You can say a lot about the crypto industry but a couple strong overarching themes continue to pervade—particularly, that (i) the space is constantly evolving and innovating and (ii) there is a continued irreverence among many, or at this point, what might be characterized as willful ignorance among some of (x) history, that is, existing norms derived from lessons long learned in law and economics, and (y) the regulatory frameworks that exist around crypto products and services and apply to them, regardless of the technology employed.
And so it is, when one door closes, several others open—while the ICO boom is long dead, a similar speculative bubble is forming in the decentralized finance (“DeFi”) space as yield farming, also known as liquidity mining, gains traction, DeFi platforms issue governance tokens that soon get listed on decentralized exchanges (“DEXes”), and money amasses in these platforms with a familiar sort of irrational exuberance, sometimes absent third-party audits of the underlying smart contracts and with predictable results.  What follows is a short overview of the mechanics around yield farming, the newest development in crypto, as well as an overview of the potential clouds looming over the space.
What is Yield Farming?
Yield farming models vary but on a basic level it is slightly reminiscent of staking but it involves users of DeFi platforms (“yield farmers” or “liquidity providers”) earning passive income on their holdings by locking crypto assets, often in the form of stablecoins, into a smart contract called a liquidity pool, which in turn lends them out to other users (or otherwise deploys them), providing the means for these liquidity providers to earn returns (yield) on their holdings, often in fees and interest on the locked assets and rewards in the form of the platform’s native governance tokens. Notably, returns in yield farming are floating and vary based on supply and demand (like demand-based Uber surge pricing) and yield farmers continually move their assets around seeking the highest returns, which can be upwards of 100%. DeFi market platforms also use governance tokens as an additional incentive to attract market participants to their platforms.
Another feature of the decentralized lending platforms that yield farmers contribute liquidity to is the need for borrowers to put up collateral, often in an amount of crypto that exceeds their borrowings, which can be automatically liquidated by the smart contract (absent the borrower depositing more collateral) if the loan to value (“LTV”) of the collateral drops under a certain ratio, thus reducing repayment risk on borrower default.
Though yield farming is a fairly new phenomenon, the DeFi space in and of itself is relatively untested from a regulatory perspective, offering products such as stablecoins and a host of financial services through platforms that often lack the oversight, licensures and other formalities that would be required in the traditional finance space based on the premise that these are decentralized marketplaces and on-platform transactions are peer to peer. Perhaps, due in part to the fact that the space has largely been undisturbed by regulatory authorities to date, a false sense of security has emerged that the path forward will be clear from regulatory intervention, emboldening some of the actors in the DeFi space to further test the limits of regulators.
However, recently regulators have started to become more active. In this vein, speaking on the stablecoin space for the first time since cautioning in 2019 that some stablecoins, particularly ones that use algorithms or other mechanics to stabilize price, may constitute securities, the Securities and Exchange Commission (the “SEC”) issued a statement on September 21st, in which they reiterate their approach to the token space while making clear that the same approach would be used to evaluate stablecoins. Namely, the SEC will apply a facts and circumstances analysis to each stablecoin, including looking at its features and how it is offered and sold to determine if securities laws will apply, while at the same time encouraging stablecoin issuers to open a dialogue and reach out to FinHub for further regulatory clarity.
Tokens? I thought we were done with tokens.
Yes, the irresistible appeal of tokens—like honey to crypto projects. Yield farming has once again spurred a bevy of token issuances in the DeFi space. But with these issuances, instead of utility tokens, we now have “governance tokens” being issued. Which will totally not prove to be history repeating itself, right? The issuance of governance tokens, which are designed to give platform participants voting rights over decisions made with respect to the underlying platform and its ecosystem, are becoming part of the yield farming platform playbook as investors rush to take advantage of any profit taking opportunities that become available. One of the earlier successful launches in the space was the June 15, 2020, launch of Compound’s COMP token, which did not involve an airdrop but rather a reservoir of governance tokens to be earned by platform participants as rewards, which peaked at an implied market cap of $1 billion dollars after being listed by an anonymous liquidity provider on a DEX, resulting in a de facto initial offering. Most recently, as a precursor to their September 18th liquidity mining program launch, the trading platform Uniswap launched UNI, a governance token, taking the bolder approach airdropping a minimum of $1,200 in tokens to platform users who opted in to the airdrop with an implied $3.7 billion dollar market cap.
Aside from Uniswap’s ill-advised airdrop of tokens, which seems like escalating behavior in the space and which the SEC has previously indicated will not shelter projects from scrutiny, both projects, in a cringeworthy ICO throwback move, allocated percentages of their token supply to their founders, their investors and shareholders, and employee incentive pools, with the respective breakdowns as follows:
What is not clear to me, or to many of the lawyers that watch this space, is why DeFi issuers have any sort of confidence that the distinctions they are able to conjure up around why these token issuances do not constitute securities offerings will survive in the face of scrutiny from the SEC.
First, from a practical perspective, relying on “governance” as a distinguishing feature that would represent a step forward from “utility” is odd given that it is an equity-like feature. Further, the use of a distribution mechanism outside of earning rewards for participation is a misstep, both in terms of initial allocations that provide any sort of concentration or centralization of voting power. Next, the choice to allow the tokens to be transferred outside the platform, though eternally tempting, puts these projects outside of the safe harbor of SEC no-action letters. It also provides those with large initial allocations with an exit opportunity (even with vesting) such that the tokens would be used in the first instance for speculation on an exchange as opposed to being used for their purported purpose.
