Bruno Pasquier, Nicolas Curchod - Liquidity Pools in Decentralized Finance (DeFi)–Private Law Issues

Transcript

thank you thank you so much for having us uh thanks for being here my name is Nicholas and together with Bruno I'm going to say a few words uh today about liquidity pools just as a disclaimer perhaps we are lawyers so we look at things from a from a different perspective perhaps we look at things from the perspective of of a predetermined system which is the legal system and you try to have a look at this topic uh from this perspective having to look at the implications from a legal standpoint so the first thing we're going to do is discuss um about the the way liquidity is provided in liquid in decentralized financed as opposed as um to in in centralized financed introducing the

concept of liquidity pools then we're going to identify the the different stakeholders and assess the legal relationships between them and then we are going to talk about our favorite topic which is problems issues what can people do what can they claim what can the different stakeholder claims stakeholders claim in case um the damage occurs and then finally we will look at the challenges that lie ahead and at the best ways to address them going forward liquidity is absolutely essential in any um on any markets no matter whether it is centralized Finance or decentralized Finance because

liquidity is defined as the way uh at at the as as the ease with which people can trade on a certain Market without affecting the price on a perfectly liquid Market um basically you could be able to place any order no matter the size of the order without at the same price so basically every single assets within that order would be able to be placed uh at the same price but markets are usually not perfectly liquid and traditionally there are two ways to ensure liquidity on the market um in So-Cal limits order markets basically the liquidity is provided by the participants by the buyers and the

sellers the buyers and the sellers Place certain orders either limit orders or Market orders and an order book a So-Cal order book matches the bids and the asks so the market participant place an order um either they say Okay I want to buy or to sell at a maximum price or at a minimum price or this is called a limit order or they place an order Market order in which they say Okay I want to buy or to sell but I do not Define the price at which I want this transaction to be made and basically in this case the transaction is fill the the order is filled instantly at whatever the at whatever price the market can

bear this is the first concept uh the frustrational concept the other one is what happens on on uh on steer markets and in that case liquidity is not provided by the market participants themselves but by market makers and market makers are usually large entities uh Brokers that are either affiliated with a with an exchange or registered with an exchange and that are regulated in the EU they have to be regulated and Market participants do not transact with each others but they transact with the market makers and the market makers have to maintain an inventory of uh the assets of the

underlying assets and they um quote um Bid And as prices for those assets and in this case as I said the liquidity is provided by them so this is the traditional ways um liquidity is provided in centralized finance and a distinctive feature of U decentralized finan is that liquidity is provided in a very different way because we do not have an order book that matches the bids and the ass and we do not have traditional market makers IND distalized Finance liquidity is provided through liquidity

pools and interestingly now not only professional liquidity providers or market makers can provide liquidity but basically anyone which is the beauty of it and tokens crypto tokens are basically deposited um are deposited in in pools and each pool is is managed by a smart contract and the price for the assets on ratio is determined exclusively by the smart contracts and not by outside factors and basically the combination is uh of of pairs is is virtually Limitless right now I think we have over the over 4,000 on Unis swap

and the liquidity providers as I said do not have to be registered with an ex change basically that can be anyone this is uh what a liquidity pool look looks like according to chat GPT so this is a nice pool with uh with several crypto tokens in in in actually they should be only two because in on each pool uh only two types of tokens are deposited this is a screenshot from Unis swap basically this is the way uh liquidity providers can provide liquidity by selecting tokens um and the key distinctive feature again is that basically

everybody can do that which is interesting from a contractual or from a legal standpoint what we want to do as lawyers as I said is first identify the stakeholders in order to see whether there is a legal relationship between them and looking at liquidity pools and looking at the way liquidity is provided uh in decentralized finance we identify three types of stakeholders first The Operators of the interfaces of the platforms second the Traders and third the liquidity providers interestingly the problem

start with the operators of the of the platforms because what we want as lawyers is identify a legal entity or person or human being because only human beings or legal entities can be bound by rights and obligations typically however with operators of platform this is not always easy to determine which legal entity entity is behind the the platform is behind the interface in the case of Unis swap for instance there is a legal entity based in the US in Delaware which is a limited uh company a limited liability company and LLC but I understand that the smart contracts are not deployed by the platform itself but by the

