Bruce Fenton is CEO of Chainstone Labs, which owns Atlantic Financial, the Satoshi Roundtable and Watchdog Capital, an SEC registered broker-dealer.
In 1602, the Dutch East India Company launched a new structure of ownership called the joint stock company. For the first time, investors could own and trade small pieces of businesses called shares. This invention changed the world.
Securities are one of the most crucial components to the operation of our global economy. Many types of securities have become heavily regulated over the last century. This isn’t a discussion in favor of the regulations (many are overly burdensome and outdated) but it does point to the importance of securities as a structure.
The logistics of operating and fundraising for public companies is hard work. Fundraising is a process with lots of friction, compliance requirements and paperwork. The ongoing operation of a public company can have complex management issues. For large companies, this is typically handled by trusted third parties like DTCC, which provides clearing and depository services. If we can make this easier, it could have a massive positive impact. Distributed ledgers allow us to replace trusted third parties and have a blockchain manage the ledger. This makes securities move more easily and quickly.
The invention of distributed ledgers, bitcoin (BTC) and blockchains is not the same as the invention of the joint stock company and Dutch East India Co. It’s not a new economic model; it’s a new technology and tool that improves how ledgers work. The invention is more similar to the printing press, the computer or the internet. It’s a big deal, but it’s not an invention that changes existing laws of economics. Just as bitcoin doesn’t change the properties of money but finds a way to improve on money, tokens don’t change the fundamentals of investing; they improve on the existing inventions. Think of it as an evolution from paper stock certificates to something better than paper but where the fundamentals of the underlying legal structure stay the same. Just because we invented a better form of paper doesn’t mean we should scrap the most productive and proven legal instrument in history for an unproven model of widgets with no terms. Instead of reinventing the bicycle, let’s improve on a proven model and update the Dutch East India Co. model for a new century.
In 2016, when I saw some of the first of the new wave of initial coin offerings (ICO), I had two simultaneous reactions:
1. Wow, this is amazing.
2. Wow, this is in violation of securities regulations.
I’ve been registered in the securities business in some form for 28 years now. Since I was 19 and done billions of dollars in transactions. So I knew it was possible to comply with the regulations. Rather than trying to avoid being a security, I figured the right choice for most companies would be to simply embrace being a security and focus on complying with regulations. This is a key difference from how many looked at it in the early days and how some still do. This isn’t because I think the regulations are great, but because I know they are unavoidable.
The first time I heard of the Securities and Exchange Commission was at about age seven when my stockbroker Mom came home and told us that the SEC, Federal Bureau of Investigation and police had arrested someone in her firm who broke the rules. I thought this was fascinating. Only 12 years later I had my first job in a brokerage where the seriousness of federal laws was emphasized in our training. These rules have been around for 87 years and are not going anywhere.
Forget trying to ignore the laws or hoping they go away or thinking “this tech makes it different.” Advocacy also matters little relative to old laws affecting trillions of dollars. Some in crypto think they can just build to violate these laws; it doesn’t work that way. This is the equivalent of a marijuana activist opening an unlicensed dispensary in Times Square. Some may support the ideology, but it would be an ineffective activist action.
In the first ICO wave, many focused on trying to prove “utility” so they wouldn’t be classified as a security. Today we still see similar efforts from some exchanges. For example, Coinbase’s Crypto Ratings Council makes a case for why certain instruments are not securities, instead of doing the harder work to become licensed to deal in legal securities.
Many DeFi projects, and efforts such as Hester Peirce’s "Safe Harbor" proposal, continue down the same road. The goal is to avoid being a security. I think this is a mistake.
The Securities Act of 1933 defines a security very broadly:
any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
Here’s the key problem: If you remove terms like profit sharing, equity or debt so something doesn’t meet the definition above, it’s a lot less likely to succeed as an investment. Investments are to pool capital and share risk. In exchange for those risks, investors get something from the definition above: they get dividends for a share of profits, they get their loan paid back or they own equity or something else. If you strip out those terms then the investor isn’t sharing in a business enterprise or investment contract and is really unlikely to make any money because they aren’t participating in any proven economic terms.
Good investments historically share the terms described in the 1933 Act, and a new thing called a token doesn’t change this economic reality. A token that’s not a security is by definition something that gives you no equity, no profit sharing, no investment contract and no ability to depend on the management of others. In other words, it’s a widget with a lot of risk and no proven way to be compensated for that risk. Purchasers who buy these protocol coins often are just getting a gift certificate to a store no one shops at, not a real investment. Also, protocols are quite hard to create and even harder to have real value. A protocol with a fundraise has an additional hurdle in that the fundraise makes them more centralized.
These terms in the 1933 Act definition are very broad on purpose and courts have ruled that they should be broad. We can’t really change that. Any major material definition change to the term “security” in the U.S. is unlikely (and maybe not desirable). By stripping out a characteristic that would make something less like a security, we are left with an asset that’s unlikely to have value.
Instead, we should be shouting: “Securities are great. The definition encompasses vehicles like stock, funds, bonds and partnership shares which have built our global economy for hundreds of years. We don’t want to avoid securities, we want to have more of them and we want to make them easier to issue and manage.”
There are many technical and regulatory things we can do to improve how securities are issued and move, including beefing up the Reg CF exemption or adding another exemption for non-accredited investors, loosening ongoing reporting requirements for smaller public companies not traded on exchanges, reducing the burdens of anti-money laundering (AML) and know-your-customer (KYC) requirements and other regulatory strategies could help.
On the technical side, there many projects promising robust potential improvements in the way securities move. These include smart contracts, asset tagging and other tools developed around ethereum ERC 1400, 1404, Ravencoin tagging and restricted assets, the Polymath/Polymesh project, Liquid and RSK on bitcoin; all offer or plan to offer. In an ideal situation, securities will move similarly to digital bearer assets like monero (XMR) or bitcoin but with embedded, attached or second layer tools to cover identity and compliance needs.
There are many ways to improve securities but core to all efforts should be the recognition that securities' status is not something to be avoided but to be embraced. It is one of the most important and beneficial inventions in economic history. Don’t run from securities, make them better.
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