The city hall on Batavia  | Jacob van Meurs (1682)

The city hall on Batavia | Jacob van Meurs (1682)

2:3 Howie Test to “Sufficiently” Decentralized

Understanding the innovation-regulation paradigm is crucial to form a holistic opinion about the larger DLT fitness landscape. The intention of regulation is always a noble affair with mandates like “protect investors” and which can be skewed towards “protect our capitalist market structure”. Intention and execution however make odd bed fellows when rigid rule structures run into new ideas for how to re-structure the entire market system to run on immutable/decentralized/math based infrastructure.

DISCLAIMER: This chapter is no way is warrantied as legal advice. Instead, think of the following as a journalistic meandering through a topic that is as difficult to understand as it is nascent. Nobody has the answers, they are still being figured out.

Remember nothing is more uniquely human than rules. No other animal has invented such a powerful social technology that can influence behavior using subtle threats of revoking property rights, physical detainment, or even capital punishment if broken.

Why do we have laws (specifically in gray areas such as securities laws)? Who are they protecting? Who are they hurting? Do real people decide things openly and transparently? Or are puppet masters hiding behind software?

  • If we were pure Zuckerbergian tech nerds, we would not concern ourselves with such vagaries. Instead, we would bend existing legal constructs as far as possible to show ads to as many eyeballs as possible. If the FCC tries to get in the way, lean harder on the Communications Decency Act of 1996 Section 230. “We aren’t making content, just monetizing it on the backs of the proletariat.. so leave us and our shareholders ALONE!!”

Looking at the same problem from a slightly different use case angle, is it illegal for a company like Amazon to offer an insurance product that cherry picks the top 10% of healthiest adults, only to make the rates everyone else pays go up?

  • For Amazon it makes capitalistic sense to leverage their immense data advantage to analyze consumer grocery habits, clothing sizes, and other prying data to build statistical correlations that calculate an approximate health score. If tying in wearable data and blood test results becomes practical at scale, the statistical model can become even more accurate. Again they are not making the content (blood pressure data/clothing size data + associated metadata), they are just monetizing it on the backs of the proletariat.

To confine our focus as much as possible in this chapter, we are only going to concern ourselves with how distributed ledger tokens are perceived as more narrow types of legal constructs. Railing after the entire centralized big data industrial complex is simply too tiring. In hopes of doing more than just complain the big picture problem FAANG siren servers pose to the middle classes and democracy, we need to drill down into how equity and debt contracts work to show how these constructs can be used in a new more progammable format that benefits more people.

This chapter thus attempts to tie:

  • paying real people in some form of ledger tokens for their contributions to the network. Be it in data, metadata, or actual “work” however that is defined.


  • how such structures are currently being devised

  • and how such structures might be interpreted by existing legal precedent

Again: we are not lawyers, please do not take anything in this chapter as legal advice. Like the rest of this book, we are only touching these issues at a very high level.

Howey Test

Guidance regulators issue to participants in the distributed ledger space have been spotty at best. As ledgers transcend national borders, projects in the space largely look towards world superpowers with the most clout for recommendations on how to proceed forward. As China is China, we won’t go there in this book. It is fun that owning Bitcoin in China is mostly legal, while circumventing capitol controls is not.

In the United States, guidance has been especially cryptic, though we do have two major lines of thinking we can attach ourselves to. In the western tradition, we will enjoy our Common Law heritage and follow the precedent set by activist judges & bureaucrats.

  • SEC Commissioner Jay Clayton has been crystal clear that token projects where there is any expectation of future economic return fail the “Howey Test” are ARE securities.

  • Conversely, director of the SEC’s corporate finance William Hinman division made waves when he declared networks that are “sufficiently decentralized” with no clear managerial oversight and control by a single group CANNOT be considered a security.

this also points the way to when a digital asset transaction may no longer represent a security offering. If the network on which the token or coin is to function is “sufficiently decentralized” – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
— William Hinman June 14th, 2018

These two doctrines taken together at least begin to shape a regulatory landscape. Both views are talking about different aspects of the “Howey Test”, a supreme court precedent set in 1946 which declared any investment with the following characteristics was indeed a security and thus falls under the jurisdiction of the Security and Exchange commission.

