFi projects, they make use of open-source smart contracts rather than proprietary code or centrally-managed systems. Uniswap also serves as an ‘automated market-maker’, aggregating liquidity for various digital asset trading pairs by providing incentives to users who make their tokens available for purchase and enabling them to arbitrage any mispricing (but not making markets in these tokens in the traditional sense). To provide liquidity to Uniswap, liquidity providers stake token pairs—for example, ETH-DAI—in ‘pools’, or markets, on the platform. Each part of the pair is priced according to a mathematical function, built into Uniswap’s smart contracts (and therefore able to be reviewed and audited by anyone), that calculates the price of each token based on the pool’s liquidity. Notably, this means that the price of tokens on Uniswap may be different than with prices available on the wider market. When this occurs, however, arbitrageurs will adjust the supply of either part of the token pair (somewhat like adjusting the exchange rate in that pool), bringing the price of the tokens in-line with that available in the wider market. Unlike on centralized exchanges, where exchange operators may negotiate token listing prices directly (eg, with digital asset issuers, market makers or other liquidity providers) or maintain order-books that collect users’ bids and offers, the pricing functions on Uniswap and other DEXs are calibrated in a transparent way and invite, and rely on, participation by the general public. Also unlike on centralized exchanges, Uniswap users are not trading against identifiable counterparties, but are rather transacting in and out of liquidity pools managed by Uniswap’s smart contracts.
In exchange for providing liquidity, each liquidity provider receives a pro-rata share of a 30 basis-point transaction fee assessed on all transactions in and out of the liquidity pools they are servicing. To represent its share of each liquidity pool, each liquidity provider receives liquidity-provider tokens (‘LP tokens’) that can be redeemed for the underlying token pairs at any time. Because of the open-source ethos of Uniswap and DeFi in general, LP tokens are freely transferrable to third parties and other platforms. Several platforms, including Sushiswap, have built integrations with LP tokens.
Though Uniswap has been an incredibly powerful presence in the broader blockchain ecosystem, reaching trading volumes that rival those on centralized exchanges, it has faced mounting pressure to alter its economics by introducing a governance token and listing the token on an exchange, like many other DeFi projects have done. 
This pressure appears to have reached a tipping point when an anonymous individual or team, going only by the Twitter handle ‘NomiChef’ forked Uniswap’s code, laying the groundwork for a new platform called Sushiswap, and changed it to include a governance token called SUSHI. SUSHI holders would receive a portion of transaction fees paid to liquidity providers on the new platform, whereas such fees on Uniswap are only paid to the liquidity-providers themselves. Users anticipated that the token itself would rapidly appreciate in price once listed on trading platforms. As discussed below, this expectation was proven partly correct.
Another important dimension of SUSHI is its design as a novel go-to-market strategy for Sushiswap. SUSHI was awarded to Uniswap liquidity providers who staked token pairs consisting of already-circulating SUSHI, which ultimately resulted in billions of dollars’ worth of SUSHI liquidity pools on Uniswap. SUSHI was designed with a feature that, when activated, would migrate the SUSHI liquidity pools off Uniswap and onto Sushiswap. Thus, Sushiswap’s strategy has been termed ‘vampire’ liquidity—parasitically fostering liquidity on Uniswap, its host platform, only to eventually pull this liquidity over to its new, competitor platform.
SUSHI and its vampire liquidity strategy were extremely attractive to DeFi users. Over the course of a few days, SUSHI grew exponentially in price, eventually reaching a market capitalization of almost $350 million, and users loaded almost $1.5 billion Uniswap SUSHI pools (compared to $1.8 billion dollars of non-SUSHI Uniswap liquidity pools). But just as it seemed that Sushiswap could surpass Uniswap in volume, NomiChef sold a stake of SUSHI tokens from Sushiswap’s dev fund. This netted NomiChef around $13 million worth of ETH but also caused an outcry from the community of Sushiswap users. Over the course of the following five days, the price of SUSHI collapsed from almost $12 to $1 per token and over $500 million dollars of liquidity was pulled from SUSHI liquidity pools.
Over the course of the Sushiswap saga, the community of SUSHI holders and others in the DeFi community banded together on Twitter threads and Discord channels to try and rescue the project, with varying levels of success. First, it convinced NomiChef to transfer the private keys for the Sushiswap smart contracts, including the smart contracts that provide access to the platform’s own SUSHI stake, to a group of prominent community-members, each of whom now holds a private key in a multi-signature arrangement. Second, it successfully activated the migration of its liquidity from Uniswap to Sushiswap, defying widespread skepticism that this would ever occur after such turbulent leadership changes. Finally, it pressured NomiChef to return the ETH he earned from his sale of SUSHI, which was perhaps the first time a project founder has been successfully convinced to return the proceeds of their alleged exit scam. The recovered ETH was eventually used to engage in a buyback of SUSHI tokens, as a way to raise the price of the SUSHI tokens that remained in circulation and therefore to return value to Sushiswap’s community of users.
Joon Kim is General Counsel of O(1) Labs. O(1) Labs leads the building of Mina (formerly known as Coda), which is a lightweight Layer 1 blockchain protocol focused on payment.
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 Uniswap has recently introduced its governance token, UNI. UNI holders will be able to adjust the calculation of transaction fees awarded to liquidity providers, allocate a stake of UNI currently held by Uniswap for ecosystem grants and make other changes to the platform. See Introducing UNI (Uniswap.org, 16 September 2020). It will be interesting to observe how competitive dynamics among DEXs will be affected by UNI. For example, UNI could make new forks of Uniswap less successful by making existing Uniswap users less willing to migrate to a new fork. It could also cause governance tokens to be a default market practice for new DEXs going forward. Regardless, however, UNI likely poses the same set of legal issues described throughout this article.