Abstract
Distributed Ledger Technologies enable the decentralised delivery of traditional financial services. They also allow the development of disruptive proposals, such as the issuance of stablecoins managed by the governance system of an autonomous decentralised organisation or DAO. One such project, MakerDAO, stands out in the current DeFi landscape. The initiative claims its proposal provides money that facilitates financial inclusion by dispensing with intermediaries through a decentralised infrastructure. However, the claim must be contrasted with the reality of the operation of the stablecoin, the vulnerabilities that can affect the project, and the interaction with the different elements of the legal system.
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Notes
The variety of use cases of DLT as an enabling technology implies that it can foster innovation and productivity growth in many economic sectors. For enabling technologies and their differences from other notions, such as general-purpose technology, see Martinelli, A., Mina, A., Moggi, M. [1], p. 162.
In this regard, several DLT projects are classified as “Blockchain 3.0”, implying they look to sort out the current problems of scalability, security, and interoperability of DLT registries to ease their industrial use. See Ackermann, J., Meier, M. [2]., p. 6.
See Zetzsche, D.A., Arner, D. W., Buckley, R.P. [3], p.173.
Algorithmics managing these decentralised financial products and services, like granting credit, currency exchanges, or asset management, work through smart contracts that do not rely on a unique person or entity but on a computer network operated by agents acting under pseudonyms. See Roukny, T. [4], p. 8.
Incremental innovations only improve a product or line from a set of technologies already generalised in producing the considered product or service. On the other hand, radical innovations or disruptions only arise when the production of a product applies for the first time a new set of technologies family of technologies. See. Acemoglu, D., Akcigit, U., Celik, M. A., [5], p. 206.
See. Buterin, V. [6].
See. The description of “TheDAO” case in Morrison, R., Mazey, N.C.H.L., and Wingreen, S.C., [7], pp. 5–6.
“TheDAO” suffered an attack because the governing smart contract´s code was vulnerable. The project could solve the issue by implementing a “hard fork”, i.e. an amendment of the transaction record that annulled the effects of the attack. The Ethereum Foundation led the intervention, and most of the community applied it. However, a minority rejected the change because the code did not foresee that measure, meaning the transaction record must have remained immutable. See Morrison, Mazey, Wingreen [7], cit., pp. 6–8.
Buterin and T. Schrepel have put forward the collaboration between the law and the technology to ease transaction decentralisation and trust among economic agents. It is an optimistic vision where they set forth that both authorities and developers must make concessions. See. Schrepel, T., Buterin, V. [8].
The 2008 financial crisis and the recent surge in inflation prove that central banks can fail to meet their mandates of ensuring financial and price stability, so the risks affecting fiat money are also relevant.
The Bitcoin White Paper compares the new monetary system with digital cash. The statement highlights a disruption since Bitcoin is money-free from the risk of an issuer. Vid. Nakamoto, S. [9].
Nakamoto recorded in the first block of the Bitcoin Blockchain (known as “the genesis block”) the following message: “The Times 03/Jan/2009 Chancellor on brink of second bailout for Banks”. The reference to The Times newspaper allows us to link the genesis block’s creation to a specific date. See. Connor, M. [10].
However, the fact that the newspaper’s headline explicitly references the bank´s bailout does not seem like a random decision. Therefore, it is reasonable to understand that Nakamoto presented Bitcoin as an alternative to the current financial systems managed by banks and supervised by public authorities.
V. Buterin participates in an interview entitled “Decentralizing Everything with Ethereum's Vitalik Buterin”. Apparently, in DLTs registries, everything is decentralised. See. Buterin, V. [11]. Nevertheless, due to the importance of V. Buterin’s activity and the Ethereum Foundation on the governing protocol as well as the intervention in the “TheDAO” case, it has been said that the Ethereum governance system is based on a “benevolent autocrat”. See Arruñada Sánchez, B., Garicano Gabilondo, [12], p. 25.
According to Llases González, the fact that the profitable investment scale grows faster than the mining market explains the concentration of the mining activity in Bitcoin. Several factors contribute to this situation: the reduction of economic incentives to mine due to the halving of the rewards and the rise of the minimum necessary investment to compete due to scale economies. See Llases González, L., [14], pp. 38–39.
See Shapiro, G. [15].
Grassi, L., Lanfranchi, D., Faes, A., and Renga, F.M., [16], pp. 323–324.
