Lawyers on Layers: The Regulatory Future of Decentralized Finance

by | October 5, 2022 | Whistleblower Law

With a rapidly growing user base, exchanges like Bitcoin and Ethereum have recently been integrating scaling solutions like Layer 2 (L2) into their blockchain network. L2 networks increase the rate and efficiency of transactions while still maintaining the decentralized blockchain architecture. L2 solutions could transform how consumers and developers use cryptocurrencies. But regulation needs to keep pace as crypto use broadens in scope. L2 solutions shed light on the ambiguities of crypto classification. Specifically, varying digital assets may require different regulatory classifications to properly mitigate harm.

What is an L2 Solution?

Layer 2 (L2) solutions build upon the original base blockchain which is Layer 1 (L1). For example, Ethereum and Bitcoin are Layer 1 solutions. Ethereum describes L2 as “a separate blockchain that extends Ethereum and inherits the security guarantees of Ethereum.”

L2 solutions increase app transaction speeds, expanding the potential uses of blockchain technology. On L1, Bitcoin and Ethereum are primarily used to store value or means of transaction. Because blockchain technology emphasizes security on a decentralized network, the base transaction speeds are extremely slow. For example, using L1, it takes between 15 seconds to 5 minutes to process a transaction on Ethereum.

L2, on the other hand, can rely on the security of L1 solutions, but with increased transaction speeds. Companies leveraging the speed of L2 solutions are beginning to expand and improve their offerings. For instance, Polygon is a new L2 solution that builds upon Ethereum’s base blockchain, which developers can use to build apps with higher transaction speeds at lower costs. L2 solutions could also enable NFTs to become more easily tradable. Immutable X, a blockchain gaming company, is an L2 solution built on Ethereum’s network designed to make NFT trading and minting more efficient and cheaper. This allows NFT gaming operations to run smoothly.

How L2 Solutions Could Impact Regulations

Despite the added benefits, L2 could further complicate how cryptocurrencies are regulated. This past June, a bipartisan Senate bill proposed that the CFTC should oversee and regulate most cryptocurrencies, classifying them as a commodity. However, some critics assert that this classification overlooks that some crypto assets function more like securities. The main difference between commodities and securities is the expectation of return and where the return comes from. Generally, a commodity is a tradeable asset that derives value from the forces of supply and demand.

To classify as a security, a transaction must pass the Howey Test:

  • Is there an investment of money?
  • Does the investment derive from a common enterprise?
  • Is the expectation of profit derived from the efforts of others?

L2s & Ethereum

Earlier this month, Ethereum switched over to a “proof-of-stake” (PoS) consensus,” where token holders are rewarded for verifying their transactions through a process called staking. Ethereum’s L2 scaling solution, Polygon, also employs a PoS model. Experts have said that Ethereum’s PoS transition could “boost the performance” of Polygon, only making it more efficient. Interestingly, the chairman of the U.S. Securities and Exchange Commission (SEC) recently added that, when digital currencies have intermediaries allowing users to have a stake in their coins, it “looks very similar to lending.” This implies that Ethereum and Polygon function more like securities. As crypto users continue to “expect” and desire profit from their investments, the CFTC may not be properly equipped to handle all regulatory concerns.

L2s & NFTs

NFTs may have a different legal trajectory. When NFTs are developed as L2 solutions and hosted on L1 blockchains, there is no third-party involvement. In these cases, users are more in control of their investments and transactions, and they get to set their own trading fees. This process indicates that Layer 2 NFTs don’t resemble securities. On the other hand, some NFTs on Layer 1 are like investment contracts. The SEC Commissioner recently commented on this variability, “[…] Given the breadth of the NFT landscape […] people need to be thinking about potential places where NFTs might run into the securities regulatory regime.”

Conclusion: Clear Regulations Stop Fraud

Despite the uncertainty, one takeaway is clear: the need for clarifying regulation. Over and over, we see that innovation outpaces regulation. Until regulation catches up, it is generally the consumer who ends up paying the price for the gap. Even once regulations are passed, employees at blockchain platforms and crypto companies can and will play a vital role in ensuring compliance to protect consumers.

Our team at Sanford Heisler Sharp represents whistleblowers exposing fraud in various avenues and industries, including crypto companies, blockchain platforms, and related businesses. With vast resources and experience, we are staying atop the evolving cryptocurrency industry, its regulations, and fraud cases that might emerge from it. If you have any questions or concerns about fraud in the crypto industry or think that you need to report it, please do not hesitate to contact our firm for help from the very beginning. You can fill out our online intake form to request an initial consultation.

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