- Layer-2 platforms operate profitably, generating revenue through transaction fees and token issuance, resembling traditional business models.
- SEC scrutiny of Ethereum could classify it as a security, complicating approvals for Ethereum-based financial products like ETFs.
Ethereum has evolved over the years, adapting to meet the growing demands of a global user base. To manage the influx of transactions, a number of layer-2 solutions have been developed. These platforms are designed to be more cost-effective and scalable, supporting complex decentralized applications that the primary Ethereum network cannot handle efficiently.
Legal Concerns Over Layer-2 Operations
Despite the success of these layer-2 platforms, which currently boast over $39 billion in total value locked (TVL) according to L2Beat, concerns about their legal status are emerging. Nikita Zhavoronkov, a lead developer at Blockchair, has recently voiced significant worries about these solutions, suggesting that they could face regulatory issues.
On the social platform X, Zhavoronkov expressed his belief that layer-2s might operate similarly to money service businesses (MSBs) but without the necessary regulatory oversight, potentially positioning them as operating outside legal boundaries.
Existing L2s on both Bitcoin and Ethereum are money service businesses (MSBs) and are likely to fail under regulatory pressure right after privacy services! ?
1. All L2s (whether sidechains or rollups) are custodial. Customer funds are either locked in a multisig contract… pic.twitter.com/YXdagxZoyB
— Nikita Zhavoronkov (@nikzh) May 16, 2024
Zhavoronkov points to the governance structures of these platforms, such as the use of multi-signature contracts and emergency councils, which he argues indicate a level of centralization. This centralization, he suggests, could make layer-2s vulnerable to regulatory actions.
Additionally, the custodial nature of many layer-2 solutions, where the platforms, not the users, control the funds, was highlighted as a central concern. This setup could attract regulatory scrutiny, particularly if these entities are seen as having too much control over user assets.
Theoretically, yes, but in practice, 99% of the Lightning usage is through custodial providers. To become decentralzed, Lightning requires a scaled L1. It’s impossible for Lightning to scale in a decentralized way to a lot of users on top 1 MB blocks.
— Nikita Zhavoronkov (@nikzh) May 16, 2024
Implications for Ethereum and the Crypto Industry
Zhavoronkov also noted that many layer-2 platforms operate as for-profit entities, generating income from transaction fees and, in some cases, issuing tokens that can influence the platforms’ revenue and token value. This blurs the lines between them and traditional companies, moving away from the decentralized ethos typically associated with blockchain technology.
Potential Regulatory Challenges Ahead
The assertion by Zhavoronkov that layer-2 solutions might be classified as MSBs under U.S. law raises the possibility of stringent regulations and compliance requirements. This could not only affect the individual platforms but also impact Ethereum’s scalability and broader adoption.
Adding complexity to the issue is the reported investigation of Ethereum by the United States Securities and Exchange Commission (SEC). If the SEC classifies Ethereum as a security rather than a commodity—contrary to how Bitcoin is viewed—it could complicate the approval process for Ethereum-based financial products like spot ETFs.
While some industry observers have dismissed Zhavoronkov’s concerns as exaggerated, the potential for regulatory intervention remains a critical topic for Ethereum and its layer-2 platforms. As the situation unfolds, the cryptocurrency community will be watching closely, aware that the outcome could have lasting impacts on the development and functioning of decentralized platforms.
