12. The Computer versus the Casino
Technology happens. It’s not good, it’s not bad. Is steel good or bad?1
Two distinct cultures are interested in blockchains. The first sees blockchains as a way to build new networks, as described here throughout. I call this culture the computer because, at its core, it’s about blockchains powering a new computing movement.
The other culture is mainly interested in speculation and money-making. Those of this mindset see blockchains solely as a way to create new tokens for trading. I call this culture the casino because, at its core, it’s really just about gambling.
Media coverage exacerbates confusion over the two cultures. That blockchain networks are so transparent and tokens are tradable 24/7/365 means there is an abundance of public information for reporters, analysts, and others to draw from. Unfortunately, many news stories focus almost exclusively on short-term activity, like price action, to the exclusion of long-term topics, like infrastructure and application development. Tales of fortunes won and lost are dramatic, easy to explain, and attention grabbing. In contrast, the technology story is nuanced, slow to develop, and requires historical context to understand. (That’s a big reason why I wrote this book.)
Casino culture is problematic. It takes tokens out of context, wraps them in marketing language, and encourages speculation in them. Whereas responsible token exchanges provide useful services, such as custody, staking, and market liquidity, reckless ones encourage bad behavior and play fast and loose with people’s money. Many of these are offshore and feature leveraged derivatives as well as other speculative financial products. At worst, they’re outright Ponzi schemes. In the most extreme cases, the casino culture’s obsession with gambling has led to catastrophes like the bankruptcy of the Bahamas-based exchange FTX,2 which cost innocent customers billions of dollars.
In addition to hurting people, the excesses of casino culture have provoked a backlash, including reactions from regulators and policymakers3 that can be counterproductive. For the most part, regulators have ignored the more extreme casino-culture activity, partly because much of it is offshore and hard to reach. They have instead focused on the nearest and easiest targets:4 tech companies based in the United States. This has incentivized exactly the wrong behavior. Ethical entrepreneurs are afraid to build products,5 and development is increasingly moving abroad.6 Meanwhile, scammers operate in foreign jurisdictions mostly unchecked, further emboldening the casino culture.
Some critics say blockchain networks benefit from lack of regulation. This could not be further from the truth. Financial regulations can, when designed properly, protect consumers, aid law enforcement, and promote national interests, all while enabling responsible entrepreneurs to innovate and experiment. The United States led the way with smart internet regulations in the 1990s that helped make it the center of internet innovation. There’s an opportunity to lead the way again in the new era.
Regulating Tokens
The area of regulation most often discussed with respect to tokens is securities laws. Financial regulations are complex and vary by jurisdiction, but it’s worth briefly discussing securities laws and how they might relate to tokens.
Securities are the subset of the world’s traded assets where investors are reliant on a small group of people, usually a management team, to generate a return on their investment. Securities laws are designed to reduce the risks that arise from this dependency by, among other things, applying disclosure obligations to securities issuers, as well as to certain other parties that transact in securities. These disclosures are designed to limit the ability of market participants with privileged information, including the management team, from taking advantage of others with less information. In other words, securities are assets where pockets of information exist that are accessible to some people but not to others.
The most familiar example of a security is corporate stock, like a share of Apple stock. There is a group of people at Apple, including the management team, who might have information that is material to Apple’s stock price. These people might know things like the next quarter’s earnings, information that could move the stock price. There are also vendors and commercial counterparties that might have material information about Apple’s business dealings. Because Apple’s stock is freely traded on public markets, anyone can acquire shares of the stock and, in so doing, would be trusting Apple’s management team to generate returns. They would also be trusting that their trading counterparties don’t have material information that might affect the stock price. Security regulations are designed to ensure that Apple fully discloses material information in a timely manner to the general public, thereby reducing or eliminating any potential information asymmetries.
Commodities are also a subset of the world’s traded assets, but they are regulated differently than securities. The most familiar example of a commodity that is not a security is gold. Information about commodities like gold isn’t uniformly distributed, but it is, for the most part, uniformly accessible. There are, of course, gold-related companies, like mining firms, and there are investors and analysts who might be skilled at predicting the price of gold. But there isn’t a set of people who have special information that could affect the price of gold the way there is with a security like Apple stock. The ecosystem around gold and other commodities is decentralized enough that anybody can, in principle, conduct research and compete on a level playing field with other market participants.
When tokens are classified as securities or as being sold in a securities transaction, they are subject to securities laws. Most of these laws were created in the 1930s, long before the information technology revolution. Applying these laws, as written, would raise a host of issues, creating hurdles that would make it difficult if not impossible for users to transact directly in tokens. Absent changes, clarifications, or narrowing interpretations of these laws, transactions of tokens classified as securities would generally need to be intermediated by registered securities brokers and exchanges, a recentralization process that would destroy a large part of the value and potential of the technology—that is, decentralization.
Tokens are digital building blocks, analogous to how websites are digital building blocks. Imagine if every time you wanted to use an internet service that used tokens as securities you had to go through the process you currently go through when buying a share of equity. Rather than just opening a social media app and scrolling, you would first have to log in to your brokerage account and place an order to purchase tokens. Want to use that app? Sign this paperwork and wait for your order to settle.
