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A few weeks ago, I told you about the new proposal put out by SEC Commissioner Hester Peirce, that would give new blockchain projects a three year “safe harbor” to build their token networks before worrying about securities law. [You can now read her full proposal here.]
Peirce has asked for feedback on her proposal, so last night, we held a Blockchain Investors Supergroup meeting, where some of the brightest minds in blockchain got together to discuss a formal response to the SEC. We split into small groups to discuss her proposal, with the aim of making it even better.
In this “decentralized discussion,” we found that the biggest problem to discuss was decentralization.
The Decentralization Discussion
The central question is this: how do you define decentralization?
In Peirce’s proposal, U.S. blockchain projects would have a three-year safe harbor, at the end of which they will either be classified as securities (in which case they register with the SEC as such), or non-securities (in which case they are not subject to securities laws). The test is decentralization. |
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In plain language, this would allow something like an Initial Coin Offering, where blockchain entrepreneurs can raise money by selling tokens—with a three-year grace period to decentralize their network. At the end of three years, there’s a “decision point” where we ask:
Is the token centralized? It might look like a stock, in which case the investors in the token will be investors in the project, and receive similar benefits as, say, a corporate shareholder.
Is the token decentralized? Like Ethereum, it might look more like an “in-game currency,” a means of payment for using the blockchain network, in which case it will still be tradeable via digital exchanges, but not legally classified as a security.
As we discussed the proposal last night with some of the smartest brains in blockchain, we kept returning to this central problem: how do you tell if a token is decentralized? Is it like great art (“we’ll know it when we see it”), or can we use objective metrics to quantify decentralization?
Fortunately, there’s a large body of academic research on decentralization, which I came home last night and devoured. (Hey, I’ve got a column to write.)
Decentralization Defined
Turns out, this is actually a very old problem.
The classic question of decentralization is in government: Is it better to have a stronger national government and weaker local governments, or vice-versa? Which type of government—highly centralized or highly decentralized—serves its citizens better?
It was this problem that the founding fathers of the United States wrestled to the ground. If you’ll remember from the musical Hamilton (where I get all my history), it was hard to get the states to agree on anything, including funding the war against Britain—until a strong central government came in.
On the other hand, we’ve seen the dangers of too much centralization of power. Centralized governments like China can control the news media, even when it harms local citizens. Centralized companies like Amazon can monopolize markets, even when it harms economies.
“But if we can define decentralization,” researchers have said for years, “then we come up with objective metrics to measure how decentralized a government is. We can create a ‘scorecard’ by which we might measure, say, China against Bolivia. Then we will finally get a raise!”
In 2003, Aaron Schneider of the University of Colorado Boulder, a.k.a. “my new hero,” tackled this problem of defining decentralization head-on: he wrote a paper called Decentralization: Conceptualization and Measurement, which has since been cited hundreds of times.
Briefly, Schneider proposed that government decentralization can be measured using just three metrics:
1) Fiscal decentralization: Measured by local revenues and expenses as a percentage of overall revenues and expenses. For example, in the U.S. we could add up the revenues and expenses of all 50 states, and measure it as a percentage of total U.S. revenues and expenses. The higher this percentage, the more fiscally decentralized (in other words, the states would have more control over the money). Then we could compare the U.S. percentage with, say, China.
2) Administrative decentralization: In simple language, how much autonomy does a local government have from the national government? This can be measured by local taxes as a percentage of local revenue (i.e., Texas taxes as a percentage of total Texas revenue), as well as government transfers as a percentage of local revenue (i.e., how much money does Texas raise on its own, without getting handouts from the national government).
3) Political decentralization: In a decentralized government, the people have more power. This can be measured as the percentage of people who vote in municipal and state elections: more decentralized governments have more local elections, and higher voter turnout.
Here’s Schneider’s example of how these three measurements might line up on a chart for a highly centralized government (Russia), a balanced government (Norway), and a highly decentralized government (Botswana). |
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The exciting news is that a blockchain-based token could be measured along three similar axes.
1) Fiscal decentralization: Who holds the money? A decentralized network will have more tokens distributed to a larger number of token holders, compared to a centralized network where wealth is concentrated in the hands of a few. To measure this, we can use a metric called the Gini coefficient, which measures inequality in the distribution of wealth.
The Gini coefficient is a number between zero and one. Traditionally, zero is perfect equality (i.e., everyone holds the same number of tokens) and one is perfect inequality (i.e., one person holds all the tokens). We’re going to flip the Gini coefficient on its head, subtracting it from 1, so higher=more decentralized, which is what we’re after.