  1. It must be an investment of money

  2. With an expectation of profit

  3. In a common enterprise

  4. With the profit to be generated by a third party (or through the efforts of a promoter)

As we will see in this chapter, regardless of the mechanisms used (paper, centralized database, or distributed database) the act of raising money upfront to perform future work inevitably leads to a security-like legal structure. Making promises with a significant risk of not materializing means ordinary people without excess money to lose need to be at minimum informed. Our system sporadically demands blood for bilking investors to discourage such behavior. Unfortunately, the enforcement mechanisms in place to go after bad actors often inadvertently backfire to stifle innovation or create even worse game theoretic outcomes.

  1. Terrible underwriting/rating/derivatives risk practices explode the economy ->

  2. Legislators create oppressively expensive Dodd-Frank compliance rules ->

  3. Small banks forced out of business due to high cost of compliance ->

  4. Less competition among the surviving oligopolies stifles innovation

  5. Or do the benefits outweigh the costs?

  6. Or maybe regulation is a multi-faceted gray monster that becomes increasingly difficult to predict.

Keep your chess brain active as we dive into our equity discussion. First order thinking is fine, but to solve important issues we must play 3D chess.

How Equity Works

Rather than view these two poles (Howey Test Vs Sufficiently Decentralized) as diametrically opposed, think of distributed ledger projects as going on a journey where they transition from a Howey Test failing security, to maybe one day something as successful as commodity/property/shared commons like bitcoin. This journey is fraught with peril at every step. It’s not just other distributed ledger project rats that can eat you, but governments, and centralized corporations intent on maintaining the status quo.

Before a distributed ledger project is birthed onto the internet, it is first an idea in the head of a single person, or small group of people.

At the idea stage, no one owns anything yet. In the traditional venture capital world, this would be the prototypical “great idea” PowerPoint possibly with some minimum viable product code, or wire-frame mock-up of how the App will one day work.

  1. If the idea is good enough, why not spend $400 dollars to set up a Legalzoom LLC, then suddenly there is legal ownership. Without a provisional patent, copyright, real estate holdings, revenues, etc the shares of the LLC have no collateral value, but do form beginnings of the corporate life cycle.

  2. The minute the 100% owner of the LLC (how about we call her Elizabeth) sells 1% ownership to her father in exchange for $1,000 in funding, we now have an equity on our hands. Not only that, we also now have a value for the business.

    If $1,000 dollars buys you 1% ownership in the business, then $100,000 would by you 100% ownership in the business. If 100,000 shares of stock were outstanding, each would be worth $1 as that was the price the most recent investor paid to buy ownership in the company.

  3. Say Elizabeth’s company is doing well and actually makes some gross revenue the first year of say $100,000. If the next year she suddenly made $1,000,000 dollars gross, the sharp growth rate would entice venture capitalists to value her business at possibly 10 to 20 times gross revenue (even if net profit margin is low or even negative because you know: hockey stick) At this point the entity would want to be structured as a Delaware C corporation in the US, but this is beside the point.

Now the same shares are worth much more than the original $1 each at a $100,000 dollar valuation. At a $10 million dollar valuation, each of the 100,000 shares is now worth $100 dollars, a 100X return!

This is the simplest example possible with no dilution, preferred shares, convertible debt, etc. etc. Any structure that looks even remotely like exchanging ownership in an entity for the chance it will be worth more in the future IS A SECURITY.

Non-Security Tokens

So what properties would a distributed ledger token need to have for it NOT to considered an equity?

First, things like raising a large amount of money to fund project development can be very triggering.

The typical Initial Coin Offering process does just this:

  1. The team presents a business plan plus hopefully a more technical whitepaper to explain their vision in more rigorous detail.

  2. Then divides ownership in the project among categories like founder tokens, advisor tokens, development funds, private accredited sales, and sometimes public offerings.

  3. With funds raised, the ICO can go on to develop proof-of-concept code into commercially viable code, then go into the marketplace to try and win over consumer or business customers.

What approach is the exacy opposite of an ICO?

Once again bitcoin.

