Do decentralized networks of automated processes really reduce information asymmetry?
The director of the SEC’s Corporate Finance Division, Mr. William Hinman, has recently explained that regulation of an electronic asset as a ‘security’ (which triggers applicability of much of the US federal law, such as those punishing securities fraud) can greatly hinge on whether it is distributed through a decentralized network of automated processes. Mr. Hinman offered two nonexclusive lists containing 13 items used in deciding whether an asset would be regulated as a security. While most of the determining factors continue to focus on the consumer use vs investment distinction from SEC v. W.J. Howey Co., 328 U.S. 293 (1946), he emphasized that the crypto-asset context brings with it the increasingly important aspect of decentralized, automated systems. As he explained:
“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” … what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified “yes.”
In agreement with many people writing on blockchain and other forms of distributed ledger technology, Mr. Hinman sees the absence of “a central enterprise” and its interested owners as an indication that dangerous interests will probably be absent from the arrangement. The system takes care of itself. The mysterious operation of such automation (obscure to nearly all users) is seen to even reduce information asymmetry, so that the disclosure mandated by the Securities Act of 1933 becomes unnecessary (“The network … appears to have been decentralized for some time … the disclosure regime of the federal securities … add little value”).
Five of the 13 deciding factors Mr. Hinman lists go to the fact that assets traded on a distributed ledger do not involve a central person or group about whom we need to know something (here using the language from his speech as indicated by quotation marks, but adding italics):
“Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?”
“Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? …”
“…Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?”
“Do persons or entities other than the promoter exercise governance rights or meaningful influence?”
“Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?”
It is very true, as far as it goes, that the absence of interested and influential persons obviates much of the existing disclosure as required by the Securities Act. However, why should we trust the arrangement of the decentralized system and its automatic processing methods? Shouldn’t we be told something about them? A slot machine can be programmed to cheat gamblers just as easily as instructions to the dealer working the blackjack table. Volkswagen knew this when it designed software that would adjust the emissions of its engines, depending on whether they were being watched by an emissions test machine or out on the open road. Fraud was still present, but it was once-removed and pre-embedded. The approach taken to a Wall Street trading bot programmed to manipulate market price could be applied to distributed ledgers on which crypto-assets are traded if the arrangement is a scheme to defraud.
Mr. Hinman sums up his new observation about distributed ledger-based assets as follows: “As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.” This is because "when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede."
Yet another asymmetry of information arises. While disclosure about the issuer or promoter and their activities becomes less important, disclosure that explains the design of the system and its operation becomes crucial. Such systems are becoming increasingly important factors in the management of our environment, from resume scanning to police enforcement. If a system were to be designed in advance to extract unfair gains from its users (or benefit some types of users over others), this premeditated act is no less worthy of regulation than one perpetrated by on-going human malfeasance. We should be grateful to Mr. Hinman for bringing this new issue to light, but we should also hope that the SEC will not abdicate its regulatory role merely because an activity has been embedded in code that dictates the behavior of a decentralized network.
David Donald, Hong Kong