2) Administrative decentralization: Who runs the network? A decentralized network will make it easy for new nodes to join, versus a centralized network that will want tighter control over nodes. To measure this, we can look at the number of “permissionless” modes (e.g., free and open) as a percentage of total nodes.
3) Political decentralization: Who holds the voting power? A decentralized network will have many token holders actively voting on important network changes. To measure this, we can look at the number of voters as a percentage of total token holders. |
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Centralization Vs. Decentralization: An Example
Let’s imagine two hypothetical blockchain projects, PermissionCoin and PeopleCoin.
PermissionCoin is a closed (permissioned) blockchain network. It’s run by a consortium of technology companies, and can only join (i.e., create a node) if you’re invited.
Fiscal decentralization: Accordingly, the wealth (or money held in tokens) is highly unequal: the founding partners hold the majority, while new invitees have a smaller share. Administrative decentralization: It’s invite-only, so there are no “open” or “permissionless” nodes available to the public, scoring it a zero. Political decentralization: The participation is fairly high in voting matters, since it’s a small group: 75% of the token holders (i.e., partners) will vote on important code changes or network updates.
PeopleCoin is an open (permissionless) blockchain network. It’s open-source, and anyone can spin up a node or buy tokens.
Fiscal decentralization: While some “whales” hold a disproportionate amount of PeopleCoin tokens, more token holders share the wealth, so it’s more evenly spread. Administrative decentralization: All nodes are permissionless, so it gets a perfect score of 1. Political decentralization: Because there are so many more token holders, there is a lower percentage of voter participation, with 46% of token holders actively voting. |
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| Since higher = more decentralized, we can now show quantitatively that PeopleCoin is much more decentralized than PermissionCoin. We can also put it on a radar chart, to see how the projects compare across the three axes: |
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Is it Decentralized? The 51% Test
Back to the SEC proposal. At the end of three years, if it’s decentralized, it’s not considered a security. We now have numbers to measure this decentralization. But how much decentralization is “enough”?
The simple answer is the 51% rule: if the average of these three numbers is 51% or higher, it’s decentralized, and thus not classified as a security at the end of three years. We’ve got to draw a line in the sand somewhere, so let’s make it 51%.
In summary, we don’t need to reinvent the wheel. Let’s build on the excellent research that’s been done around decentralization, applying it to the new world of blockchain securities. If we can get a few common-sense numbers, then we can have a common-sense test.
I’d love to hear what you think about these ideas. Send me your decentralized feedback, and we’ll try to centralize our formal response for the SEC.
Health, wealth, and happiness, |
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| John Hargrave Publisher Bitcoin Market Journal |
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Eating Each Other
Never really got the chance to review the Democratic debates the other day. Probably for the best though. Watching these people 'debate' each other is kind of like watch a tank full of hungry cannibalistic sharks eating each other. Or like a Roman gladiator tournament. You get a bit queasy but man, that's good entertainment.
Good thing we get to see them doing it again next Tuesday. Nobody's happier of course, than Donald Trump who's clearly the main benefactor of Democratic infighting. The issue here isn't that the Democrats are trying to pick the best candidate to represent their vision. It's that each candidate has a completely different vision and the party doesn't know which direction to take.
The more each individual progresses, the worse off the party is. If Sanders doesn't take the ticket, you can bet his supporters will stay at home in November. Any new supporters that Warren or Bloomberg or the others bring on, would be less likely to vote for Sanders.
Nevertheless, the stock market has been falling the last few days. I've personally taken out a small money, high leverage, short on the Nasdaq and long on gold portfolio recently as I don't believe the Coronavirus is accurately priced into the markets. Also, I feel like investors might get nervous that the Fed stimulus is set to expire in April. |
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Gold has been out of control lately and currently trading at its highest level since 2013. The only real explanation for this is that people are fearful from central bank actions and are looking for a way to hedge their portfolio.
Here's an interesting video that I watched today from someone I've been following on Twitter for the last few years but never knew his name until today. The presentation really shows how much gold bugs and bitcoin fans have in common. So, check that out here. |
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Cool Off
As the crypto market consolidates and volumes cool down, seeing how the price progresses over the weekend could be interesting. The markets had been behaving by the books for most of the year so I guess that makes it even more surprising when something does happen. Still, sentiment doesn't seem to be affected too much with many thinking that this was simply some temporary movement caused by large players.
This chart from Lunarcrush shows that social sentiment on bitcoin has been building since the beginning of the year and though it did dip the last few days is still quite high. |
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Wishing you an amazing weekend ahead!!
Best regards, |
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Mati Greenspan Analysis, Advisory Money Management |
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