Are Public Blockchain Systems Unlicensed Money Services Businesses in Disguise?


In this essay I use Bitcoin as a case study for a general analysis of public blockchain governance. I begin by describing the evolution of an ideological civil war within the community. I find that that civil wars such as this put businesses using the protocol under a tremendous amount of legal risk. The most efficient way to avoid confusion and consequently legal risk, is to associate a brand with a software development team therefore transferring legal risk to it. Due to states’ overwhelming preference for consumer protection, if businesses join an attempt to wrestle control of the brand from an unwilling incumbent, they assume the legal risks associated with loss of customer funds. I show that this thesis finds support in how many businesses, despite originally supporting a new software client with new rules to assume the brand “Bitcoin” or “BTC”, have now backtracked in the face of legal threats from both supporters of, and members of the developer team for the main Bitcoin reference client, Bitcoin Core. They will instead issue the new currency with the ticker ‘B2X’. A similar outcome favouring the incumbent team occurred when the Ethereum network split in 2016.

These outcomes, in my opinion, constitute backdoor trademark enforcement and have revealed what amount to some very uncomfortable truths for proponents of public blockchains. It first of all told us that some entity must control the brand in order for a cryptocurrency system to be functional without legal risk from brand confusion to businesses that build on top of the protocol. Secondly, it told us that ultimately it is the state that attributes control of a cryptocurrency brand even if it doesn’t officially make a ruling on it. Thirdly it showed us that since proof-of-violence is the ultimate consensus mechanism in defining the rules of the system, that phenomena like client heterogeneity, proof-of-work and decentralised consensus on the order of transactions are arguably obfuscations of the reality that administrators of public blockchain brands are administering networks that represent unincorporated, unlicensed money services businesses.

Both non-mining and mining nodes are effectively working on behalf of those that code the software and ultimately enforce the system’s rules via their enforcement of naming rights. If there are multiple software clients competing for the same brand and one or more fall out of consensus – whether intentionally or otherwise – a decision is made by someone with power on which one is the ‘official client’ for the brand in question. The person (or persons) that makes that decision is responsible for the rules and is therefore logically responsible for the whole system. Bitcoin, Ethereum and all other public blockchain-based currencies are thus, in my opinion, merely convoluted versions of E-Gold. The question is: Are they convoluted enough for brand administrators to avoid the long arm of the law?

The Bitcoin Story Thus Far

*If you are well versed in Bitcoin politics you may want to skip this section

The Bitcoin civil war has now raged for a number of years and has reached a point where it appears compromise is impossible. The ideological schism first reared its head within the informal institution that is Bitcoin Core. This group, via the control of the access rights to the Github repository for the main Bitcoin reference client, has control over its development. As developers of the main client, Bitcoin Core group is the natural Schelling point for community leadership to form. It is the arena where protocol Bitcoin policy-making has occurred. It follows from this assumption that in order for protocol upgrades to happen, Core must either come to a consensus over what changes to make or come to a consensus that majority rule voting applies to decision-making.

When an ideological dispute arose over how much space the protocol should allow to store transaction data in each block, no such consensuses could be reached. Aside from the role of lead developer, which itself is unlikely to grant much extra influence beyond membership of the group, no sources of power other than the power of numbers are identifiable to me. (The person(s) who controls access to the repository may be considered as having outsized power but if this power was used unilaterally a new repository under a new account would simply be instigated and I suspect most likely recognised as the official repository. The ideology of the majority has duly prevailed and little by little the influence of the minority group in this schism was eroded to the point that they are now frozen out of development decisions with their commit access revoked. Since the Github repository’s access is permissioned and the majority of users used the Bitcoin Core client, this meant that the dispute was settled without any confusion or disruption for politically passive members (the vast majority) that simply want to use “Bitcoin”.

Of course this is not where it ended however. In the absence of a name that is protected by a system with strong guarantees of private property rights and physical force, mounting attacks to take control of a brand are eminently possible if you have the resources to do so. The minority opinion within Bitcoin Core thus set about convincing the right people of the merit of their ideology. It of course helps matters when this ideology happens to further the economic interests of the leadership of another political group with veto powers over any legislative proposals – this group being the dominant Bitcoin mining interest group who hold veto powers since it is they that implement software updates in the process of adding blocks to the ledger. Since the larger blocks favoured by the dissenting opinion in Core result in higher revenues for the miners, a natural coalition of interests formed. When it did, the mining interest group was able to successfully veto a Bitcoin Core proposal without unanimous community backlash. This is because former Core developers and other politically active, influential members of the community granted the veto political legitimacy. With Core’s grip on access to the main client’s development process and the miners’ grip on the power to veto legislation, an inevitable stasis occurred.

Legislative deadlock is never a desired situation in any system of government. In order to overcome the deadlock, supporters of Core’s policy began to work on a solution that would bi-pass the miners. Separately, economically powerful actors began to become politically active in order to seek a resolution to the impasse. Digital Currency Group, a relatively big player in the industry brokered an agreement – known as the New York Agreement – in which 58 companies in the space committed to a compromise between the big block and small block factions. Notably the vast majority of miners supported the compromise whereas Core would not despite it meaning their legislative proposal would pass under the agreement. Core claimed that they would not compromise for ideological reasons – primarily because they have an aversion to the method used to increase the block size limit – but it is also quite possible that they wished to continue wielding the power to initiate legislation as they consider themselves the most competent policy-makers. I suspect both these theories are true.

