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Decentralized Exchange (DEX) Regulatory Framework

There are three areas of policy that are relevant to decentralized exchange: 1. Financial surveillance (also known as anti-money-laundering), 2. Securities regulation, and 3. Constitutional law (First and Fourth Amendment, free speech rights and search and seizure rights respectively).

The first two categories, surveillance and securities, are regulatory structures that may or may not apply to persons developing, implementing, hosting, or using decentralized exchange infrastructure. The third, constitutional law, can be a shield for those people from regulatory application in certain circumstances.

1. Financial surveillance and DEX

Since the 1970s, the Bank Secrecy Act (BSA) — a federal law — has obligated financial institutions serving U.S. persons to collect and report certain information about their customers’ identities and transactions to a bureau of the Treasury Department, the Financial Crimes Enforcement Network or FinCEN for short.

This category of obligated businesses, financial institutions, originally included only those who were obviously engaged in traditional financial services, such as insured banks, but grew to include a variety of finance-adjacent businesses like pawn shops, casinos, and, yes, cryptocurrency custodians and exchanges.

This is the law that obligates exchanges to do “know your customer” checks, and to report suspicious transactions to law enforcement in so-called Suspicious Activity Reports or SARs. As we’ll address at the end of this article, it is worth noting that all of this data collection, retention, and reporting (arguably a search and seizure of sensitive customer data) takes place entirely without warrants or any particularized suspicion on the part of law enforcement. It is a warrantless dragnet. That aside, how do these financial surveillance laws apply to decentralized exchange?

The crypto community argued that the only activities performed using cryptocurrency that should trigger surveillance obligations are those in which a person or business has actual control over the cryptocurrency of another person (their customer) and acts on their behalf. This mirrors traditional financial services — we expect that banks (who hold people’s dollar accounts) will be subject to the BSA, but we don’t expect safe manufacturers (who simply build tools that allow persons to hold their own cash or valuables) to be subject to the Act.

The same should be true with respect to cryptocurrency business: only custodial wallet and exchange providers like Kraken and Coinbase should be required to comply with the BSA, and entities that are not third-party custodians, such as individual holders, software developers, miners, full nodes, and multi-sig providers (assuming they don’t have sufficient keys to transact) should never be subject to the BSA.

The Uniform Law Commission worked on model language to define the custodial act specifically so that there is no confusion over to whom regulations should apply. Only those with “the ability to unilaterally execute or indefinitely prevent a cryptocurrency transaction on behalf of a customer” should be regulated. While that model language was intended for consumer protection, it works in any context where defining custody and control is relevant.

Thus far, such efforts have paid off. FinCEN has offered clear guidance explaining that persons who don’t have “independent control” over customer funds will not be subject to the registration and surveillance requirements of the BSA. That guidance came in May of 2019, and we believe it is excellent. In it, FinCEN lays down the basic principle: you must have independent control over customer funds to be subject to the law, and FinCEN offers specifics for various activity fact patterns, including decentralized exchange tools:

“Under FinCEN regulations, a person is exempt from money transmitter status if the person only provides the delivery, communication, or network access services used by a money transmitter to support money transmission services. Consistent with this exemption, if a [convertible virtual currency] trading platform only provides a forum where buyers and sellers of [convertible virtual currency] post their bids and offers (with or without automatic matching of counterparties), and the parties themselves settle any matched transactions through an outside venue (either through individual wallets or other wallets not hosted by the trading platform), the trading platform does not qualify as a money transmitter under FinCEN regulations.”

So, at least with respect to financial surveillance regulations, if software facilitating a decentralized exchange is designed—as the name implies—to never give some third party custody over the cryptocurrency, and to simply match persons who will settle trades peer-to-peer, then the developers of that software are not regulated under the BSA. Neither are the users of that software regulated under the BSA if they are simply trading on their own behalf, as FinCEN has stated in guidance as early as 2013

2. Securities regulation and DEX

The BSA analysis alone, however, does not mean that decentralized exchange is never regulated. Securities regulations may apply to some activities that some people might perform using decentralized exchange.