As said earlier, DAOs are organisations whose government is supposed to be decentralised. Nevertheless, some authors have shown their scepticism about the effectiveness of governance systems not backed by “additional coordination mechanisms” and supervised by the authorities Vid. Makarov, I., and Schoar, A., [17], pp. 38–39.
Having a “permissioned network” assigning obligations and responsibilities to specific individuals implies reversing decentralisation.
The node’s identification as miners or validators depends on the consensus protocol running on the DLT system. In the DLT registries using proof of work as their consensus protocol, nodes receive the denomination of miners because they “mine” cryptocurrencies as a reward for spending time and resources solving a math problem. On the other hand, editing nodes in DLT registries working on a proof-of-stake protocol do not compete among them since they are randomly chosen. However, their probabilities rise if they “stake” more tokens. Vid. Lin, S., [18], p. 960.
Ibáñez Jiménez distinguishes between native and derivative tokens depending on whether the crypto asset is issued in an automated consensus protocol system or a specific issuer has offered it to the market. Bitcoin and Ether belong to the first case, whereas the second refers to tokens linked with specific issuers or projects. Vid. Ibáñez Jiménez, J. [19], p. 67.
This finding helps differentiate between cryptocurrencies that the states can regulate from those that remain immune. It is due to the possibility of finding a responsible subject. Therefore, the MiCA regulation does not regulate native tokens from permissionless DLT networks like Bitcoin y Ethereum. In contrast, it does handle stablecoins attributed to specific issuers and uses an asset reserve as a stabilisation mechanism.
Nevertheless, regarding this research, it is assumed that every governance token on DAOs can be subjected to regulation.
MakerDAO offers more than one token, each with its legal status. This paper focuses on the stablecoin Dai and the governance token MKR.
Strowel, [20], pp. 1–11.
Lessig pioneered the idea with his proposal of regulating cyberspace by applying additional technical architecture layers to identify network users. Afterwards, De Filippi y Wright, following Lessig’s proposal, set forth that the approach Law is code or code as law may also imply a disruption for the law since DLT technologies can automate its application. Vid. Lessig, [21], pp. 91–92 and De Filippi, P., Wright, [22], pp. 196–199.
Nevertheless, De Filippi and Wright concede the difficulty of regulating permissionless DLT registries like Bitcoin or Ethereum due to the need to intervene in every node participating in the network. See De Filippi, Wright, [22], pp. 185–187.
The SEC reports that “TheDAO” tokens are securities because the investors pursued to obtain benefits from a third party’s work. Therefore, the issuer should have filled with the SEC the offering of the token. See Securities and Exchange Commission, [23], pp. 11–17.
The SEC highlighted that “TheDAO” token holders had a secondary role in the organisation’s management. Instead, “TheDAO” developers selected a set of administrators, or curators, to approve the funding proposal before voting. Ultimately, the developer company managed “TheDAO”, which was not genuinely decentralised. Vid. Securities and Exchange Commission, [23], pp. 13–15.
Shapiro, G [15].
De Filippi, Wright [22] pp. 185–187.
Schrepel [24], pp. 322–325.
Previously, it has been pointed out how the SEC exposed “TheDAO” as a centralised organisation. Moreover, Sun, Stasinakis, and Sermpinis have developed an empirical study where they find that the MakerDAO governance system is highly centralised in terms of participation, voting concentration, and efficiency in decision-making (the more concentration, the more efficiency). See Sun, X., Stasinakis, S., Sermpinis, G. [25], pp. 15–16.
Proxy voting is one of the mechanisms that concentrate decision-making power.
Meanwhile, the regulation of token holders is not straightforward, as anonymity may hinder the capabilities of public powers to chase the persons with the decision-making power.
Among others, the analysis requires a review of financial stability, the payment system, market infrastructure, and banking supervision regarding the Eurozone in the ECB Crypto-Assets Task Force [26].
See MakerDAO, [27].
Currently, investors only use stablecoin as a temporary store of value. Traders in crypto markets can keep their capital gains in stable assets without resorting to an Exchange, probably vulnerable to cyberattacks, or transferring the funds to a credit entity. Vid. Clark, J., Demirag, D. and Moosavi, S., [28], p. 44.
If prominent undertakings backed a stablecoin, they could spread its use among their clients. In this case, The Libra stablecoin project entails a global risk of monetary substitution. Vid. Arner, D., Auer, R. and Frost, J. [29] pp. 107–108.
