The .LY domain is Libya, and their government recently cancelled the registration of the short and snappy VB.LY, provoking great gnashing of teeth. If you direct your attention to the address bar above this page, you'll note that it's at JL.LY, equally short and snappy. The .LY registry started allowing two letter second-level domains last year, and there was a quiet land rush. Now they restrict those domains to people actually in Libya, but say they'll let us keep the ones we have. How concerned am I that they'll take my domain away, too? Slightly, but not very.
Honestly, it was pretty foolish to put a sex site on a domain in a Muslim country. VB is Violet Blue, a very elegant high class sex site, but there's no way it's anything else. She argued that VB.LY was only a redirector to underlying sites and had no sexual stuff on it, which may have been technically correct, but it was utterly obvious to anyone what showed up on your screen if you typed http://vb.ly in the address bar. I think Violet Blue is swell, but it is naive to imagine that the Libyan government would not feel differently once they noticed it.
Every two-letter top level domain is a assigned to a country or country-like geographic area, known as a ccTLD. The rule that countries own their ccTLDs is far older than ICANN. Even though the US government has always had its thumb on the DNS root, they have been notably silent as domains for Cuba, North Korea, and Iran have been delegated and redelegated. ICANN has told me that they reserve the right to refuse to make a change to a ccTLD, but they never have done so. My impression is that they engage in polite negotiations when a ccTLD asks to do something technically ill-advised, so they don't exactly refuse, but they don't exactly make the change, either. It's clear they only would flatly refuse to prevent serious technical problems.
In the agreements it has with some ccTLDs, ICANN doesn't ask countries to do anything beyond some non-binding requests to notify each other if something of interest to the other party comes up, and sometimes for the countries to make token contributions toward ICANN's expenses. One correspondent asked why ICANN doesn't demand fuller disclosure of the policies, but what would be the point of asking? ICANN's only recourse would be to pull the plug on a ccTLD and they're not going to do that.
VB claimed to be unaware that she was violating Libyan laws, which is probably true. But the world is a big place, and the US is only part of it. Libyan laws are in a hard to read foreign language, but foreign countries are like that. (Libyans presumably have the same complaint about US laws, which are not written in easy to read Arabic.) I don't think it takes a profound understanding of world culture to be aware that .LY is in Libya, Libya is a Muslim country, and Muslim tradition encourages modesty and forbids alcohol, so a site which features pictures of scantily clad women holding drinks isn't going to work.
Although it can seem hard to believe at this point, domain names are intended to be stable identifiers, not fashion accessories. In most countries, people register in their country domain, so Canadians register in .CA, in .MX, French in .FR, and so forth. An ill-advised policy prior to 2002 required that all .US domains contain city and state, e.g. IBM.ARMONK.NY.US, so we all used .COM instead, but that's unique to the US. If you live in Libya, .LY works fine, and you wouldn't be doing anything contrary to Libyan law anyway.
Here's a thought experiment: let's say someone lives in Denmark, where pictures of 17 year olds are considered legal erotica, and builds his web site. He registers a domain for it in .US or .GU or .AS or .PR or .VI or .MP, where US law considers those pictures child pornography. How long would the domain last? Would it matter that he didn't know, or that he couldn't read the English fine print? Same issue.
I also have the short and snappy SP.AM which I got in 1999, by politely asking the university that ran .AM at the time. I don't see any danger of it going away, but I do realize that Armenian law applies, and I don't read Armenian. Ditto my much newer JL.LY, which I use for my blog — they might take offence and take it away, so I do have other US-based domains just in case.
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