SEC Director Hinman gave a public speech about three weeks ago which was subsequently affirmed by testimony from Chairman Clayton the following week. A key point in his speech for many was his observation that ether (ETH) was no longer a security because it had become sufficiently decentralized.
In Hinman’s speech, he also provided an ad hoc checklist for issuers to go through to make sure they do not fall afoul of securities registration requirements.
But in doing so, the guidance does not really seem helpful as it raises more questions than answers which are discussed below. Note: the discussion for how – if at all – the rules are updated or changed is not within scope of this short article.
The first is technical and pedantic: ETH as we know it, is actually the first major fork of Ethereum Classic (ETC). Recall that following The DAO attack (hack) in June 2016, key participants in the Ethereum ecosystem coordinated a hard fork which resulted in two separate chains – what we now call ETH and ETC – and that ETC represents the original chain. So transitively, does Hinman actually mean ETC is sufficiently decentralized too? Or is it just a property for the fork, ETH?
While most people are aware that it was the exchanges -- specifically Poloniex -- which decided to recognize and associate specific chains with specific ticker symbols, exchanges were also key – existentially critical -- during the first moments after The DAO attack (hack) was discovered.
How integral were they? And how did they coordinate?
A public chat log from June 17, 2016 details the coordination between core Ethereum developers and exchanges. One such dialogue is the following:
The specific passage highlighted above shows how key developers requested that exchange operators stop trading ETH and after some discussion, the major exchange operators - such as Poloniex - temporarily acceded to the request. It bears mentioning that the chat above is missing some additional context around locked DAO tokens (which were still locked up for several more weeks) and that this provisional trading freeze was being done to protect all coin holders.
This wasn’t the first time that core developers attempted to coordinate with exchanges after a mistake has occurred. In March 2013, a group of Bitcoin developers, miners, and exchanges did something perhaps more glaring – coordinated off-chain to stop a hard fork -- in an IRC chat room during an unintended hard fork of Bitcoin.
If you follow the dialogue in either chat room, it is clear that a relatively small set of participants has influence and especially in the Bitcoin fork instance, arguably administrates the chain and its governance during these critical time periods.
And at least one question arises from this: is the ongoing success of the system (and the token's value) reliant on the ongoing efforts of others? If not, why not.
Arguably the answer is yes for most of these public blockchains. And based on the handy “arewedecentralizedyet” chart we can see that similar – and probably more – types of centralization exists for many other cryptocurrencies too.
But recall that Hinman’s speech seems to assume that ether was a security at one point and then through some process that is still not explained, is no longer a security. What day did that transition take place? Was it before or after the ICO in 2014? Before or after the coordinated hard fork in July 2016 (as a solution to The DAO attack (hack))? Before or after <insert other milestones or forks>.
For those counting at home, following the July 2016 hard fork, this means that the ETC chain was actually created twice and in both cases was the work of a small group of known people, some of whom continue to maintain it. After all, blockchains don’t automagically fix themselves.
Is it possible for a coin or token to become un-decentralized? And if so, do the maintainers get something like a 90 day grace period to make it re-decentralized otherwise the coin is sent to some kind of securities purgatory?
While we wait for more clarity and specific answers to these questions, another potential issue is with HoweyCoins.
HoweyCoins is a parody ICO website published by the SEC on May 16, 2018 – right smack in the middle of “Blockchain Week” in New York City. The website is supposed to serve as a lampoonish illustration to coin issuers of what not to do when fundraising – and also serve as a warning to investors for what to look out for as red flags such as early participation discounts. It’s definitely good fun - my friends and I frequently refer to it in jest.
And while Hinman’s speech explicitly punted on how Ethereum was initially funded, the Ethereum public sale back in July 2014 also relied on discounts (or bonuses) to early investors during its six week sale.
The first two weeks, participants received 2,000 ETH per BTC, which linearly declined until the final epoch in which investors received 1,337 ETH per BTC. Were the designers of the HoweyCoins website aware of this discounting?
