What could “decentralization” mean in the context of the law?

How Bitcoin's inception helps us understand good policy for securities regulation

SEC Director of Corporate Finance William Hinman’s speech yesterday on tokens has spurred (or perhaps renewed) a debate on what “decentralization” really means in the context of securities law and cryptocurrency.

Coin Center has been advocating vigorously for a decentralization standard for years now because we believe it is, in fact, more justiciable than “utility” or "function." Also it addresses directly both the “common enterprise” prong of Howey (if the relevant court requires pooling of invested funds to find horizontal commonality) as well as the “third party efforts” prong. If the network is decentralized then, by definition, no funds are being pooled to build the innovation. If I buy a bitcoin from my friend who mined it (assuming he is one of several miners), then the invested funds are going to my friend and not to the promoter of the network—the funds are not being “pooled” network-wide under the control of the promoter or developer hence there is no common enterprise (but note that some courts do not require pooling to prove common enterprise). Similarly, if there are several persons developing the software and powering the network then there is no single person or affiliated group of persons upon whose essential managerial efforts investors rely. This is a stronger argument than focusing on the “utility” of the token, which merely provides a counterfactual to the “expectation of profits” prong. We've previously written about this generally, and with respect to ether specifically.

But what are the full contours of decentralization? Where does it begin and end?

First, we have to take a moment to recognize that what regulators and courts will be trying to ascertain is not what counts as “decentralized” in a metaphysical sense or even as a computer science question, but as a legal matter under the securities laws. We get some indication of how folks at the SEC may be thinking about this from an interesting detail in Hinman's speech; he said "The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception."

At Bitcoin's inception there was one developer (or a small group all going by the same pseudonym) and one miner. Now, that is a level of "operational" that makes plenty of sense: you could have installed the client software that Satoshi shared on mailing lists and received payments from him/her on the network, mined in competition with him/her and sent payments to others. Functional. Note that this also underscores the fundamental difference between a token that is merely theoretical and promised in a fundraising effort and a token that has actual new software and a new network backing it up. This is what, we believe, Director Hinman meant by “putting aside the fundraising that accompanied the creation of Ether.” That fundraising is a whole different ball of wax, and anyone suggesting Hinman has now declared that all ICOs for decentralized tokens are not securities is ignoring this very important part of his reasoning (because all ICOs I know of are exactly that sort of fundraising).

But what about the level of decentralization at Bitcoin’s inception? One developer and one miner? It may actually be plenty. Satoshi may be the only developer and the only miner, BUT the software he/she has released is open source and the consensus mechanism is open to participation with commonly available hardware. In economic terms we may think of Satoshi as a monopoly provider at the date of inception but it is, in theory, an extremely contestable monopoly -- and in short order there were, in fact, several other people contributing code and hash-power. In fact, Satoshi could even fully disappear and the network carried on just fine—talk about lack of reliance on the promoter! We believe that this level of contestability (thanks to open consensus and open source software) should be sufficient to indicate decentralization. As an important corollary, for this argument to hold we must also assume that the developer has not made any promises about profits or future efforts in marketing materials—as Satoshi did not.

Based in Washington, D.C., Coin Center is the leading non-profit research and advocacy center focused on the public policy issues facing cryptocurrency and decentralized computing technologies like Bitcoin and Ethereum. Our mission is to build a better understanding of these technologies and to promote a regulatory climate that preserves the freedom to innovate using permissionless blockchain technologies.