Ultimately, for tokens to achieve their potential, they can’t be regulated as conventional securities within current securities laws regimes. These regimes were designed for a world that used analog tools to transfer stock certificates representing interests in companies. Blockchain networks can compete with corporate networks only if they can offer comparable, state-of-the-art user experiences. Friction is a death knell.
The good news is that the fundamental goals of regulators and of blockchain builders are ultimately aligned. Securities laws try to eliminate pockets of asymmetric information with respect to publicly traded securities, thereby minimizing the trust that market participants need to place in management teams. Blockchain builders try to eliminate centralized pockets of economic and governance power, thereby reducing the amount of trust users must place in other network actors. Although the motives and tools are different, disclosure regimes and network decentralization have the same philosophical goal: eliminating the need for trust.
Regulators and policymakers generally agree that tokens that power “sufficiently decentralized” blockchain networks should be classified as commodities, not securities.7 It is widely agreed that Bitcoin has reached this threshold of sufficient decentralization. There is no group of people who have special knowledge that is material to the future price of Bitcoin. Therefore, Bitcoin is classified as a commodity like gold, instead of a security like Apple stock, and isn’t subject to cumbersome processes.
Every software project starts small, with a founder or group of founders. Bitcoin started with Satoshi Nakamoto, Ethereum had a core founding team, and so on. At the early stages, by virtue of being small, these projects were centralized. At some point, however, the initial development teams behind Bitcoin and Ethereum faded into the background and the broader community became the driving force. Other, more recent projects are at various stages of decentralization, a process that takes time.8
The challenge for entrepreneurs building blockchain networks under current rules is that although they are clear at the beginning and end, they aren’t clear in the middle.9 What precisely does it mean to be sufficiently decentralized? The best guidelines come from regulations and court precedents from the pre-internet era. The most famous is a 1946 U.S. Supreme Court case that created what’s called the Howey test10 for deciding what constitutes an “investment contract,” another term for a security. The Howey test consists of three elements, or prongs. Applied to digital assets, the test looks at whether an offer or sale of digital assets involves (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profit to be derived from the efforts of others. All three prongs must be met for the offer or sale of a digital asset to be considered a securities transaction.
As of this writing, the last time the Securities and Exchange Commission (SEC), the main regulator of the U.S. securities markets, gave substantive guidance on the topic11 was in 2019. The guidance suggested that blockchain networks that were sufficiently decentralized would fail the “efforts of others” portion of the third prong of the Howey test, and therefore that securities laws would not apply to their tokens. The agency has since brought several enforcement actions12 alleging that certain transactions of tokens were subject to securities laws, and it has done so without providing further clarification about the criteria by which it makes these determinations.
Applying pre-internet legal precedents to modern networks leaves gray areas that provide significant advantages to bad actors and non-U.S. companies that don’t follow U.S. rules. Bad actors take shortcuts to decentralization. They are quick to launch tokens, which help them grow. Meanwhile, good faith actors spend heavily on lawyers to determine how “sufficient decentralization” applies to their projects, which creates a competitive disadvantage compared with those who don’t bother to do so. The situation today is so complex that regulators themselves can’t agree where to draw the line. For example, the SEC has suggested that Ethereum’s token is a security,13 but the Commodity Futures Trading Commission, the primary U.S. regulator of commodities, has said that it is a commodity.14
Ideally, policymakers and regulators would clarify15 the criteria that distinguish securities and commodities and provide a path for new projects to become sufficiently decentralized such that they are regulated as commodities. Today Bitcoin is the gold standard for decentralization, but it too started out centralized, as all inventions do. Had regulations without a path to decentralization been in place back in 2009, Bitcoin could never have been created. Without such a path, older technologies that developed before regulations were in place will be allowed, but new technologies will be blocked. In effect, this would arbitrarily outlaw future innovation.
It should be noted that there are various regulations that apply across the board to traded assets, whether they are securities or commodities. For example, for any traded asset, it’s illegal to corner the market or manipulate prices. Consumer protection laws also prohibit false advertising and other misleading behavior. Everyone agrees these rules should apply to digital assets just as they do to traditional assets. The debate is focused on the narrower question of when digital assets should be subject to additional rules traditionally reserved for assets classified as securities.
Ownership and Markets Are Inextricable
Some policymakers have proposed rules that would effectively ban tokens16 and therefore, for all practical purposes, blockchains. If tokens were purely for speculation, these proposals might be justified. But, as I’ve argued here, speculation is just a side effect of tokens’ true purpose as essential tools that enable community-owned networks.
Because tokens can, like all ownable things, be traded, it is easy to think of them as purely financial assets. Properly designed tokens have specific uses, including as native tokens that incentivize network development and power virtual economies. Tokens are not a sideshow of blockchain networks, a nuisance that can be stripped out and discarded. They are a necessary and central feature. Community ownership doesn’t work unless communities have a way to own.
