SEC Chair is right. We need a new class of regulated fundraising for crypto.
Nobel prize winner Elinor Ostrom points the way to using Consumer Tokens to manage the commons or public goods.
US SEC Chair Jay Clayton recently reaffirmed previous SEC analysis that decentralisation of a digital asset may change its nature so that it no longer represents an investment contract. We’d like to take that a step further.
My purpose is to call for a special class of corporation and associated regulated fundraising used to bootstrap the creation of a commons, public good or non-profit.
In these applications a network of users, providers and facilitators eventually decentralises and value accrues to participants rather than a central entity. At the same time, we must acknowledge that bootstrapping a network requires risk capital, risk labour and risk data. The early contributors are taking a risk of loss in expectation of a return, even if they are simply pre-purchasing a good. Therefore we need sufficient level of transparency and accountability from the beginning. In the longer-term, liquidity is essential to the effective operation of network incentives, while preventing illicit activity, so AML/KYC must be applied. At some point the network crosses a threshold away from private ownership and becomes community managed.
While there has been an explosion in innovation, these applications are complex, immature and rapidly developing space. We do not have definitive answers as to how they might develop or be regulated. However, as described below, such applications may unleash considerable social and economic benefit and are therefore worthy of favourable legal and tax treatment.
This post is based on a submission I made to the Australian Treasury consultation on initial coin offerings.
Narrowing the Scope to Consumer Tokens
To narrow the scope of discussion, I have adopted the GDF Taxonomy for Cryptographic Assets published by the Global Digital Finance project. The taxonomy is quite similar to that used by Switzerland, the Brooklyn Project and others. According to GDF, the three main categories are:
- Payment Tokens: “Tokens whose intrinsic features are designed to serve as a general purpose store of value, medium of exchange, and/or unit of account.” Often called cryptocurrencies.
- Financial Asset Tokens: “Tokens whose intrinsic features are designed to serve as or represent financial assets such as financial instruments and securities.”. Often called Securities Token Offerings or STO.
- Consumer Tokens: “Tokens that are inherently consumptive in nature, because their intrinsic features are designed to serve as, or provide access to, a particular set of goods, services or content.” These can be further subdivided into Ownership, Coupon Rights and Activity Rights (including a reward or license). Often called utility tokens.
The following discussion will focus on a subset of Consumer Tokens which, when combined with well designed crypto-economic incentives, enable new decentralised organisational structures (e.g. a digital autonomous organisation or DAO) and new ways to manage the commons or public goods. As such, their applications and opportunities lie well outside what could be achieved with conventional for-profit financial products or securities.
A question for further research is whether an additional dimension to the taxonomy is required to support Consumer Tokens used to enable a commons, public good or non-profit. For example the degree of decentralisation, mode of governance or distribution of earned value could be important factors. Perhaps part of the definition could be based on an understanding of the “good” enabled by the token, regardless of the ability to privately own the token. That is, can the current form of the good be defined as non-rivalrous or non-excludable? To whom the benefits accrue in a steady state of the network? How do we know the network is decentralised rather than proprietary?
While this post supports the concept of consumer tokens or utility tokens, we recognise that many of the projects in the ICO boom of 2018 were of questionable economics and utility. In some cases, the proposed native token could have been replaced with a payment token (e.g. Bitcoin or Ethereum) or even with a conventional fiat currency, without any impact on the utility of the network. Moreover, many of the projects were not attempting to enable decentralised governance of a commons or public good. We also acknowledge there were many failures in transparency and investor protection driven by naivete, inexperience and opportunism, and in some cases outright fraud. This history serves to underline the need for appropriate regulation to create investment confidence and protect retail investors. Although arguably, many of the “investors” in the 2018 ICO boom were speculators rather than investors and showed scant regard for due diligence or risk management.