users with respect to the Traders this category is fairly easy to to understand and is not really different than what we would find in a on a centralized platform and as I said the liquidity providers can be basically everyone so the big question and they are incentivized of course they get a reward reward for providing liquidity so the big question from a legal standpoint is really what is the legal relationship between those people is there any legal relationship between those people perhaps we need to Define what is a contract first a contract is an agreement which means that the stakeholders need to want

to be bound by a contract by a legal contract not a smart contract a legal one and this is far from obvious in decentralized finance do the different stakeholders really want to be bound if we have a look at the different stakeholders in their relationships actually they have there are some suggestions that they want to be bound if you have a look at the terms of service of Unis swap or other platforms you can see that um in those terms of service the contracts are mentioned and in order to be able to use the platform the user must have must be able to to enter into a legal

contract basically while the users do not necessarily know that they are actually entering into a legal relationship they what they do and what they get what they give and what they get really look like contractual obligations if we have a look at the relationship between Traders and operators for instance on the one hand the platform has the obligation to provide access to an interface and on the other hand the Traders have the obligation to pay a fee or fees in peo under Swiss law typically this could be a contract for work and services which means that the actors could be bound by these contracts with the uring rights and obligations that exist under Swiss law or under any other

law that could be applicable same thing with liquidity providers and um and operators of uh of platforms again the the platform operators have a duty to provide access to the interface this is one way uh to to look at this which would imply typically a contract for work and services and on the other hand you can say that the liquid supervisors are actually needed they are a key part of the entire system and from a legal standpoint that could mean that they could be considered as um as um as people who are needed to perform a contractual obligation and who could bind actually the platform the

platform operators that would be vicarious agents in legal terms so hence here again potential illegal implication the last one the relationship between liquidity providers and Traders here we think there is no legal relationship there is no contracts because those people do not interact with each other the assets are pulled the tokens are pulled and there is typically no interaction between between those categories of actors now I give the floor to Bruno for the issues that may arise in connection with liquidity pools that's better hi thank you very

much Nicola so I will continue with the present ation so as you know there are several types of risk related with uh decentralized finance and dexs particularly so for example um the possibility that a smart contract used by a um decentralized uh application got hacked by someone and that the F got uh drained and liquidity providers as well as Traders may lose their funds in this situation and we were asking the question whether

according to the current law users so liquidity providers or Traders uh may ask a compensation and of course so Nicola were discussing the possible entity that may be held responsible and I assume that it would be pretty straightforward to go after the operator of the deck so not against the hacker itself because often the hacker would be not a known entity and the question is if we apply the current laws so we were analyzing the Swiss law uh is there any chance that users losing their money may

go after the Dex operator I can give you a short answer because uh before explaining you um our reasoning so it will be very difficult according to current Swiss law to have a compensatory claims because our current legal system is not well suited for this kind of compensation so we have two types of liability we have the contract liability as it was discussed before we came to the conclusion that there was a contract between the Dex operator and the users so this is a possibility and to

liability so thought liability is a type of liability that does not require any contractual relationship so if we have a look at the conditions under current swis law so at Dage this condition may be given uh contractual Bridge so this is the first problem that we have so it may be very difficult for a user to prove a contractual uh Bridge because the user would have to prove that the operator of the

Dex was breaching the contract so for example being negligent with the smart contract and as we know sometimes it would be different to prove this negligence I mean they can be very good hackers and so on so this is the first problem that we have under current law uh the caal Nexus so the the connection between this brge of contract and the Damage this this is possibly Um this can be proven possibly and finally the fraud is a condition that may not be proven easily because um we can consider that Dex operator try their

best uh to have working Dex so one of the problem we identified as well the Dex operator according to their terms of agreement they have the promise to provide an interface but they are not responsible for the smart contracts so at least if there there are clear terms of agreement in this sense if there is any problem with the smart contracts the Dex operator may not be responsible for this uh as I told you the negligence may be very difficult to prove in such

situations and one more uh problem is that the Dex operators will try to limit there are liability uh under Swiss law under current Swiss law you can limit your uh liability except for U cross negligence I will be pretty quick with the Tor liability because basically we have the same problem so the fault will be very difficult to prove and with the Tor liability there is one more conditions that will be very um difficult to prove it's the torous act so the uh user should prove must have to

