What Makes Crypto Exceptional
As crypto enthusiasts, we spend a lot of time asserting that the Howey test (determining what is and is not a security in the US) doesn't apply to digital assets.
But we don’t spend much time explaining why it doesn’t apply.
To us, crypto seems so self-evidently different from traditional finance that it shouldn’t need explaining.
But we also spend a lot of time talking about protocols like they're companies and about tokens like they're stocks: We want protocols to win customers, earn revenue, buy back tokens, and pay dividends.
We want DAOs to allocate capital wisely and develop new products people will pay to use.
And when we buy a token, we consider its multiple of earnings (or future earnings). And we have an expectation (or hope, at least) of profit.
All of which is to say, the discourse around digital assets is not much different from the discourse around traditional assets.
What, then, makes tokens different? What makes crypto exceptional?
I think it comes down to legal rights vs. smart-contract rights: A crypto investor has no rights outside of what’s in the code.
If it’s not hard-coded into a smart contract, a token holder has no claim on the assets acquired or revenue earned by a protocol.
This is a feature, not a flaw: It's what makes crypto exceptional.
Last week, a proposal to have the Lido DAO pay revenue out to stakers of its LDO token sparked a lot of first-principles discussion about whether protocols should be sharing revenue with token holders.
Lido’s revenue more or less matches its expenses, and the proposal would have roughly half of that revenue paid out to stakers.
That's, um, not how it works in TradFi — it would be nonsensical for a breakeven start-up to pay money out to shareholders.
But crypto is different!
In crypto, it may be that returning capital to token holders before any profits have been earned has signaling value in excess of its cost.
LDO is just a governance token — it does not give holders an ownership stake in the Lido protocol. So, at first glance, it’s not clear why any revenue would be paid out to token holders — ever.
But Lido, like a company, has expenses. And those expenses are largely funded with LDO tokens it holds in its Treasury.
To meet its expenses, Lido therefore needs to imbue the LDO token with value.
The proposal does this by giving LDO utility (staking) and then paying the holders that choose to stake it.
This is awkward.
Staking looks like a fig-leaf excuse to distribute revenue to token holders. And that makes Lido look a lot like a loss-making company that’s perpetually selling new shares to pay its expenses.
As business plans go, there’s nothing wrong with that.
But it will look very familiar to regulators, who will see an issuer making a promise to investors — and promises are what turn an asset into a security.
The SEC keeps telling us that all crypto tokens other than bitcoin (and maybe ether) are securities.
And Coinbase keeps telling us it “doesn’t list securities.”
Weirdly, both may be correct: Like the quantum superposition of atoms, the regulatory state of any particular crypto token may depend on how it’s being observed.
Because, at the most basic level, an investment becomes a security only when the observer detects a promise.
That’s most easily detected in the initial sale of any transferable asset: With stocks, for example, the seller is promising to (eventually) generate and distribute excess earnings.
But subsequent sales of that same asset (made on secondary markets) may or may not qualify as securities transactions.
Coinbase argues the crypto tokens it lists are not securities because there are no promises buying made: There's no relationship between the secondary buyer of a token and the issuer of that token.
The issuer mostly likely will have made an implicit promise to the original buyers that they would endeavor to give the token value. But that promise does not extend to subsequent buyers as it does with equities.
Secondary sales of equities are securities transactions because the promises made in the initial public offering are transferable: Stocks come with legally enforceable claims on assets and cash flows and those claims pass from seller to buyer with each transaction.
In crypto, they do not: There are no explicit, transferable promises being made by an issuer — there’s only code.
But there are implicit promises being made, as evidenced by the general expectation that protocols like Lido will return earnings to token holders in the same way that companies return them to stockholders.
That, in the eyes of the SEC and many other regulators, is enough to turn tokens into securities: The regulatory state of a token is a function of how it’s being observed and many of us are observing tokens as if they are stocks.
I agree with Coinbase: Because there is no issuer making explicit promises to investors, tokens are not securities.
It’s what makes crypto exceptional.
But we’ll have to do a better job of explaining that to regulators.
And the more we talk about tokens as if they are unexceptional stocks, the harder that explaining will be.