There are now enough governance missteps in the crypto space to combine with lessons that should be learned from the traditional finance space to be cautious of whether governance mechanisms in a decentralized environment fulfill their purported use cases—especially when such tokens have a liquid market outside of the platform they purport to help govern. Crowdfunding offerings have often led to cap table management issues from the resulting sheer number of shareholders, each with a small economic stake. It also has created issues with shareholder engagement, participation (including even reaching quorum) and free-riding problems have abounded. Yet while equity provides economic rights in the enterprise as well as governance rights to shareholders, governance tokens divorce the economic stake associated with equity as far as the platform ecosystem is concerned and just provide the governance rights, arguably exacerbating the voting issues experienced in the equity crowdfunding space. Moreover, in what should be a stark lesson from the ICO era, crypto secondary market liquidity provides an alternate (and likely predominant) use case for these tokens, especially when allocated into the hands of platform investors, and skews the incentive structure for holders of governance tokens, as users are motivated to make decisions based on realizing short-term gains in the secondary market as opposed to making decisions that would support long-term ecosystem growth.
Ultimately, if this article doesn’t make you war weary from the overwhelming sense of déjà vu, as we continue a theme of lessons unlearned and broken record regulatory pronouncements, then you weren’t following the crypto space over the past several years. Absent a change in law, regulators have and will continue to apply a tech-agnostic approach to this space, reviewing the underlying base characteristics of digital instruments together with the facts and circumstances of their offering and sale to look through “the label or terminology used to describe a digital asset or a person engaging in or providing financial activities or services involving a digital asset, [which] may not necessarily align with how that asset, activity, or service is defined under the laws and rules administered by the SEC.” And while I am decidedly terrible at predictions, I doubt the SEC will lead with more pronouncements before becoming more active in the face of token issuers replicating past bad behaviors in the space so overtly. In all, if the UNI airdrop doesn’t get the SEC off the bench and into the enforcement mix in the DeFi space, I am not sure what will.
If you would like more information, please contact a member of Harter Secrest & Emery LLP’s Digital Assets and Disruptive Technologies group at 716.853.1616 or 585.232.6500.
 See, for example, the recent problems with the unaudited smart contracts for Yam Finance which contained a bug that was deemed not capable of being fixed after $300 million was deposited and which resulted in $750,000 in losses.
 For more in-depth overview of the yield farming space, see CoinDesk, What Is Yield Farming? The Rocket Fuel of DeFi, Explained https://www.coindesk.com/defi-yield-farming-comp-token-explained;.CoinCentral, What is Yield Farming?, https://coincentral.com/what-is-yield-farming/, https://www.coinspeaker.com/guides/what-is-yield-farming-risks-and-benefits-involved/
 See Sept 21, 2020 statement from the FinHub Staff on Stablecoins https://www.sec.gov/news/public-statement/sec-finhub-statement-occ-interpretation
 For an overview of the COMP token launch, see https://tokentuesdays.substack.com/p/comp-distribution-exceeds-expectations
 “[T]he lack of monetary consideration for digital assets, such as those distributed via a so called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation.” See SEC Framework for “Investment Contract” Analysis of Digital Assets
 See e.g., this defense of COMP tokens and how they can be distinguished from utility tokens, in part relying on decentralization arguments, available at: https://cointelegraph.com/news/defi-governance-tokens-tread-carefully-as-the-secs-invisible-hand-looms; others make a functionality distinction, see e.g. https://cointelegraph.com/news/defi-may-not-be-like-the-ico-boom-but-is-that-a-good-thing. However, functionality as a bright line has been implicitly rejected by the SEC in the SAFT context, as we saw playing out recently with Telegram, especially in the event a pre-sale is integrated and viewed as one continuous offering with the ICO, a blow for any other project making utility at sale arguments.
 These initial allocations continue to prove to be a fatal mistake for many projects, most recently (as in the days before we circulate this article), Kik lost its fight against the SEC on summary judgment, a pretty brutal K.O., with the court noting that 30% token allocation to Kik gave it incentive to establish a market for Kin tokens in analyzing the expectation of profits prong of the Howey test (in addition to noting the lack of utility at the time of ICO and integrating the pre-sale).
 See, e.g., Karjalainen, Risto, Governance in Decentralized Networks (May 21, 2020), available at SSRN: https://ssrn.com/abstract=3551099 (arguing that decentralized networks should apply lessons of law and economics learned and inherent in the design of existing governance and voting systems).
 See https://www.sec.gov/news/speech/2007/spch042007css.htm (describing basic disincentives around voting by investors with small stakes given the effort involved in making informed voting decisions leading them to “under-invest in producing information that can help them improve their voting decisions and the production of such information can be viewed as being subject to a “free-rider” problem. This observation is related to the “paradox of voting” in which if the individual’s probability of affecting the outcome is sufficiently small, then the individual will not vote”…).
 Conversely, in both the traditional markets and decentralized markets, absent restrictions on the ability to do so, stakeholders can amass significant voting blocks and predictably, though perverse to the principles behind decentralized governance, this gives rise to a vested interest in actually participating in voting as well as practically having the ability to sway a vote. See, for example, a recent vote on Compound that was voted on by relatively few users and determined by a small subset of larger holders https://compound.finance/governance/proposals/12; see also https://www.yahoo.com/news/defi-just-ico-boom-regulators-182617086.html (citing that “crisis governance has become too frequent in DeFi. Many of these projects rely on governance protocols where a very small group of participants are able and/or pressured to change the protocol”).