In looking at the actual HoweyCoins whitepaper there is no technical meat that issuers or investors alike can count on for guidance. That is to say: there is no technical attributes describing the functionality of how HoweyCoin mechanically works. In its 8 pages it describes a couple use-cases but – like most ICO whitepapers – is very vague at how it will accomplish or achieve them.
But ignoring the Ethereum initial fundraising period and its Terms and Conditions, a problem that is not resolved in either Hinman or Clayton’s recent speech and testimony is that HoweyCoins, for all of its vague promises of high yield returns is a strawman that does not really help provide guidance as it relates to the facts and circumstances around how Ethereum – or any crowdfunded coin – can become sufficiently decentralized.
After all, what is to stop someone from spinning up their own blockchain called “HoweyCoins,” raise ~$17 million through a public sale and 12 months later, formally launch the mainnet (as Ethereum did)?
The wording and justification for why Ethereum is not still a security – that it somehow at some point became sufficiently decentralized – seems ripe for debate and will surely be gamed by future coin and token sales. Without explicit parameters, if Ethereum is sufficiently decentralized, then so to – at some point in the future – could HoweyCoins. And then it’s no longer a parody.
A third and final point is that while Hinman alluded to them, even if these chains are finger quote “decentralized,” and thus not falling strictly under the "common enterprise" in the literal sense (i.e. where there is literally a single legal entity determining the success), how does a "community enterprise" present less risk to investors? Tangentially, isn’t this the same type of argument that mob bosses frequently used and as a result RICO Acts were created to pierce through?
If we take the view that the spirit of the regulations (1933, 1934, 1940 Acts) which led to the Howey ruling was actually to protect small investors, does a non-singular, and quasi-independent, but systemically important influential organization actually reduce risk?
If that is the view that they are taking, it would be helpful to see how the commission has come to that conclusion.
After all, it is plain as day to see that most coin foundations are heavily influential in the maintenance and success or failure of a coin. And representatives from investment groups like DCG are routinely making statements which have the single effect of moving the price and/or direction of coins such as ETC.
Even if these groups are superficially independent of the mining and operation, on the day-to-day they are directly traceable to the volatility in the market and to a large extent the success or failure of projects.
Most, if not all of the coin foundations, market and advertise milestones which depend on the coordinated effort and work of developers that are paid with investors' money. Coin foundations typically register and own trademarks and other IP so (theoretically) they could force exchanges to associate a specific ticker symbol with a specific chain. And often there is a hierarchy within a coin foundation with respect to the “community” it manages and oversees: it owns IP, controls investor funds, manages the verified social media accounts, and empirically calls the shots.
Look no further than Nano and dozens of other coin projects that have been hacked or “exit scammed” because of how centralized the command and control structures typically are. Another instance just last week, EOS block producers got on a conference call and paused their network (and later proposed scrapping their constitution). Ignoring their year-long $4 billion ICO, is that series of actions sufficiently decentralized?
To be fair, the SEC has an unenvious role to try and regulate something (a network-based coin) in just one jurisdiction whereas these coins are also trading and custodied in other jurisdictions. For instance, the FCA doesn’t currently regulate tokens (e.g., that are not equity or debt instruments). And the Howey test is not applicable in the UK.
Perhaps opening a public comment period to provide suggestions could be helpful in conceptualizing objective measurements and quantifying decentralization (assuming it is not an oxymoron). Though, that inbox would likely just get spammed so maybe just start with credible opinions such as those of the BIS.
In closing, a hypothetical HoweyCoins and its benevolent overseers and thought leaders at the HoweyCoins Foundation could mimic other sufficiently decentralized projects and host an annual HoweyCon; simultaneously emceed by none other than Howie Mandel and Howie Long. If and when this occurs, is the only thing that HoweyCoins did “wrong” was promise to provide discounts to early investors?
Maybe not, at least if they donate some of their proceeds to coin lobbying groups to help explain to policy makers and regulators that HoweyCoins is not a security, because it is sufficiently decentralized (e.g., more than one Howie exists).
Either way, I bet there will be some amazing schwag at HoweyCon, really looking forward to it. There may also be an announcement about the forthcoming HoweyCoins Classic fork.
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