Evaluating the thesis that unregulated trading in securities is desirable.
November 2022 update
We are adding a brief update to this piece to note the spectacular collapse of one of the world's largest crypto exchanges, FTX, in late 2022. This provides compelling further evidence that a tougher regulatory approach is and always was needed for crypto. Find out more via our deep dive on the FTX collapse, and its tragic vindication of our analysis.
Subclaim 1: A better, easier way to raise money for my venture
It is very easy to create an equity crowdfunding and cap table structure on top of crypto platforms like ethereum. Individuals can do it anonymously and raise billions of dollar equivalents in seed capital for ventures that are very early. The SEC, government or lawyers do not need to get involved at all.
Previously this kind of access was gated to US persons with connections and access to funds and capital. This is a liberatory and egalitarian force that democratizes company formation that lowers barriers and allows all types of common enterprises that were previously prohibited by law.
Subclaim 2: Ability to raise capital outside of the rule of law
The ability to raise capital outside of the rule of law is not only a good thing, it is an outright human right that is a safeguard against tyranny eg Edward Snowden, SciHub, Wikileaks. See [Bitcoin as an Anti-Authoritarian Force][../notes/bitcoin-as-anti-authoritarian.md] for more details.
Subclaim 1: A better, easier way to raise money for my venture
The smartphone era gives retail investors access to the public equities market with unparalleled levels of simplicity unseen in markets. There’s also a genuine interest in giving retail investors access to private equity investments. But is access to the public equities market appropriate for retail investors?
While there is a chance of high return, there is high risk: 95% of new ventures fail. And if we lower the barriers to entry, the ICO bubble is a case study in even higher failure rates.
In addition, giving seed-stage ventures billions of seed capital detached from revenue, traction, or product market fit is not desirable. It creates an incentive to abscond with seed money rather than actually building anything.
Furthermore, the whitepapers of these companies are complex, and even people with PhDs in econonomics and software engineering can’t parse what's going on. How is the lay public supposed to analyse what they are being told and make well-informed decisions?
The likely result is high risk for retail investors and, as a result, wider systemic risk.
We tried the complete laissez-faire caveat emptor securities model in the 1920s. It ended very badly. Fly-by-night “There Will Be Blood” actors ran wild selling securities to the public. Most US states created Blue Sky Laws to "to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines and other fraudulent exploitations."
History is repeating itself. Shibu Inu and Dogecoin were the blue sky securities of the 1920s. People were attracted to get-rich-quick schemes back then just as much as they are today. Human psychology is remarkably invariant across time.
As part of the New Deal, the United States signed into law the Securities Act of 1933, Glass-Steagall Act of 1933, Securities Exchange Act of 1934. These largely cleaned up the fraud. The US framework is the blueprint for many industrialized nations to do the same. Following this introduction of regulation, the Great Depression ends, bank runs are entirely eliminated and there is a long period of peace in financial markets. US capital markets become extremely large, robust and a new era of unrivalled growth and private innovation proceeds.
When things go wrong, the impact can be financially devastating and socially corrosive: the state and its institutions and leaders are blamed and trust is corroded in the state as well as markets. If we assume that financial markets have some value then undermining faith in them is problematic.
Subclaim 2: Ability to raise capital outside of the rule of law
From the perspective of civil society, the ability to raise capital outside the rule of law is not desirable.
Crypto facilitates tax evasion
Today there already exists an enormous shadow banking space which facilitates the creation of credit and movement of money through jurisdictions with questionable money controls and loose enforcement of policy. Many wealthy individuals avail themselves of this transnational network of trusts and shell companies to avoid paying taxes in their country of residence, opting to instead hide their money abroad in opaque financial structures set up in island nations like the Bahamas or Cayman Islands.
The incorporation of crypto into the shadow banking system, which is already happening, is providing even easier access for disreputable individuals to avoid taxes and to expand their holdings abroad. Instead of offshore shell companies, these individuals will use stablecoins and cryptoassets to hide their money from tax authorities.
From the public interest perspective none of this setup is desirable, since it allows the already wealthy to avoid paying taxes and supporting public goods and the welfare state which supports people with less resources than wealthy individuals. Crypto thus exasperates wealth inequality and allows individuals to circumvent the rule of law and undermine the entire social contract of democracy.
Crypto facilitates dark money flows
For every one Alexandra Elbakyan or Edward Snowden there are a thousand arms dealers, cartels, human traffickers, money launderers, and warlords who would also use crypto for far less benign purposes.
See [Bitcoin as an Anti-Authoritarian Force][../notes/bitcoin-as-anti-authoritarian.md] for more details.