The object of securities regulation is to protect investors from fraud and misrepresentation; that’s distinct from financial surveillance laws like the BSA where they object is to collect information that can be used to stop money laundering. As such, securities laws only apply when the asset being traded is, you guessed it, a security. The definition of a “security” is complex and flexible, and since 2015 the crypto community has been developing policy research on the question of whether and when a cryptocurrency will qualify as a security.

The short answer is that tokens that do not have an issuer upon whom token-holders rely for an expectation of future profits are not securities, and those that do are securities. In practice, that means that Bitcoin and cryptocurrencies like it are not securities because there is no central issuer who manages the network and promotes and sells some initial offering of tokens. Meanwhile, promises of future tokens will be securities because we rely on the developer of that future network to deliver on her promises.

Finally, new tokens that travel on decentralized networks but that were initially sold in a presale as a promise of the developer are a grey area: the initial sale was a security offering, but if the network today is truly decentralized then the resultant token on a running network may not be a security. See EOS, for example, the promoters of which settled with the SEC over their pre-sale—admitting that the presale token was a security, but the current network token is not regulated as a security.

Regardless, if a token is a security then it cannot legally trade on exchanges that are not SEC-regulated as registered National Security Exchanges or Alternative Trading Systems. The definition of an exchange in the securities laws is broader and more flexible than the definition in the BSA: it does not rely on the concept of third party custody and could extend to persons who don’t have custody but merely match buyers and sellers or facilitate settlement. Therefore, if you are developing or implementing a tool for decentralized exchange and if some of the tokens that are trading with that tool are securities, then you may be liable for facilitating or operating an unregistered securities exchange.

In 2018, the SEC accused Zachary Coburn, the original developer of EtherDelta, of operating an unregistered securities exchange, and they ultimately settled out of court. EtherDelta was an Ethereum-based DEX platform and was used to trade several tokens that the SEC had already found to be securities (and several other tokens that likely would be found to be securities if the SEC took a hard look at them). So, even though EtherDelta never had any third party custodian (and therefore would not have been subject to the BSA and associated financial surveillance obligations) it still may have been an illegal securities exchange under U.S. securities laws.

In theory, a DEX platform that only facilitates the exchange of non-security tokens like Bitcoin would not be subject to either the BSA or securities laws. In practice, developers build tools that can be used for trading any token, security or non-security. Whether a developer who intended her tools to be used only for non-securities exchange could be liable if those tools were eventually used by others to trade securities is an untested question. Part of the answer will depend on what the developer did and whether her actions can be construed as protected speech under the U.S. Constitution, our final topic.

3. Constitutional law and DEX

If someone developing or implementing tools related to decentralized exchange was ever charged with violating securities laws (because people were trading securities tokens using the tool) or financial surveillance laws (if those laws were ever changed to expand their coverage to non-custodial entities) then they may be able to use constitutional law as an affirmative defense. Two promising defenses that we’ve written extensively on are our First Amendment freedom of speech rights and our Fourth Amendment right against warrantless search and seizure.

If a developer is creating and releasing versions of decentralized exchange software to the general public, and if that developer is not also advocating the illegal usage of that software, collecting fees from person’s use of the software, or maintaining a website through which people might access and use the software, then there is a strong case that this software publishing activity alone is constitutionally protected expression.

That doesn’t necessarily mean that the government can never regulate that activity. But it does mean that any regulation curtailing the otherwise free expression will face strict scrutiny from the courts, which means that the government will have to prove both that (a) the regulation furthers a compelling state interest, and (b) that no less-speech-restrictive means could achieve that interest. In practice this level of scrutiny forbids the state from passing laws that would ban the publication based on content or viewpoint.

Open-source decentralized exchange software is a particular type of content that advocates a strongly held political viewpoint: that we should be able to engage in payments and transactions free of middlemen and censorship. In practice, strict scrutiny forbids the state from passing laws that create a “prior restraint” on speech, that is to say a ban on speech that is in place before the speech is actually made. In other words a punishment for saying something defamatory after the fact is not a prior restraint, but a law that says “no one shall be allowed to say anything untrue about the President’s character” is a prior restraint. Any law that attempts to ban the publication of decentralized exchange software or make publication illegal without a license or some other precondition would be a prior restraint. In practice, courts always find these forms of regulation to be unconstitutional.

