Understanding token regulation in context and why dual-token structures may become standard

The background

The current debate on crypto-tokens and their regulation tends to focus on labels and legalistic distinctions, and similarly the objective of token design has become to satisfy minimum exogenous requirements. What continues to be lacking is an understanding of the why things are done or, in other words a lack of contextual understanding.

Regulation above all is requirements for information disclosure, supported by penalties for market manipulation and finally the restriction of certain activities to parties that are expected to understand the risks they are engaging in[1].

To give perspective, the history of regulation can be related to the stock market crash of 1929, the behaviour that led up to it, and the consequences of the crash — a decade long economic depression. The general objective of regulation may be summarised as the prohibition of the abuse of information asymmetries or of false information. The more specific version is to protect investors; to maintain fair, orderly, and efficient markets; and to facilitate capital formation[2].

Activities involving the participation of retail investors are most strictly controlled, as these are seen to involve the highest risk of information asymmetries. There is a popular conspiracy myth that securities regulation exists to force private individuals to use institutional middle-men and exclude them from the most attractive opportunities in the market[3] — unfortunately this is akin to the myth of extraordinary risk-free returns.

The consequences

Market abuse or asymmetry ultimately has one principal consequence: it raises the cost of capital and reduces its availability. Thus, it is the economies that place most emphasis on their markets that have the biggest incentive to ensure the functioning of these markets, which is typically reflected in stringent regulation and rigorous enforcement.

The current state of crypto token markets lies in stark contrast as there has been a casual adoption of most of the practices outlawed from the securities markets. Selective or misleading disclosure, insider trading, pump-and-dump, front running, market manipulation and de-facto pyramid schemes all feature[4]. Not to mention the lack of adherence or commitment to plans proposed in white papers. As the crypto-community refuses to acknowledge this state of affairs (or acknowledge it as a problem), there are two emerging outcomes: a) the number of investors that are willing to participate will rapidly diminish, and; b) the market has set itself up for aggressive regulation.

Secondly there is a lack of understanding of how stocks and bonds have conceptually evolved over long periods of time as standardized financial instruments, now also known as securities. This process has mostly been a function of market practice, with participants benefitting from a number of standard definitions, concepts and expectations, many of which have been further codified into law or regulation.

These concepts now allow participants to set out in shorthand the rights and obligations of investment agreements, without significant case-by-case negotiation. Moreover, the codification that has emerged as market practice reflects a balance of those rights and obligations. Ultimately the purpose of this is that it also secures the highest availability of capital at the minimum cost of capital, and with minimum transaction costs.

In more technical terms, codified market practice minimizes coordination costs to maximize market efficiency. The benefits of this are easiest to see when there is no codification, or when terms, conditions and adjucation need to be agreed on an ad hoc basis, the result being massive legal-administrative externalities.

To somewhat state the obvious, the response to the above is not to assume a market where rights and obligations do not need to be agreed, which is a generalization of the view that tokens have been a great way of raising capital because it does not make founders accountable, the release of funds is not dependent on making progress, there are no disclosure requirements and there is no relinquishing of control (i.e. the investors do not have any say in the business).

How should we think of tokens as investments?

Considering tokens from an investor standpoint there are thus two core angles: avoiding the abuse of information asymmetries or of false information; and achieving a balance of rights and obligations.

Enforceable disclosure requirements are likely to come only from exogenous regulation, but the investment instrument itself should include or encode characteristics that deliver parity between investors (unless agreed otherwise), pre-agreed governance mechanisms, executive accountability, minority protections, and founder incentives that are triggered on the success of a project rather than upfront capitalization of projected NPV[5].

The instrument described above is generally known as an equity security. However, the point is that if the characteristics can be secured, it does not matter what the label is on the instrument. If these can not be secured, then the assumption must be that token-capital can only be raised at a higher cost than equity-capital, and will be more limited in availability.

The regulation of security tokens

If we allow that tokens that are investments generally resemble securities, then from a market standpoint the regulation of these security tokens should reflect the twin objectives that they should not lend themselves to investor or market abuse and that they should maximally leverage codification to simplify documentation and minimize case-by-case ruling.

On the other hand, the regulatory challenge is that a token as an instrument is very different from existing security instruments, namely equity. To name the obvious, the token is also typically a means of payment, it has fungibility, which is not a characteristic of other instruments classified as securities.

Simply applying current securities regulation without modification is likely to lead to suboptimal outcomes, again leading to reduced availability of capital and at a higher cost. This is contrary to most macro economic objectives and it should not be motivated for any regulator to pursue such a course long term. However, the longer the current egregious market practices continue, the more likely it is that we will see an over-reaction in regulatory oversight.

Leading to a dual-token world?

From a token standpoint, the practical consequence of the above is that the token economy may be heading for a separation of security and utility tokens, where most projects involving application logic will require both. One token being the external instrument for financing and the other the internal unit of account and fungibility. In so far as the token is principally the information transfer mechanism tying together a DAO (Decentralized Autonomous Organization) it is difficult to see that a security token, burdened by current securities regulation, can fulfil that information transfer role on its own. However, nor can the internal utility token meet the requirements for raising external investment capital.

Thus, the principal design challenge, and likely the new regulatory frontier will be the engineering of value transfer between two tokens within the same architecture. The challenge will relate to making the external capital available to the internal token economy, while avoiding making the internal token a security (this matters even if there is never a public issue of the internal tokens).

Startereum is an emerging world token project that has sought to fully consider the above and proposes one solution in its implementation[6].

[1] Bjarke Staun-Olsen has a great piece on the topic in https://blog.creandum.com/icos-and-what-makes-financial-markets-work-d1e84a19e1f9

[2] SEC Chairman Jan Clayton, April 2018. https://www.sec.gov/news/speech/speech-clayton-2018-04-10

[3] A myth well cultivated in the crypto markets, which are currently highly dependent on retail investor demand

[4] Howard Marks has been one of the people calling attention to this. https://hackernoon.com/4-ways-altcoin-exchanges-promote-fraud-611648ecb86c

[5] See Jill Carlson on token convexity https://medium.com/@jillcarlson/short-convexity-8793f18629bb

[6] See www.startereum.com for details.