Crypto tokens should be regulated as securities
According to the SEC, crypto tokens meet the Howey Test and thus are securities contracts. This fits with our general intuition about the intent and purpose retail day traders are buying them. They’re investing in common ventures with the expectation of profit from the sale of tokens the same as equity. Some DAO governance tokens quite literally are designed to imitate voting shares as seen in existing equity structures.
What are securities?
- A security is a collective legal fiction that pools money and mediates income-cashflows between people according to an agreed-upon framework.
- “A joint-stock company is a business entity in which shares of the company's stock can be bought and sold by shareholders. Each shareholder owns company stock in proportion, evidenced by their shares (certificates of ownership). Shareholders are able to transfer their shares to others without any effects to the continued existence of the company.”
- An idea that goes all the way back to the 12th century, where medieval peasants would buy shares in a common enterprise of mills that would grind wheat. https://en.wikipedia.org/wiki/Bazacle_Milling_Company
- Gave rise to a modern framework of laws that cover financial products from debt instruments, bonds, equities, and derivatives. The legal foundation on which all of market capitalism is built.
- Because of their centrality to markets, securities have strict registration, ownership and transfer regulation.
The debate surrounding crypto investments
- There is currently debate about how crypto investments fall under the existing securities regulatory framework. This is being debated inside the government regulatory agencies, on the floor of the Senate, and in the courts.
- The outcome of the final ruling will potentially impact trillions of notional value in “scofflaw” investments of potentially unregistered securities.
- Landmark case from 1946, SEC vs W. J. Howey Co. set the Howey Test precedent for determining what is a securities contract.
- (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit and (4) to be derived from the efforts of others.
- Many things can be sold as securities. (stocks, chinchillas, whiskey barrels, orange trees). It’s very context dependent.
- If we accept the premise that crypto tokens aren’t currencies, then tokens are clearly investments made with the expectation of profit. Are crypto assets unregistered securities?
- Crypto tokens currently exist partially outside the US securities framework.
- The SEC has taken action against some Initial Coin Offerings, selling debt instruments to retail, against outright Ponzi schemes, and firms acting as bank-like entities.
- District courts have set precedent in many investment fraud cases that have consistently indicated that token sales to US persons meet Howey Test and Dodd-Frank criteria of securities sales, even if done internationally (i.e. from Switzerland). If you sell to US persons it becomes a security under US law.
- A federal case or executive order that sets precedent nationally has yet not been heard in the courts.
- Thousands of companies' and projects' success or failure rests on token sales not being regulated as securities. If they are regulated as securities it is quite possible the entire market implodes.
- Sale of securities depends on who you are selling to, and what kind of risk and return are presented in the prospectus.
- Selling to the general public is highly regulated, with lots of disclosures, auditing of financials by PWC, Deloitte, etc., and transparency in ownership and inside stock sales.
- Selling securities to institutions and high net worth individuals is not as highly regulated. SEC defines “accredited investor” as:
- A company you are a director of.
- A limited liability company or family office with over $5 million.
- Individual with income greater than $200,000.
- Case example: Theranos raised $724 million from private accredited investors including Henry Kissinger and Betsy Devos. The people in the blast radius of the fraud were all fabulously wealthy and invested capital they already allocated to high-risk investments anyways.
- Many policymakers on both sides of the aisle debate whether or not the accreditation laws are too restrictive and shut the public out of high-risk-high-return investments that only wealthy people have access to.
- On the right, then individual choice is a paramount, the government shouldn’t dictate risk-taking in markets. Just “evolution” and the natural state of being.
- On the left, Pikkety’s analysis that wealth generated from capital grows faster than economic output and that patrimonial capitalism leads to distortions of markets and inequality.
Steel-manning the position that crypto investments should not be brought within the securities regulation framework
- It is very easy to create an equity crowdfunding and cap table structure on top of crypto platforms like ethereum.
- Individuals can do it anonymously and raise billions of dollar equivalents in seed capital for ventures that are very early. Don’t need to involve the SEC, government or lawyers at all.
- Previously this kind of access was gated to US persons with connections and access to funds, connections and access to capital.
- This is a liberatory and egalitarian force that democratizes company formation that lowers barriers and allows all types of common enterprises that were previously prohibited by law.
- Ability to raise capital outside of the rule of law is not only a good thing, it is an outright human right that is a safeguard against tyranny.
- Edward Snowden, SciHub, Wikileaks, etc
- Equity markets are ripe for disruption and it is time for the twilight of the Securities Act and the start of a new era that will reconfigure the entire global economy.
- Hypothesis: What happens on the other side of that financial reconfiguration can only be better than we currently have.
- We tried the complete laissez-faire caveat emptor securities model in the 1920s. It ended very badly.
