When each seller signs up to sell on Etsy, they agree to these terms and are each responsible for their own items.
From the TOU:
"Restricted Activities: Your Content and your use of Etsy shall not:
5. Contain items that have been identified by the U.S. Consumer Products Safety Commission (CPSC) as hazardous to consumers and therefore subject to a recall."
In other words as a seller on Etsy, you are ultimately responsible for anything you place for sale on Etsy. You are responsible for complying with any and all laws and regulations regarding your product. Etsy is merely a middleman. Statement 5 is especially noteworthy. Nearly any product on the market is subject to a recall if a particular hazard is discovered. The problem for children's product makers is that lead has been defined as a hazardous substance. Pthalates have not been defined as such but it is still subject to restrictions.
On February 10th there will be many an Etsian selling children products illegaly or closing up shop.
I know that Etsy, as a third party provider, is trying to dodge responsibility. I think they could do a better job of educating their sellers about laws and regulations. There are many, many sellers making and selling products that didn't even comply with existing regulations - like care/content tags, drawstrings, small parts, etc. Ebay has a close relationship with CPSC (probably forced by the government). Etsy better watch out or they may be held liable in the same way as Ebay. I see the CPSC knocking on the doors of Etsy corporate.
In any event Etsy/Ebay will be losing A LOT of business come February 10, 2009.