prove that the Dex operator was trying maybe to steal the assets and so on and that will be very uh difficult unless there is a rook pool or such kind of events exactly so one of our conclusion is that the current uh legal system is not well suit fortify because basically there are almost no protection for users on top of the legal issues that we mentioned we have to consider that defi

is of course decentralized and transnational so apply ing the law would require a cooperation between the state and this is a very hard to a goal that is very hard to uh achieve and we came to the conclusion that the legal system identifies subjects of Law and maybe a more suitable system for the5 would be to consider actions instead of partici ipants so maybe to sanction some types of uh Behavior instead of trying to identify the legal entities involved and

to sanction their behavior so law enforcement is particularly challenging in the defi environment some moreal reasons so the participants in defi are of course course pseudonymous sometimes depending on the blockchain used maybe even Anonymous and transactions are irreversible so all these reasons lead to the conclusion that in case of any problems in relation to defi it would be very hard for users to uh get a compensation so we were uh as well

discussing um or we want to discuss possible legislative actions and in our opinion there are two possibilities so first the question to be assessed is do we need and do we want a greater protection of users and the first possibility would be to have more license regulation so to to check to review better the Market participants including the Dex operators so for example to um provide that any Dex operator should uh obtain a license

before entering the market so this is in our opinion not the way that should be taken because it would be very hard to enforce I mean any Dex operator or operator of Dex could move to another country where this regulation does not exist uh so this is not the way to be taken in our opinion and uh we realize that the European uh regulation the mica is not this considering this option uh either because the mica does not apply to defi so the European Union uh decided

not to take this way so not to provide greater um protection in the defi by having more licenses or other kind of regulations for Market participants in uh the defi ecosystem a possible uh action to be taken in our opinion is to introdu a more strict or compulsory liability for the market participant for example um to cut off the condition of the F in the thought liability for participant in a defy ecosystem so this would be um an solution that would be in our opinion

preferable to the opinion of adding more uh licenses requirements and so on for the market participants so thank you for listening to our thoughts regarding the legal regulation of um decks and I think we can answer some questions if there are some questions guess there might be room for two questions so far we have one thank you and sorry in the very some of

the very first slides you said there is no legal relationship between the liquidity provider and the trader there's a there's a relationship between the liquidity provider and the amm and the amm and the trader for a centralized entity for us which accepts asset from clients one of the key questions is always if somebody or a client has Let's uh let's say eth out of eth usdc Unis swap pool for some reason but like a week earlier like a rook hacker or illegal entity whatsoever provided liquidity into that eth usdc pool and our client now basically bought his eth from that pool which now has like

tainted e somehow in it so would you say that the amm itself separates the illegal entity which provides the the tainted coins as sufficiently enough for a centralized Exchange Bank whatsoever to be able to accept such coins because if you're very specifically and nitpicky you would say well theoretically the E that the guy just bought out of you Unis swap amm pool could theoretically be the tainted e that some other guy provided a day earlier thank you okay so thank you for the question so um

we came to the conclusion that there is no contractural relationship between uh the Traders let's call them like that and the liquidity providers because both entities have a contractual relationship to the Dex operator only because there is no will to enter um a relationship between the users your question to my understanding is more related to the AML uh regulation and maybe the criminal um aspects so uh to my understanding um so this is not something we addressed in our

presentation so of course the uh seix have liabilities regarding T AML and want to act in a way that would not make them liable for criminal actions and I would say that to my understanding in some countries at least this AML or criminal law regulation May Force the cax to have adequate measures to make sure that for example some people are not using liquidity pools that were obviously hacked or using by hackers um and I know that there is a lot of change

in this aspect lately as well with the mica that has the the goal to to have a uniform uh regulation in in Europe and I would have like really a closer look uh at the content of this regulation but um I think there may be some obligations with this regard so the fact that there is no contract between the users the not lead to the legal conclusion that uh s um operator don't have any uh obligation to to check that there was not any um criminal activity involved I don't know it if it was

unerring the the question so our presentation was only about the contractual relationship and the possible liability like civil um Li liability related to it so compensation of damage but not the AML and criminal uh consequences amazing we are unfortunately out of time so please uh ask your questions out there um and of course like you guys will you know have a chance to to talk later on thank you again gentlemen [Applause]