- The kind of fly-by-night “There Will Be Blood” type of charlatans ran wild selling securities to the public.
- Most US states created Blue Sky Laws to "to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines and other fraudulent exploitations."
- History is repeating itself exactly like it did then. Shibu Inu and Dogecoin were the blue sky securities of the 1920s. People were attracted to get-rich-quick schemes back then just as much as they are today. Human psychology is remarkably invariant across time.
- As part of the New Deal, the United States signs into law the Securities Act of 1933, Glass-Steagall Act of 1933, Securities Exchange Act of 1934. These largely clean up the fraud. The US framework is the blueprint for many industrialized nations to do the same.
- The Great Depression ends and the US is victorious in WWII.
- A long peace in financial markets.
- Bank runs are entirely eliminated.
- US capital markets become extremely large, robust and a new era of unrivalled growth and private innovation.
- Centrist Hypothesis: Regulated capital markets, taken on the whole arc of human history, produce relative prosperity.
- According to the SEC, crypto tokens meet the Howey Test and thus are securities contracts.
- This fits with our general intuition about the intent and purpose retail day traders are buying them. They’re investing in common ventures with the expectation of profit from the sale of tokens the same as equity.
- The enterprises possibly now exist as anonymous internet entities and Discord servers now instead of law firms and board rooms.
- Some DAO governance tokens quite literally are designed to imitate voting shares as seen in existing equity structures.
- How do we bring the great mass of scofflaw unregistered securities within the regulatory perimeter to protect the public? Is this even possible?
- The smartphone era gives retail investors access to the public equities market with unparalleled levels of simplicity unseen in markets. There’s also a genuine interest in giving retail investors access to private equity investments.
- Is such a structure even possible?
- Horizon and liquidity concerns of private investment vehicles (like VC funds) are challenging for writers of small checks.
- As an entrepreneur do we really want a cap table with 200,000 retired janitors from Idaho writing $500 checks into early companies. What is the legal overhead of this under the Securities Act?
- Is it desirable?
- High risk, high return. But with a 95% failure rate is it even appropriate for retail? Venture is not a great asset class compared to index funds in terms of brute returns.
- If we lower the barriers to entry, the ICO bubble is a case study in even higher failure rates. Unprecedented levels of fraud unseen in developed markets since the 1920s.
- ICOs are like a public stock offering before the company even exists or has a product.
- Giving seed-stage ventures billions of seed capital detached from revenue, traction, or product market fit is a recipe for disaster.
- There’s a perverse incentive to simply abscond with seed money rather than actually build anything.
- There’s a perverse incentive to build technical Potemkin villages that focus on “token value go up” without building anything. Many crypto companies are here.
- Can read the whitepapers of these companies and even people with PhDs in econ and software engineering can’t parse what they’re doing. How is the lay public going to do due-diligence on claims of financial perpetual motion machines?
- Is such a structure even possible?
- Is there a legal investment vehicle structure that balances the risks of retail investors with their desire for access to high-risk early ventures?
- Or should we simply bracket these kinds of securities sales to the already-wealthy? Because the check-size to risk ratio just empirically fits in the “Goldilocks zone” of the practical regulatory/legal/public-interest concerns.
- Where should the accredited investor red line be?
- Can the courts scale to handle millions of new investment fraud cases every year?
- Is extreme levels of fraud simply the price we pay for a more dynamic economy or does this all lead to ruin like it has in the past?
- Evolution and capitalism metaphor: extremophiles.
- What is the right interplay between investment risk and the rule of law? Is creative destruction by any extra-legal means a positive force in the world?
Deep dives and notes
- Deep Dive: Fintech Incrementalism And Responsible Innovation
- Deep Dive: The FTX Collapse
- Crypto: can these financial perpetual motion machines work?
- Notes on Dan Olson's 'Line Goes Up'
- Deep Dive: Market Fundamentalism
- A Macroeconomics Perspective on Cryptocurrencies
- Shri T Rabi Sankar. Cryptocurrencies – An Assessment
- Crypto: can these financial perpetual motion machines work?
- Bindseil, Ulrich. et al. ‘The encrypted threat: Bitcoin’s social cost and regulatory responses’
- Is crypto legal?
- Is bitcoin compatible with ESG investing?
- Why do people invest in crypto tokens?
- Are crypto tokens a negative-sum investment?
- Are crypto assets a bubble?
- Do crypto assets have a verifiable valuation model?
- Are crypto assets a form of gambling?
- What is the narrative economics of crypto assets?
- What consumer protections exist for crypto assets?
- Are crypto assets predatory investments?
- Are crypto assets a systemic risk to the economy?
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