PoolTogether Lawsuit Will Test Whether DeFi Really Is Decentralized

At a Senate Banking Committee hearing on stablecoins in December, Sen. Elizabeth Warren called decentralized finance (DeFi) “the most dangerous part of the crypto world.”

Read more: Sen. Warren Calls DeFi the ‘Most Dangerous’ Part of Crypto at Senate Hearing

Now, Joseph Kent, the technology lead for Warren’s 2020 presidential campaign, is taking DeFi to court in an effort that will test the core assumption of DeFi — that no one is in charge or responsible for what happens.

DeFi projects offer crypto holders access to financial services without the need for a trusted third party. The core principle — and value — of DeFi is loans without a bank, trading cryptocurrency (and potentially tokenized stock shares) and participating in futures contracts without an exchange management company making the rules and taking a cut.

Once built, the lending protocols and decentralized exchanges (DEXs) are run by smart-contract controlled decentralized autonomous organizations (DAOs) that do whatever token-holders vote for.

See more: Unpacking DeFi and DAO

Not Just for Money

What Kent is trying to do in New York federal court is to rule that there are people in charge of DAOs, or at least investors who can be held accountable for a decentralized application’s (DApp’s) actions. And he’s using New York’s lottery laws to do it.

In a lawsuit against PooledTogether, a blockchain-based app that encourages users to save their cryptocurrencies by offering them the chance to win awards, Kent said he is “is gravely concerned that the cryptocurrency ecosystem — which requires the use of enormous amounts of electricity — is accelerating climate change and allowing people to evade financial regulations and scam consumers.”

The point of the lawsuit, beyond a payout, is to test the basic DeFi doctrine that no single entity is in control of a DAO, and therefore there is no one to be charged by the Department of Justice, taken to court in a civil enforcement action by the Securities and Exchange Commission (SEC), or sued by investors.

Asked about the case by The Wall Street Journal (WSJ), Kent’s attorney, Charlie Gerstein, said: “When people work together using the blockchain to violate the law, that’s not a technological breakthrough; that’s a conspiracy.”

PoolTogether project founder Leighton Cusack told WSJ the lawsuit is “clearly written by someone who doesn’t understand how protocols operate or even what PoolTogether is.”

Either way, the SEC will be watching.

See also: SEC Has Long Road Before DeFi Regulatory Framework Is Ready

In August, SEC Chairman Gary Gensler warned that DeFi is not as decentralized as people think, telling the WSJ, “There’s still a core group of folks that are not only writing the software, like the open source software, but they often have governance and fees. There’s some incentive structure for those promoters and sponsors in the middle of this.”

That same month, crypto-friendly SEC Commissioner Hester Peirce the SEC is “struggling to get their arms around” DeFi at a Chamber of Digital Commerce event.

Kent’s Lawsuit

In Kent v. PoolTogether Inc. et al, Joseph Kent is arguing that the crypto savings application is an illegal lottery under New York State law. The platform takes crypto from investors and sends it to a lending pool on another DeFi project, Compound, a leader in crypto lending and borrowing.

The interest earned is distributed back to PoolTogether investors, who receive premium bonds representing their investment. Those bonds act as lottery tickets in a weekly prize pool that’s currently $143,000.

As Kent invested $10 in the premium bonds issued by the company, he can claim compensatory damages from PoolTogether Inc. That’s the private company that developed PoolTogether, the DeFi lending project of the same name. PoolTogether Inc. built the project and still makes software updates, but it has no direct control.

Read also: What is Yield Farming and Liquidity Mining?

Of course, the Kent lawsuit has one big flaw: The judge could rule on the lottery law aspect without touching the DeFi legality questions.

Kent is also suing Compound Labs, which developed and works on Compound but does not own or control the DAO-run platform. Other defendants include Cusack, and several venture capital investors, and influential crypto investor Michael Novogratz’s Galaxy Digital Capital Management, in the lawsuit that he wants to make a class action.

See also: DeFi’s Very Real Risks

This case is not the only one in which DeFi’s legal liability is being tested.

In March 2010, a top DeFi lending platform, MakerDAO, had a software flaw exploited by hackers who stole $8 million in ether from platform borrowers, who had locked their crypto in as collateral. Once fixed, DAO members were asked to use funds held by MakerDAO from transaction fees to make good on their losses.

The DAO’s token holders voted “no,” and the loser brought a class action lawsuit.