Tragedy of the Commons
The tragedy of the commons, public goods and natural monopolies are well known economic problems. The “Tragedy of the Commons” was coined by Garrett Hardin in 1968. He described how individuals, acting independently according to their self-interest, can accidentally destroy a shared resource. Together, economists, policy makers and engineers have designed tools to mitigate the costs. For example, land tenure (essentially privatisation) solved overgrazing of commons. Regulated returns were enforced for utilities with natural monopolies. Set-top boxes helped pay to launch TV satellites. Toll-gates enable road funding. Buying groups enable neighbourhood grocers to compete with retail giants. Typically the solution has been some combination of private ownership and central regulation.
However, despite centuries of such policy intervention, modern markets still demonstrate one or more of the “Big 4” market failures:
- Concentration of market power, i.e. an oligopoly of giant players or regulatory capture by natural monopolists.
- Failure to provide public goods e.g. poor system reliability and resilience, congestion, or limited access for vulnerable communities.
- Externalities from exploitation of commons, e.g. environmental (i.e. air, water, climate) or social, e.g. free riding by corporations and underpayment of software developers contributing to open source software projects.
- Asymmetry of information, i.e. volume and price data, aggregation of consumer data.
Cryptographic Networks to the Rescue
Clearly private ownership and central regulation have not always worked. But there are commons and public goods that have worked without either private ownership or central regulation. There is an open source peer to peer payments system that has been operating for 10 years with no central owner, no single point of failure, and no central regulator. The community using this system are inherently motivated to improve the usability, security, and reliability, and therefore grow the size of the community and value of network. That network is called “Bitcoin”.
Wild and futuristic? Perhaps not. Elinor Ostrom (1933–2012), winner of the 2009 Nobel Prize for Economics studied how communities managed common pool resources in Switzerland, Kenya, Guatemala, Nepal, Turkey and Los Angeles. Some of these systems dated back hundreds, if not thousands of years. She identified eight design principles:
- Define clear pool and group boundaries.
- Match rules governing use of common goods to local needs.
- Ensure those affected by rules can participate in modifying rules.
- Devise community based monitoring system.
- Use graduated sanctions for rule violators.
- Provide accessible low-cost means for dispute resolution.
- Make sure rule-making rights of community respected by authorities.
- Build tiers of governance of commons from local to global level.
At a national level these governance principles are analogous to Citizenship, Law, Democracy, Enforcement, Penal System, Courts, Sovereignty, and Federalism.
However, until recently, these principles for managing commons were not viable at scale, essentially limited to the size of a workable human community (e.g. Dunbar’s number), geography, or the speed of transactions within that community.
Enabled by blockchain, we’re now seeing experimentation all over the world and the promise of a revolution in human organisation potentially equal to that of the blossoming of the joint-stock company 500 years ago.
Bootstrapping a New Model needs Risk Capital, Risk Labour and Risk Data
Prototype organisations such as Bitcoin, Ethereum and other aspiring projects demonstrate that Ostrom’s principles can be applied at global scale between people that cannot know each other personally, thus creating a new tool for managing markets, public goods and the commons.
The challenge is how to bootstrap such a network? Creating a new network requires capital, labour and data. However there is a strong risk that the network will not reach scale, resulting in insufficient returns on those resources. In the case of a for-profit enterprise, angel investors or venture capitalists may provide risk capital in return for equity. However, a return to equity or debt may not be applicable to a decentralised commons, public good or non-profit enterprise.
Pre-selling a consumer token economically tied to the network is one way to raise capital for such a venture. The community of innovators have spent a lot of time trying to convince ourselves and others that such token sales are not a securities offering. Moreover, jurisdictions such as Malta, Switzerland and Wyoming have made made changes that recognise the special nature of Consumer Tokens.
However, we argue that criteria such as “not marketed as investments” embodied in these new laws does not recognise that some expectation of economic return on the part of buyers and contributors is required to bootstrap a risky network, even if the ultimate form of the network is a commons. There is a risk that such criteria will create continued uncertainty for honest projects. We cannot shy away from the reality that there are aspects which are securities-like, while we try to define this new decentralised model.