  1. Released as close to fully working open source beta software, bitcoin immediately began to generate interest from developers who could contribute to the open source code base, and earn money by mining for the earliest bitcoins. Rather than raising money first, then deploying code.. the bitcoin model started code first, with adoption second.

  2. Once bitcoin could be exchanged and began to have real monetary value, open source contributors to the code base with bitcoin holdings were incentivized to help the protocol along. As the number of total bitcoins was finite (21 million) early developers and users knew if they promoted the network their holdings had a chance to increase in value as more dollars chased fewer bitcoins.

This approaches lends itself to a much less formal distribution of wealth in the system. Instead of founders get X%, developers get Y%, Investors get Z%, in essence Bitcoin was a “reverse ICO”. As in build a minimum viable product FIRST, then and only then when complete strangers begin contributing does it have any value.

If bitcoin were released in a traditional equity structure, Satoshi would have raised money from private investors before launching the bitcoin “mainnet” or official release.

These private investors would have probably used a SAFT or secure agreement for future tokens, wherein they pledge capital to the project before it is launched, in exchange for receiving discounted tokens at a future date if the network actually comes to fruition.

In such as system, bitcoin would have had tokens set aside for development, marketing, etc. with some form of governing body deciding how token equity is spent.

But bitcoin was NOT released as an equity, it was released as a purely open source expression of mathematics. Does this mean bitcoin is somehow free from governance and politics? Absolutely not.

Distributed Governance (Howey 3&4)

The key distinction Hinman made between equities and some hypthetical new kind of digital commodity in his speech revolves around projects like bitcoin being sufficiently distributed that no single governance cabal controls the entire project.

To decipher the difference, we can ask, “who controls FAANG?” Of course it is the C-level executives with a strongman corporate culture, backed up by a board of directors to set the governance agenda.

Who controls bitcoin? This answer is much less clear.

  • The largest mining pools?

  • The core developers?

  • Second layer developers building lightning networks?

One of the great mysteries of our time is who exactly controls Bitcoin, and if it is possible that no single authority can have a sustained outsized sway on the network. Put more bluntly, as long as the integrity of the data can be proven, does it even matter who is in charge?

If the goal of public ledgers is to store immutable hashed data, then as long as there are enough copies of the original ledger with distributed enough hash power, it doesn’t really matter who is in charge.

Even if bitcoin goes in a completely different direction (such as becoming a permissioned system where changes are voted in my central authorities) all ledger data from before the change will still be forever in the public domain for future generations for analyze.

To further the point made in the last chapter about why public ledgers matter, the “neutral Switzerland” argument becomes especially important when regulators attempt to determine how distributed ledger projects will be regulated.

For instance, if a token is airdropped (strategically given away without any exchange of value such as bitcoin or fiat currencies) instead of fundraised, there is less evidence to support the Howey Test. As contracts typically require “consideration”, by not accepting payment in exchange for tokens projects are less susceptible to being considered equities.

Working backwards on the Howey Test we can quasi rule out 3 & 4.

  1. In a common enterprise

  2. With the profit to be generated by a third party (or through the efforts of a promoter)

That is if the enterprise really isn’t common, but instead communal. If a board of directors were able to reset the Bitcoin emissions curve, the fork wouldn’t have as much in common with the real “unforked” Bitcoin. Can an enterprising developer increase the token supply to 84 million and replace SHA 256 with Scrypt? Sure, but that’s Litecoin, not Bitcoin.

Using the Howey test Rubric, Litecoin would fall into a similar category as Bitcoin, though has different ownership and thus must be studied as a separate entity. Is Litecoin owned by more people or less people? Do developers get paid by rich benefactors, or by a foundation that directly diverts some of the mining reward? All good questions to ask.

Making Money (Howey 1&2)

This next section will border on a Bill Clinton-esque gaff on the meaning of what Is
but what is an “investment” of “money” and what is an “expectation” of “profit”

  1. It must be an investment of money

  2. With an expectation of profit


For most people, money must be made using and acceptable medium of exchange. So if a decentralized social network releases tokens to users in exchange for posting content, has money really changed hands?

As this stage, it’s not real money, but instead monopoly could be considered more like monopoly money fun points.