The doctrine identifies the following modalities: tokenised funds, as a case where each stablecoin unit is backed by an underlying asset whose redemption in parity conditions is guaranteed; stablecoins backed by off-chain assets, i.e. no crypto assets; stablecoins backed by on-chain assets, i.e. crypto-asset managed by smart contracts, and algorithmics stablecoins, whose stability relies on automated management of cryptocurrency’s supply and demand. See Bullmann, D., Klemm, J., and Pinna, A. [30], p. 3.
The MiCA regulation even reaches algorithmic stablecoins, which typically do not use reserve assets. According to Recital 41: “Where a crypto-asset falls within the definition of an asset-referenced token or e-money token, Title III or IV of this Regulation should apply, irrespective of how the issuer intends to design the crypto-asset, including the mechanism for maintaining a stable value of the crypto-asset”.
Firstly, Dai as an asset-reference token might be controversial. It should be noted that the MiCA Regulation requires reserve assets to be kept by a financial intermediary (vid. art 33.4). However, the on-chain collateralised stablecoin like Dai can dispense with specialised intermediaries regarding the custody of reserve crypto assets. See Bullmann, Klemm, and Pinna [30] p. 20.
Art. 15 MiCA Regulation.
Riva, S. [31] p. 619.
The Vermont and Wyoming states' legal reforms are highlighted. The first has introduced a new incorporated form based on blockchain, called Blockchain-based Limited Liability Companies; the second, in addition, contemplates the possibility that algorithmically managed DAOs have legal personality. See Schuppli, B., Jafari, G. A. [32], p. 343.
Title 11: Corporations, Partnerships And Associations, Chapter 25: Limited Liability Companies, Subchapter 12: Blockchain-based Limited Liability Companies available at https://legislature.vermont.gov/statutes/fullchapter/11/025.
Wyoming Decentralized Autonomous Organization Supplement, Title 17 Wyo. Stat. § 31–101 (2021). https://wyoleg.gov/NXT/gateway.dll?f=templates&fn=default.htm&vid=wyoleg:laws.
These DAOs lack nationality and governing law since their international nature erases the possibility of legally finding their legal system. Vid. Lehmann, M. [33], p. 111.
However, Riva proposes that these “mavericks DAOs” can produce legal effects as they would have been formed in the “online jurisdiction” under the “law of code”. Therefore, a national law could internally regard these DAOs as international legal entities correctly formed to provide legal certainty to their transactions. Vid. Riva [31], p. 631–637.
Authorities will not apply Private International Law but the internal substantive law to undertakings carrying out their activity on their jurisdiction. For instance, art. 2 of MiCA states: “This Regulation applies to persons engaged in the issuance of crypto-assets or provide services related to crypto-assets in the Union”. Therefore, it does not matter if the undertaking has legal recognition in the Union; the regulation applies, provided the issuance of service provision affects the Union.
The British Law Commission report on DAOs points out that if DAO were to be classified as a general partnership, every partner is personally liable to meet the debts and obligations of the partnership. See Law Commission [34] p. 31.
However, as the report puts forward, it is true that DAO must not be characterised as a general partnership in every case. There must be an analysis of the decentralisation of DAO elements. See Law Commission [34] pp. 31–32.
Christian Sarcuni et al. v. bZx DAO et al. Case No.: 22-cv-618-LAB-DEB, document 49 at 12–27 (United States District Court Southern District of California, 2023).
The defendant must have minimum contact with the forum as a condition for the court to assert its jurisdiction over them. In the bZx DAO case, the court found that it could not judge a relevant bZx member since the defendant´s contact with the state of California did not qualify as a specific jurisdiction. See Christian Sarcuni et al. v. bZx DAO et al. Case No.: 22-cv-618-LAB-DEB, document 49 at 21–24 (United States District Court Southern District of California, 2023).
See Brummer, C., Seira, R., [35].
Similarity between the LLC and the tailored legal wrapper for DAOs are straightforward in documents like Wyoming Secretary of State [36] “Decentralized Autonomous Organizations: frequently asked questions”, 2022, available at https://sos.wyo.gov/Business/Docs/DAOs_FAQs.pdf (last consultation, on 18.01.2024).
See Boss, S., [37] “DAOs: Legal and Empirical Review”, Blockchain & Society Policy Research Lab Research Nodes 2023/2, Amsterdam Law School Research Paper No. 2023–27, Institute for Information Law Research Paper No. 2023–06, Institute for Information Law Research Paper No. 2023–06, 2023, p. 5, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4503234# (last consultation, on 08.12.2023).