Clearly the early buyers are taking a risk, and they are also anticipating an economic return, either through access to the network or through appreciation of the token value. While the long-term objective is a decentralised non-profit with no private ownership, the initial sale of tokens does have risks similar to a securities offering.
Moreover, trading and some speculation would be essential to enable liquidity of tokens and the operation of incentives in a network. However, speculative trading of tokens (or of conventional equity shares) is generally very damaging to early stage projects that have yet to find product-market fit or established cash positive economics. Moreover, secondary markets without adequate regulation can create incentives for poor behaviour such as “pump and dump” or “deep discount and dump” schemes. We believe lock-ups for founding teams and early investors are good practice and promote long-term investing rather than speculation. That said, a degree of speculation is useful to create liquidity in any market.
There is a clear need to protect token buyers and ensure confidence through fair, efficient and transparent markets. Also clear is the hybrid nature of the tokens. The design of regulation is further complicated by uncertainty over when such a venture makes the transition from the initial securities-like state to a real commons.
William Hinman of the SEC has spoken on some of these challenges in the US context. The recent legislation in Wyoming also implies a recognition of the difference from a conventional securities offering.
A Special Class of Corporation and Fundraising
We argue that token sales focussed on creating a new commons or a managed public good should receive special consideration, and perhaps even separate categorisation, on the following basis:
- Potential for solutions for market failures and inefficiencies in many conventional markets dominated by private ownership or regulation.
- Ability to fund commons, public goods and non-profits, which is clearly differentiated from assumptions of private ownership implied by financial products or securities.
- Promotion of finance for public benefits, which already gets favourable treatment in many jurisdictions e.g. taxation of local government bonds.
- Promotion of risk capital, innovation and technology ecosystem, especially in regions remote from tech centres like Silicon Valley, e.g. similar to the favourable tax treatment of early stage venture capital limited partnerships (ESVCLP) or treatment of mineral prospecting using NL structure.
- Ability to enable long-tail capital formation for such projects from international token buyers, rather than being limited to a small local market.
- The inherent transparency and traceability of blockchain technology can actually enable simplified and more effective regulation.
How can we enable such projects while holding the proponents accountable for achieving the decentralised state? One concept could be the creation of a special form of corporation for such projects, distinct from a limited liability company, partnership or trust. Jurisdictions have previously used unique corporate forms to stimulate important industries, e.g. the No Liability company structure created by Australian states in the mid to late 19th century to foster the mining industry*. Such a corporation could be eligible for special legal or tax treatment but have restrictions on converting to a for-profit status. The corporation could potentially be time boxed or “self destructing” life may be a useful may to enforce intent from the beginning.
In return for such restrictions, and subject to adequate AML/KYC, lock-ups, transparency and continuous disclosure (perhaps similar to current regulation crowdfunding) the entity could have higher and more flexible fundraising caps (We believe regulation crowdfunding caps in most jurisdictions are too low to adequately fund a company taking technical risk).
The special corporate structure could also enable tax certainty, perhaps even concessional tax treatment in recognition of the societal benefits. Current tax treatment of token sales tends to skew the structuring and behaviour of the participants. Could the proceeds be treated as a donation, grant or loan with certain rights? Could any tax liability be deferred or perhaps even eliminated at the issuer and treated as a form of capital gain in the hands of the token holders (which would also capture profits by members of the founding team and partners). For token holders, could personal use of the tokens be treated as currency, trading as regular income, and bulk sales from the ICO as a capital gain?
Eligibility for special treatment would need to be tested or applied at the time of issue, at the time of “transition” to a decentralised non-privately owned status, and/or at the time of “exit” or sale by a buyer, be that before or after the point of “transition”. However, having a special form of corporation could simplify the assessment.
We have no illusions as to the challenges of defining the criteria, proving eligibility at issue, then dealing with changes in plan prior to exit (i.e. the inevitable pivot beloved by startups). However, we see evidence of market failures in the commons and public goods all around us. The tragedy of the commons has become the biggest existential risk to humanity in terms of climate, water and economic access. The benefits of enabling this innovation far outweigh the risks.