Lawyers get specific on “decentralization” of crypto projects

by Arthur · August 8, 2022

“Decentralization” is this abstract term that floats all over crypto. It seems like one of those boring buzzwords that business people favor (like “solutions”, “tailored” and “synergy”).

The big picture: Advocates who see a future in blockchains have taken pains to articulate what decentralization really means when it comes to keeping token projects on the right side of laws meant to protect investors.

It can be crucial in determining whether a project’s token is a financial security.
If it is a security, it becomes more trouble to work with than most startups would find worth.

Zoom out: “At the heart of the innovation of decentralized cryptocurrencies is their ability to mitigate risks through technology,” Jack Solowey and Jennifer J. Schulp of the Cato Institute wrote in a paper published Tuesday.

Anyone who has been on the internet for more than a decade has felt betrayed by a technology platform. When did it sink in that Facebook and Google knew unpleasant things about you, for example?
Decentralization transfers control of platforms to users, but not in a rhetorical, hand-waving way.

That is, crypto lawyers recommend that it will only count with the Feds if that decentralization is genuine.

Jargon alert: The term art (and boy is it controversial how seriously to take this term, but…) is: “sufficiently decentralized.”

In June 2018, the director of the Securities and Exchange Commission’s (SEC’s) Division of Corporate Finance said that the top smart contract blockchain, Ethereum, was “sufficiently decentralized” to not be considered a security.
Of the note: The SEC is currently in a battle with Ripple, the company behind the XRP cryptocurrency, over how seriously to take that speech.
All other takes it quite seriously, as the closest the SEC has ever said anything positive about how to get the law right.

Island life: Later that year, Prof. Todd Henderson and Max Raskin published an article in the Columbia Business Law Review that attempted to define tests to determine whether or not an asset created specifically by a blockchain project is considered a security.

On decentralization, they came up with the imaginative “Bahamas test”. They wrote:

“If the sellers fled to the Bahamas or stopped showing up for work – like Satoshi Nakamoto – would the project still be able to exist? If the answer is ‘yes’, the risk of fraud is sufficiently reduced so that the instrument is not a security.” ”

Yes, but: It’s not always that simple. Many projects start out fairly centralized and gradually decentralized (Uniswap’s recent move is an example). For example: a team with an idea sells a token so they can afford to develop the idea.

Even though they hand over the project completely to the users the moment they finish their work, it’s still completely centralized until they do.

The Cato Institute article mentioned earlier went line by line in US law and suggested places where Congress could make changes to allow a project to upgrade its asset from security status when decentralized.

What they say: “To stimulate the development of cryptocurrencies … that provide consumer protections focused on addressing actual risks, not preserving a regulatory status quo,” the paper’s authors write.

How now? Everyone except the SEC seems to think there is an urgency to get actual regulations for this industry on the books (even the White House). Until then, startups will have to make do with this rough maybe-guideline of “adequate decentralization.”

To that end, dYdX’s attorney Marc Boiron released a paper Tuesday, via the Variant Fund, that provided token projects with guidance on gaining full decentralization in all aspects of their operations.
“Most legal advice around securities laws focuses on decentralizing the web3 technology stack. But equally important is decentralizing the day-to-day activities of off-chain community contributors,” advises Boiron.
In what follows, he breaks down the fundamentals of a typical crypto startup and offers suggestions for consistently aiming for a decentralized operation.

Bottom line: This is all just guesswork until there are actual regulations for blockchain businesses, or, perhaps a bit more likely, a specific new law.