In the “TheDAO” case the SEC found these governance tokens to be securities.
See MakerDAO [38] “The Maker Foundation Focuses on Its Dissolution” https://blog.makerdao.com/the-maker-foundation-focuses-on-its-dissolution/ (last consultation, on 27.01.2024).
Article 34.1 states: “Issuers of asset-referenced tokens shall have robust governance arrangements, including a clear organisational structure with well-defined, transparent and consistent lines of responsibility, effective processes to identify, manage, monitor and report the risks to which they are or might be exposed, and adequate internal control mechanisms, including sound administrative and accounting procedures”.
Naudts, E., [39] p. 27.
MakerDAO [27]
MakerDAO [27]
Regarding financial inclusion, the Tether USTD dollar may offer a stronger alternative, as it is the third cryptocurrency in market capitalisation and has US dollar reserves backing each unit of the stablecoin on a 1:1 parity. Vid. https://coinmarketcap.com/currencies/tether/.
Kim, S., [40] Chapter 7 of the online version, https://www.oreilly.com/online-learning/ accessed 02 May 2023).
Such risks would not exist, at least those related to the market sentiment, if the collateral is the same as the one to which the stablecoin is pegged, e.g., an off-chain stablecoin pegged to the US dollar could use the dollar as collateral to avoid the risks. Furthermore, on-chain stablecoins could increase their soundness by relying on tokenised safe assets.
See Baughman, G., Carapella, F., Gerszten J. and Mills, D. [41].
The MakerDAO governance must establish the liquidation ratio for each accepted collateral and the penalty fee. Therefore, token holders must decide if they prioritise the competitiveness or security of the virtual currency.
Furthermore, Kim warns about the importance of tracking the collateral value to check that the collateral’s value lies above the liquidation ratio. For instance, if ethers valued at 1000 $ are deposited with a liquidation ratio of 170%, the Dai issuer will only get 588 24 Dai (1000/1,70). Furthermore, for security reasons, it is recommended to deliver additional collateral to get a margin against the ether’s volatility. See Kim [40].
The MakerDAO governance also establishes the stability fee. Voting is necessary to decide the specific fee. However, as a rule of thumb, the stability fee will increase when the Dai price is below the reference to “burn” or remove Dai from the maker, lowering Dai’s supply. On the contrary, if Dai’s Price exceeds the reference, the stability fee will decrease to spur the supply of Dai.
Decisions on the stability fees affect open positions in Dai. Therefore, “the terms of the loan” can vary as part of the monetary policy agreed on by the MakerDAO governance system. Vid. MakerDAO [42].
As the Whitepaper puts it: “Maker Vaults allow for permissionless trading by users, who can use Dai generated against Vault collateral for working capital. To date, there have been numerous instances where Vault owners use their Dai to buy additional ETH (the same asset as their collateral), thereby creating a leveraged but fully collateralized position” (italics are mine). See MakerDAO [27].
Kim [40], chapter 4.
Kim [40], chapter 8.
Prices in the second Exchange could change while the first executes the transaction. Vid. Kim [40], chapter 8.
Kim [40] chapter 8.
Like admitting new crypto assets as collateral, modifying the key risk parameters for accepted crypto assets or adding new risk parameters to one or more accepted collateral, manipulating Dai Saving Rae, and selecting regular and emergency oracles. It should be noticed that the the emergency oracle can unilaterally activate the emergency shutdown. See MakerDAO [27].
The reserve gets Dai from collateral auctions, penalties, and stability fees.
If the buffer were to have a Dai surplus above the limit, the protocol triggers an auction selling the surplus Dai for MKR tokens to burn them. As a result, MRK token holders experience a spike in the value of their crypto assets due to the reduction of the MRK supply. See MakerDAO [27].
Bullmann, Klemm, and Pinna [30], p. 25.
Putting the two coins structure into practice, it turns out that if the stablecoin price is below the peg of 1 $, the arbitrageur could buy the stablecoin in the market and then exchange it at a fixed price in a smart contract for the support token valued at the target price. On the contrary, if the stablecoin circulates over the target price of 1 $, the arbitrageur can obtain from the smart contract the stablecoin cheaper than in the market and, subsequently, they will sell the minted stablecoin on the market.
See Clements [44], p. 138.
