Why the DeFi liquidity pooling has regulatory risk? What is the alternative?

Liquidity pooling is very extensively used in DeFi. It is one of the DeFi key pillars together with open-source smart contracts plus governance tokens. This article will look at:

  • Regulatory risks of the liquidity pooling
  • Alternatives to the liquidity pooling in the DeFi

What is liquidity pooling?

Liquidity pooling is most known via the Compound and Uniswap:

  • Compound operates the money market funds, the lenders add their assets into the money market funds, the borrowers can borrow the assets, and the interest is distributed between the money market fund investors. Practically speaking – investors pool their assets and earn a return on the assets. Which is a definition of an investment scheme.
  • Uniswap operates a decentral exchange, the liquidity providers can provide liquidity into the trading pairs, for example, ETH-USDC, ETH-DAI, etc. The liquidity providers are the market makers in the traditional finance terminology. Uniswap is charging 0.3% per every decentral trade on the platform and most of these fees are shared between the liquidity providers. And again – investors pool their assets and earn a return on the assets. Which is a definition of an investment scheme.

The money market funds are distributing the borrower’s interest payments to the investors. The decentral exchanges are distributing the trading fees to the investors (liquidity providers/market makers). Both constructs are legally speaking investment contracts.

Most of DeFi has built on the liquidity providing concepts – most of DeFi lending platforms are doing this, all trading platforms are doing this, all futures and derivatives platforms are doing this.

What is the regulatory issue with the asset pooling?

Pooling has a regulatory side effect – from 50+ users (depending on the jurisdiction) the pool will become an investment contract, meaning the pool operator needs an investment fund manager license and the pool needs an investment fund license. 

An investment fund manager license is required usually only in one jurisdiction. However, the investment fund license is required in any jurisdiction, where the investment product is offered to the clients (or where it’s advertised).

These licenses are costly, they take time to apply, they involve quite some fix-costs  – that’s why the investment funds try to have at least 5+ mUSD assets. And like said, on needs them in every jurisdiction …

What’s about an open-source?

Declaring something open source doesn’t remove these regulations – pooling retail client assets and offering return to the pool is an investment contract and a regulated activity.

Many DeFi projects counter these requirements by creating the government tokens and declaring that the community owns the product via the government tokens. This idea works like – there no central entity making the decision, this means there is no-one whom the regulator can sue. It’s like the defense strategy, where one creates uncertainty for the protection. However, it’s still a defense strategy because there are regulations in place.

The regulator has multiple ways to counteract:

  • The protocol developers could be sued – writing open-source code is protected in the U.S. via the freedom of speech clauses in the constitution. But no other country has so strong freedom of speech clauses as the U.S. – and not all software developers are in the U.S.
  • The website, which offers access to the platform is a central point of access to the platform. There will be a legal entity or a natural person behind every website. The DeFi websites could be classified as “investment advisors”, which are again regulated activity in most of the jurisdictions
  • The users of the platform could be sued too – via the KYC/AML laws, which are active in every country. There constitutional freedom of contract. However, from certain amounts, one needs to know who is the counterparty. Not knowing this exposes the users to the “terrorism financing” laws
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This means, if the regulator wants, then there will several legal “hooks” available even if the source code is open-source.

Why are DeFi protocols using so extensively liquidity pooling?

DeFi protocols are built on Ethereum, which is setting quite some limitations to how the products can be built. The fundamentalist idea in DeFi is that everything has to run on the blockchain.

For example:

  • Collateralization ratio’s in the Aave and Compound protocol are hardcoded (although in traditional finance the collateral ratio’s are client-specific)
  • The interest rate in Aave and Compound are defined via the utilization formula (although there should be the market mechanism for setting the interest rate)
  • The market price in Unswap is defined via the “A x B = C” formula (Uniswap assumes that the resulting price-arbitrage will be done outside of the DeFi world – in the central exchanges)

All these examples are simplifications of traditional finance – either the collateralization ratios or interest rates or market price. But not only, there is another reason. Setting the fundamentalist restrictions that everything has to be on the blockchain, one limits the possible implementations. These fundamentalist limitations have resulted in extensive liquidity pooling. It’s clear, that there has to be liquidity either for lending or market-making. But there might be alternatives?

What are the alternatives to the liquidity pooling?

It’s about the asset pooling/liquidity pooling. One should not pool the assets. Or if one pools assets, then it should be always below the level, from which it’s considered as an investment contract.

This means:

  • Either you use pure peer-to-peer transactions or
  • You use asset pooling below the regulatory threshold

So, far there are only two projects in the DeFi world doing this:

  • Maker DAO – which is minting DAI stablecoin via the lending transactions. There is no counterparty, there is no asset pooling
  • SmartCredit.io – which is providing peer-to-peer crypto lending

How does it work in SmartCredit.io?

SmartCredit.io is tokenizing the peer-to-peer loans into the Credit-Coins (ccETH, ccDAI, etc). This transferability of the loans allows building the Personal Fixed Income Funds for the investors. Investors define their investment parameters and Personal Investment Funds will then invest automatically in the borrower’s loan requests.

Loan requests from one borrower can be fulfilled from multiple investors at the same time – the loan is tokenized into the loan tokens and every investor (Personal Fixed Income Fund) is receiving the loan tokens. Personal Fixed Income Funds can sell or buy loan tokens.

SmartCredit.io is using an alternative, regulatory secured approach – instead of creating one pool (like Compound and Aave) are doing this – SmartCredit.io is creating multiple pools – one for every lender. These pools can invest in the same loans, but they are doing this always below the regulatory threshold.

All the legal/regulatory risk of asset pooling/liquidity pooling does not exist in SmartCredit.io at all.

Additional information

For more information, please use our application

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