Last September, the Wall Journal Journal reported that the SEC started investigating Uniswap for violation of securities regulations. Since then, Gary Gensler at the SEC has repeatedly called for more regulation of cryptocurrencies, even suggestively stating that an outright ban is “up to Congress”.
Meanwhile, in the crypto world, the focus has been on circumventing securities regulation by framing tokens to avoid the “security” designation. However, few have considered whether this new technology warrants an entirely new approach to securities regulation.
Modern securities laws begin in the 1930s on the heels of the 1929 stock market crash. Prior to the Securities Act of 1933 in the U.S., there were few laws that enforced the nature and scope of disclosures. As a result, during the bull market of the 1920s, fraud was rampant and difficult to enforce.
Since only a few institutions at the time controlled the issuance and trading of securities, the most obvious legislative response was to centralize the nature of security disclosures. Today, public securities offerings not only require accurate and complete disclosures, but they must go through a costly registration process with the SEC.
But equity-like tokens reflect an entirely new reality for two reasons:
- Issuance and distribution of tokens are almost free. This opens the door to new compensation models that are more equitable to contributors and limit concentrations of power and money.
- In theory, all information about a protocol is disclosed on the blockchain. Hence, there is no need for centralized enforcement of disclosures (i.e., the S-1 registration).
Zero Economies of Scale
Stock sales prior to 1933 were not that different than they are today: the founders formed a company, developed a track record generating revenue, and finally hired a dealer to list and distribute their stock.
Note that listing and distribution, both then and now, have high economies of scale. It doesn’t make sense to sell $10mm of stock if it costs $5mm to list and distribute the stock. Hence, when the SEC opted to consolidate the enforcement of disclosures (via the S-1 registration), it didn’t materially change the economics of the transaction. Going from high costs to higher costs didn’t fundamentally alter the microeconomics of IPOs.
However, when the costs are close to $0, the dynamics and opportunities are entirely different. For example, VC financing and employee equity grants are distributed largely on the basis of somewhat arbitrary norms and conventions. For example, convention dictates that founders get x% of equity, employees y%, and seed investors z%, etc. These are all ad hoc representations of value creation.
A better model would be for all employees to have an equal share of value creation, which could be called communal equity. Assume you need 5 engineers to bootstrap a software project. Initially, everyone gets 20% equity. As you bring on more employees, you keep going with this model; in the future, the distribution of new equity would be based on the gains. So say the market capitalization of a governance token increases by $25mm over a quarter and there are now 10 employees. Then new tokens could be minted such that all 10 employees get $2.5mm market value of equity.
This model also eliminates the need for contentious and time-consuming salary negotiations. Everyone that joins the project has the same terms. A potential employee only needs to decide if the product is worth her attention and if she respects the other contributors.
Additionally, it totally obviates the need for VC financing and the status-centric culture that this entails. Contributors “invest” their time in lieu of a salary. If and when a project’s contributor needs cash, she can just sell some equity on a decentralized exchange. There is no longer a need for a neo-aristocracy that takes massive fees to act as a gatekeeper to bridge the gap between current cash flow needs and an IPO in the distant future.
No Title of Nobility shall be granted by the United States: And no Person holding any Office of Profit or Trust under them, shall, without the Consent of the Congress, accept of any present, Emolument, Office, or Title, of any kind whatever, from any King, Prince, or foreign State.
- The U.S. Constitution, Article I/Section 9
Essentially, this is a model where employees are self-financing with their own contribution of time. The employee now has equal status as a VC, which has two broader implications. First, it means that builders decide what is important to focus on. Since builders typically understand the technology better than ivory tower investors, this means a better allocation of resources. Second, it means that there will be more builders/operators and fewer VCs since VCs have a more limited role to play in this kind of ecosystem. This is a great thing for society and capitalism… and it simply cannot exist within the current securities framework.
The securities regulations assume that people who sell equity are oftentimes crooks who deliberately hide information to make money.
However, the very nature of open-source and decentralized systems implies that all information is public and control structures are communal property. So why is SEC registration even required?!
To be sure, there is a myriad of ways to build centralization into smart contract protocols. However, it makes sense that the regulatory framework is amended to exempt protocols that meet certain criteria e.g. if the contracts are not upgradable and there are no keeper wallets.
In simple terms, smart contract protocols exhibit hyper-disclosure i.e. they already disclose far more information to investors than what’s typically available in an S-1 registration document. In the ethos of open-source, decentralized protocols, everything about a project is disclosed, not only things that an expensive lawyer might arbitrarily deem “material”.
In the context of hyper-disclosure, centralized registration of securities is simply a vestigial artifact of the 20th century.
Suggestions for Future Development
- Crypto projects should gain the moral high ground by using the communal equity model to highlight that blockchain technology demands an entirely new regulatory framework for securities offerings.
- The SEC should consider exempting token sales from registration if they meet certain well-defined disclosure criteria.