Sometimes people ask if it’s possible to get the benefits of blockchains while removing any hint of the casino by making tokens impossible to trade, through either legal or technical means. If you remove the ability to buy or sell something, however, you remove ownership. Even intangibles, like copyrights and intellectual property, can be bought and sold at their owners’ discretion. No trading means no ownership; you can’t have one without the other.
Eliminating token trading also interferes with the productive uses of blockchains. Blockchains need token incentives to motivate validators to run network nodes, which cost money to operate. Whereas corporate networks fund their operations and development with fundraising, stock options, and revenues, blockchain networks fund their operations and development with tokens. If there aren’t markets or prices associated with tokens, then users can’t buy tokens to access the network. They also can’t convert tokens into dollars or other currencies, making it hard, if not impossible, to use tokens as incentives for network participants, as discussed in “Building Networks with Token Incentives” and “Tokenomics.” There are no known ways to design permissionless blockchains without tokens and token trading, and you should be skeptical of anyone who tells you otherwise.
One interesting question is whether hybrid approaches can tame the casino while still allowing the computer to be built. One proposal would prohibit token reselling after the debut of a new blockchain network, either for some fixed period or until specified milestones are met. Tokens could still be awarded as incentives to grow the network, but token holders might need to wait several years, or until the network hits certain thresholds, before trading restrictions are lifted.
Time horizons can be a very effective way to align people’s incentives with broader, societal interests. Think of the hype cycle described earlier that technologies go through, with the early hype phase followed by a crash and then the “plateau of productivity.” Long-term restrictions force token holders to weather the hype and its aftermath and to realize value by contributing to productive growth.
Some blockchain networks are self-imposing these kinds of restrictions, and there are legislative proposals in the United States and elsewhere to make temporary token restrictions mandatory. This would allow blockchain networks to use token incentives as a tool to compete with corporate networks, and it would encourage token holders to focus on creating long-term value as opposed to short-term hype. The milestones can also be tied to regulatory targets like “sufficient decentralization,” satisfying the goals of securities and other regulatory regimes.
The industry needs further regulation, to be clear, and that regulation should focus on achieving policy objectives, like punishing bad actors, protecting consumers, providing stable markets, and encouraging responsible innovation. The stakes are high. As I’ve argued here, blockchain networks are the only known technology that can reestablish an open, democratic internet.
Limited Liability Corporations: A Regulatory Success Story
History shows that smart regulation can accelerate innovation. Until the mid-nineteenth century, the dominant corporate structure was a partnership.17 In a partnership, all the shareholders are partners and bear full liability for the actions of the business. If the company has a financial loss or causes nonfinancial harm, the liability pierces the corporate shield and falls on the shareholders. Imagine if shareholders of public companies like IBM and GE were personally liable, beyond any money invested, for mistakes the companies made. Very few people would buy stocks, making it much harder for companies to raise capital.
Limited liability corporations did exist back in the early nineteenth century,18 but were rare. Forming one required a special legislative act. As a result, almost all business ventures were close-knit partnerships among people who deeply trusted one another, like family members or close friends.
This changed during the railway boom of the 1830s and the period of industrialization that followed. Railroads and other heavy industries required significant up-front capital—more than could be provided by small groups, even when the groups were very wealthy. New and broadened sources of capital were needed to fund a transformation of the world economy.
As you might expect, the upheaval ignited controversy. Lawmakers faced pressure to make limited liability the new corporate standard. Meanwhile, skeptics argued that expanding limited liability would encourage reckless behavior, effectively transferring risk from shareholders to customers and society at large.
Eventually, the factions settled on a way forward. Industry and lawmakers crafted sensible compromises, arranged legal frameworks, and made limited liability the new norm. This led to the creation of public capital markets for stocks and bonds and all the wealth and wonders those innovations have generated since. Thus, technological innovation drove pragmatic changes19 to regulation.
The history of economic participation is one of increasing inclusion thanks to a combination of tech and legal advances. Partnerships had small groups of owners that counted in the tens. The limited liability structure expanded ownership dramatically, to the point that public companies today have millions of shareholders. Blockchain networks, through mechanisms such as airdrops, grants, and contributor rewards, expand the circle once more. Future networks could have billions of owners.
Just as industrial-era businesses had new organizational needs, so do network-era businesses today. Corporate networks bolt an old legal structure, C-corporations and LLCs and the like, onto a new network structure. This mismatch is the root cause of many of the problems with corporate networks, including their inexorable switchover from attract to extract mode and the exclusion of so many contributors from the upside of their networks. The world needs new, digitally native ways for people to coordinate, cooperate, collaborate, compete.
Blockchains provide a sensible organizational structure for networks. Tokens are the natural asset class. Policymakers and industry leaders can work together to find the right guardrails for blockchain networks, just as their forerunners did for limited liability corporations. The rules should permit and encourage decentralization, not default to centralization as corporate entities do. There are many things that can be done to rein in casino culture while allowing computer culture to develop. Hopefully, smart regulators will encourage innovation and let founders do what they do best—build the future.
The casino should not hold the computer down.