If a developer is told that she must include a surveillance or “know your customer” tool (or backdoor) in her decentralized exchange software, this could be challenged as unconstitutional compelled speech. Regulations compelling speech, especially if the speech in question concerns non-commercial expressive content, also face strict scrutiny review.

Finally, if a developer is compelled to include surveillance tools in her decentralized exchange software, that mandate can be challenged as an unconstitutional warrantless search in contravention of the Fourth Amendment’s warrant requirement. As described earlier, the Bank Secrecy Act already mandates massive warrantless data collection from centralized exchanges and other financial institutions. The only reason this dragnet is constitutional is because the subjects of the search (individual users of the exchange) willingly provide their information to a third-party. Since the 1970s, courts have held that when the subject of the search voluntarily hands information over to a third party — and that third party retains the information for legitimate business purposes — then the subject loses her reasonable expectation of privacy over the information. With no reasonable expectation of privacy, the government need not get a warrant to search or seize the information in question.

However, if the user is buying or selling in a decentralized exchange, then there is no third-party to whom the user has handed over the information. This third-party carve-out to the warrant requirement would not apply. The bulk of the Bank Secrecy Act’s data collection and reporting obligations (e.g. SARs) are warrantless, and therefore these could not be used to gather information that has not been voluntarily revealed to a third party; that data remains subject to a warrant requirement.

Jurisdiction Filtering and Token Limits

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DEX regulatory framework details

Alternatively you can limit the allowed swappable tokens by tokenid.This wo\ uld block any stablecoin or security trade.

NFTscan have a custom swap fees depending on NFT type. For example a concer\ t ticket resold could have a 10% fee, while a restaurant meal voucher could have a 5% fee.


fincen.gov guidance may 2019

Peter Van Valkenburgh TheBlockCrypto.com

Coincenter.org DEX and the constitution

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Automated market making (AMM)

Automated market making (AMM; AMM also refers to an automated market maker) is a feature of trading platforms in DeFi (decentralized finance). Instead of a cryptocurrency trading platform organizing an order book of bids and offers. Decentralized platforms rely on AMMs which stand constantly ready to buy and sell the smart contracts, or in our case swap transactions.

A DEX, or decentralized exchange, is mainly a type of cryptocurrency exchange. It operates like a stock exchange, except it is run by a smart contract on the Ethereum blockchain that enforces rules and executes trades. Users can trade cryptocurrencies and DEXs do not require a centralized authority to operate, but they do need access to a reliable source of liquidity to service their users.

To better understand how they operate, let’s compare a DEX to a centralized exchange (CEX).

Financial exchanges are where users buy and sell financial assets. Traditionally, the CEX takes orders from buyers and sellers and takes custody of their assets. DEXs do the same thing but without the custodial aspect and they can offer more in the way of security and anonymity. A user can simply interact with a smart contract directly from their crypto wallet.

Some DEXs have pools of currencies to trade or swap, whilst other DEXs use order books with Maker and Taker orders. Maker orders provide liquidity because they’re not immediately matched on the order book. Whereas a Taker order is instantly matched with an order already on the books. Thus, fees for Maker orders are lower than fees for Taker orders (or they can even be zero).

How does a DEX work? While DEXs can differ in how they’re designed, they are similar in how they connect buyers and sellers across a global liquidity pool. Most DEXs require the user to have at least enough ETH to cover the transaction cost of doing the trade. Some don’t charge transaction fees for Maker orders but make up the difference by charging higher fees for Taker orders, while some return a portion of the trading fees to traders who willingly supply capital to their liquidity pools.

Are DEXs Risky? There’s always a risk anytime you use a CEX because you first have to deposit your funds. CEXs hold millions of dollars in deposits and thus are constantly targeted by hackers looking for big money heists. The big risk in a CEX, therefore, is that of custody, which a user forfeits the entire time their deposit is being held.