Clements [44], p. 138.
IRON and TerraUST stablecoins and their respective support tokens, TITAN and Luna have failed because of this sequence of events.
In this regard, the doctrine has pointed out how backing crypto assets’ volatility may not prevent a death spiral; capital losses in stress conditions provoke massive sales of the crypto assets, bringing about a new loop of losses, resulting in over-collateralised stablecoins losing their peg.
See Catalini, C., De Gortari, A. [45], p. 3.
Over-collateralization makes using the stablecoin expensive and does not protect the peg against extreme events.
See Catalini, C De Gortari [45], p. 8.
There is a negative correlation between the Ether Price and Dai. Therefore. When the Ethereum return increases, it lowers the value of Dai as its holders sell it in exchange for Ether.
In reverse, if the Ethereum returns fall, investors reduce their Dai borrowing, reducing the Dai supply. At the same time, they increase the demand for Dai in secondary markets to hold a safer asset.
See Kozhan, R., Viswanath-Natraj, G. [46], pp. 2–3.
MakerDAO diversifies its portfolio of collaterals by admitting new backing crypto assets, and the governance system gauges for each collateral a series of risk parameters, establishes the intervention of a sort of market makers known in the MakerDAO jargon as keepers that provide liquidity in the auctions; hires DAO teams that offer specific services to MakerDAO; selects price oracles that provide updated information about the price of the collateral and sets the possibility to activate by the token holders or emergency oracles an “emergency shutdown”. This last measure “freezes” the collateral price within the system before a final auction takes place; Dai issuers can remove the deposited excess collateral provided it does not cover a current debt, and Dai holders can request the redemption of their Dai units in exchange for the existing collateral. However, they might suffer haircuts if the protocol is under-collateralised because of the volatility.
“The emergency shutdown” works as a sort of “stop loss” order that pursues to reduce the losses but cannot guarantee any results.
Catalini, De Gortari [45], p. 13.
Dimand, R.W. [49] p. 182.
Gorton G.B., Zhang, J.Y. [50], p. 949.
Bank for International Settlements [51].
Each central bank can control its CBDC issuance and redemption, transactions and amounts, and visibility in the mBridge Project. See Bank for International Settlements, [51], p. 31.
However, it should be noticed that: “the EBA, in close cooperation with ESMA and the ECB, shall develop draft regulatory technical standards further specifying the liquidity requirements, considering the size, complexity and nature of the reserve of assets and of the asset-referenced token itself” (article 36.4 MiCAR).
The Wyoming State and Switzerland have passed new banking charters to foster the growth of fintech entities in regulated spaces tailored for those specialised in providing crypto assets services. This measure aims to reduce the regulatory burden that the legal regime of regular credit institutions entails. However, this benefit also implies limiting the scope of the chartered entity or subjecting them to new legal requirements. For instance, the “Swiss Fintech Licence” limits the amount of deposit-taking and bans banks from investing them. Moreover, Wyoming’s “Special Purpose Depository Institution” must have the deposits fully backed permanently. See Finma [52] and Division of Banking [53].
Selgin, G., [54], pp. 3–5.
Libra was announced in 2019 without previous regulatory approval. The authorities’ refusal to approve the project led to its demise in 2022.
Although Libra’s approach was proved wrong, and governments aim to preserve the current status quo characterised by the existence of “monetary sovereign” in each jurisdiction, the reality is that this refusal has wasted the opportunity to promote a regulated stablecoin. It should be noted that, unlike Bitcoin and other cryptocurrencies, public powers could impose on Libra requirements of obtaining previous licences, risks management, capital and liquidity requirements, etc. See Zetzsche, D., Buckley, R. P., Arner, D.W., [55], pp. 98–110.
DAOmeter scores 97% in the MakerDAO governance system. See DAOMeter, “MakerDAO” [56].
See Hosp, J., [57] “Tether: A Controversial Titan in the Crypto World” https://www.linkedin.com/pulse/tether-controversial-titan-crypto-world-dr-julian-hosp/ (last consultation, on 26.01.2024).
See Sandner, P., Groß, J., Schulden, P., Grale, L. [58] p. 48.
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Zapata Sevilla, J. Analysing decentralised autonomous organisations (DAOs): limits and perspective. J Bank Regul (2024). https://doi.org/10.1057/s41261-024-00236-z
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DOI: https://doi.org/10.1057/s41261-024-00236-z