What gives imaginary internet money value? EXCHANGE

  • The second a trading pair is instantiated, price discovery can happen.

  • The second price discovery happens monopoly money fun points become “real” because they can be exchanged for something “real”.

In this system we have created an approximation of LABOR -> PROFIT.

Where labor is loosely defined as anything that generates data. This could be writing a 200,000 word epic on the Russian Revolution, but more likely your geo-spatial Lat/Long data while driving, or cell phone photo that makes it to the top of a Yelp profile. Under the assumption that provably unique data can indeed = money, does the end user need to contribute real money in (such as US dollars) to receive real money out?

Of course not! If you want to fail the Howey Test then YES. If you do not want to fail the Howey Test, then seed the initial marketplace with a finite supply of tokens that only gain value when actual value is created.

Sure, hoard 30% for yourself, 30% for the developers, and give away the remaining 40%, but DON’T ask for dollars/bitcoins/sheckels/kopecks from users unless you want them to be legally protected investors.

At least don’t ask directly, let the exchanges develop trading pairs for you. Better yet, build a natively decentralized exchange on your platform that allows users to seamlessly convert their earnings into their favorite medium of exchange without bein under the direction control of a centralized intermediary.


All decentralized systems are governed by a series of programmatic rules that determine how new supply is created, and what the transaction fees are for post new transactions and data to the shared network.

For real “profit” to be generated, there must be some kind of reason someone would want to hold the token. If token holders receive a portion of the fee revenue generated by the protocol, a rough approximation of return of capital can be calculated.

The earlier a project is in development, the more risk there is. This is true for any new enterprise as it makes the perilous journey from idea through to minimum viable execution, then hopefully scale against all odds of being drowned out by other players on the fitness landscape.

As a DLT makes it through successive stages of development the project becomes more “derisked” thus increasing the price users are wiling to pay to hold a piece of a winning protocol. Keep in mind, these speculator investors are an integral part of the ecosystem, but by no means the only part. Developers, IT infrastructure providers, ultimately end users are the most important part of the system.

Certain users might be simultaneously all four user types, investor, user, developer, and IT, but most likely not. Given the statistics behind how few professional developers exist, the investor/user will always be the most common user type unless the project is extremely early in closed development.

Making it crystal clear how the economics work as early users are by the nature of project development also investors. Even if they only invest their time, they most likely have expectations of future profit. E.g. with a finite supply of social media tokens, early users will hoard supply to release onto the larger market at a later time.

Inherent in widespread success, an influx of new users/investors must enter the platform by either exchanging their data or money for access. This certainly does sound like an elaborate Ponzi scheme, and to be honest most DLT projects are. As insiders and early users have large incentives to dump their holdings for profit on future holders, if the project does not eventually turn into a revenue positive machine, the investors buying tokens at higher valuations will inevitably lose.

Like rats on a sinking ship, if the project does not have the fortitude to survive technical set backs, governance set backs, or even legal set backs it will die. Not usually all at once like Bitconnect ponzi scheme, but through a slow and painful bleed out that could last years until all hope is lost and the last developer has moved on to greener pastures.

Everything Fails

While essential for the fitness landscape to improve, let’s not be trite that “failure is great!” Some types of failure are fine. We don’t fault people learning to drive when they run into a concrete pole at a gas station. But we do when they commit vehicular manslaughter.

In the same way, we try not to fault people for failing at business, unless there is some known, intentional, provable duplicity at hand. Our hope with this chapter is to lay out a broad framework to think about the interplay of regulation and innovation. We want the distributed ledger space to succeed. The current paradigm of centralized servers hoovering all of our data is not sustainable unless we collectively prefer digital feudalism.

This is why we need to work within securities law precedent to create more transparent structures where participants can better deal with the immense risks posed by doing something new. At a practical level, we don’t what DLT cut off at the knees for non-compliance. The deck is already stacked in the centralized incumbents favor, every Bitconnect-like scam that enters the mainstream narrative plays into the hands of the existing power structures that want the space to fail.

浑水摸鱼 (muddy waters make it easy to catch fish)
— Chinese Proverb