Hackers have made off with millions of dollars as well as reams of user data by cracking into CEXs over the years, the most infamous being the Mt. Gox hack in 2014. That exploit gave Bitcoin a black eye from a security reputation standpoint, and opened the door for gold-shilling naysayers like Peter Schiff to boast, “I told you so!” It’s this lack of security that has tarnished the image of crypto exchanges and hampered them from becoming potential competitors to conventional exchanges.

Hopefully, DEXs can change all that because the assets are only transferred at transaction time naturally making them more secure. So DEXs can offer non-custodial solutions that bigger CEXs like Coinbase or Binance cannot. Even though they are still the 800-pound gorillas in the room, DEXs are poised to compete with them due to improvements being made in usability, liquidity, and security.

Here is a list of some of the advantages of trading on a DEX:

  • Pseudo-anonymous: No lengthy forms, background info, or ID is required to participate.
  • Automatic: So long as there is sufficient liquidity, DEX trading is instant.
  • Non-custodial: You don’t have to turn over your funds to 3rd party control.
  • Lower cost: Minimal trading fees.
  • So, as long as a user can keep their private keys in check, using a DEX should mitigate the risk of getting hacked. However, different DEXs can vary in how they operate, so let’s take a brief look at three you may have heard of:


    Uniswap is one of the most popular DEXs around and has rapidly become the leading exchange for active traders looking to swap DeFi tokens. Far from the DEXs of old that offered a poor user experience and thin order books, Uniswap crashed through the window of opportunity to create a simple yet effective DEX known for its wide selection of trading pairs.

    Uniswap launched in 2018 with funding from the Ethereum Foundation after creator Hayden Adams (inspired by Ethereum’s Co-Founder, Vitalik Buterin) began studying the Solidity programming language. Many observers often stress the advantages of being a “bidler” (not just a “hodler”) to be successful in crypto, and Hayden certainly defines what it means to be a successful bidler. After all, he ended up creating one of the most interesting projects recently seen on Ethereum that’s quite different from the traditional DEX.

    The short description of Uniswap is that it’s a simple one-click interface where traders can swap ETH or ERC-20 tokens on-chain by pooling liquidity. This can all be done through a Web 3.0 wallet without having to deal with a centralized order book to deposit or withdraw.

    A set of smart contracts on the Ethereum network is deployed, but it’s open-source and there are no Uniswap investor tokens, no fees paid to the founders, and of course, no central authority involved. Simply by leveraging smart contracts, Uniswap allows traders to perform on-chain transactions at lower costs in a few clicks. There are no KYC or custodial issues to worry about.

    For example, let’s say you want to trade ETH for DAI. On a traditional exchange, you would have to deal with centralized order books organized around various price points with different demands at each price point. Not so on Uniswap. You simply connect your wallet, select ETH to trade, and DAI to receive, and Uniswap automatically performs the transaction and updates your wallet balance.

    Automated Market Maker

    So, rather than selecting a buy or sell price, you would select ETH and DAI and get the market rate from Uniswap. Global liquidity pools are leveraged to create markets for ETH and DAI by using an Automated Market Maker (AMM), the exchange can then quote prices. AMMs are controlled by algorithms and they define rules for trades to be able to provide constant liquidity regardless of the order’s size.

    Also, with the new and improved Uniswap V2 version, traders can now benefit from new token pairs and flash swaps.

    Here are some of the advantages Uniswap has over the traditional DEX:

    There are no listing fees It boasts some of the lowest gas costs. The project is trustless and permissionless.

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    A bot can automate the checking of valid received swaps. Once a valid swap is received from its own address pool and the price is within limits, the swap is signed and broadcasted.

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    DEX AMM Product Sheet

    Swap Quick Start

    SLPswap Whitepaper html pdf

    Third-Party Library

    PSBT Trustless Txs

    PSBT Documentation

    BIP 174 – PSBT (github)


    DEX Automatic MarketMakers

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