When Core’s proposal passed subsequent to the NYA, and Core had cast doubt on the viability of the block size increase proposal, another faction saw an opportunity to make a move. ViaBTC, a Chinese company with interests in both mining and exchange initiated a split of the protocol and labelled it Bitcoin Cash. Given that their version (forks as they are known in the industry) involves an increase in the block size, they were also able to claim a certain amount of legitimacy by representing well-established ideology within the community. A number of exchanges listed it, albeit under a different ticker (BCH), and when this happens, pressure is exerted on others to do so in fear of losing market share and/or being exposed to risk of legal action from users wishing to access the new version of the currency. It is evident that there is potential for a lot of upside with very little risk for those seeking to commandeer the Bitcoin brand for financial gain. All that is required is a marketable story.

Despite the existence of Bitcoin Cash meaning both prominent ideological divides within the community were technically represented, the majority of the signatories of the NYA committed to continuing with their plan. At this point it became clear that the motive was no longer compromise but rather a putsch. The aim is to not simply make a spin-off of Bitcoin such as BCH, but commandeer the brand outright by claiming the BTC ticker on the exchanges. Supporting evidence for this thesis can be found in the NYA group’s initial refusal to implement a feature called replay protection, meaning many users could lose coins on Core’s blockchain when moving coins on their version. It’s difficult to interpret this in any other way than this is an overt attempt to kill off Core’s version by making it insecure. Further evidence of these motives can be found in leaked chats in which an admission of the aims of the NYA can be found.

As is the case in most political power struggles, the other side will use any tools at its disposal too. If the omission of replay protection was the NYA group’s nuclear option, Core’s nuclear option is the threat of state legal action. Core developers have openly threatened legal action on Twitter and one has also written to the SEC in order to instil fear of prison into the NYA developers. They have also published a list of companies that support the protocol change and clearly insinuate that anybody that represents the new version as with the BTC ticker will be acting fraudulently. To an objective observer this is clear signalling for those looking for people to blame in the event of a loss of funds from the political infighting. Many of Core’s supporters took up the fight and began declaring that the NYA signatories would be committing fraud if they persevered with their actions.

These events are very interesting as not only is it a tacit admission by Core developers that Bitcoin can be – and is in fact – governed, it is a request to the government to define what Bitcoin is. It therefore contravenes the very foundation of Core’s stated ideological perspective of what Bitcoin is. In their eyes it is supposed to be a system that nobody controls – especially not the state.

As a result of this pressure, one by one, the exchanges and businesses folded and announced that the new software client would be represented by the ticker symbol B2X. In my view there was a realisation that there would inevitably be legal problems ahead and the most prudent thing to do was to surrender to Bitcoin Core. Those outliers that have remained open as to which ticker they will choose have been vilified and I believe a world of legal hurt awaits if they don’t fall in line.

So What is Bitcoin?

Let me begin with a short analysis of the events that transpired. When I began writing this essay prior to the outcome of the power struggle, it was intended to be an analysis of the various power distributions in the ecosystem. I was going to employ established political science theory and anarchy was to be the rules of engagement. I concluded that the exchanges were the most powerful actors due to their control of liquidity and were thus kingmakers. As events unfolded it became abundantly clear that this theory was useless.

Since not all the exchanges and wallet providers supported the NYA we’ll never know for sure whether the theory would have held but the events that followed tell us that we don’t need to. The bottom line is that Bitcoin Core and its supporters feared that this coup would be successful. This tells me that if the game was being played in anarchy, they believed they’d lose. As a result, they engaged in a campaign of legal threats, some thinly veiled and some outright. They let businesses know that the coordination problem they faced amongst themselves would quickly turn into a legal one as they would face claims of fraud and be directly in the firing line if customers suffered a loss of funds in the confusion. Essentially they let the NYA signatories know that the problem was not actually a coordination problem in anarchy, but a legal one. Core and its supporters may not have enforced the “Bitcoin” trademark in the past so can no longer own it in full, but they left the exchanges under no illusions that the “BTC” ticker belonged to the Bitcoin Core software client (other clients that follow its rules are tolerated) and was not at all up for grabs. At this point the exchanges came out and conceded that BTC would not only remain the ticker for the “legacy chain” (Bitcoin Core’s rules) after this particular schism in the hope of avoiding situations like this in the future, intonated that it would always represent Bitcoin Core as exchanges cannot change ticker symbols “for operational reasons”. If it wasn’t obvious that the BTC ticker was the prize the antagonists in the dispute sought, it became obvious subsequent to these declarations. The Bitcoin Core side knew they had won.

So what is Bitcoin if not Bitcoin Core? Well for starters it it is now abundantly clear Bitcoin cannot rely on being defined by slogans or memes. Slogans such as Bitcoin is: “math-based money”, “non political money”, “the chain with the most work”, “cheap international transactions” “banking for the unbanked” “defined by its users” are not going to fly. It must be defined by something tangible so that agents can efficiently come to a consensus on what Bitcoin actually is. Since the only tangible parts of Bitcoin are the distributed ledger of transaction history, miners and the software people download to join the network, it means Bitcoin must therefore logically be defined those. Since the distributed ledger history can be adopted by new software with new rules at any time, and pseudonymous miners can enter and exit the system at will, they are not reliable entities for the purposes of defining Bitcoin. For example, if we relied on accumulate work in order to define what Bitcoin was, it could be possible that the exchanges would have to regularly change the ticker symbols on account of hash rate changes. The same would apply to new software such as the BTC1 client proposed by the NYA group. As we have seen exchanges will not tolerate the legal risks that arise from this and have sided with the status quo software client. As a consequence, we are left with only the incumbent software clients for the purposes of definition. Since we know there is one dominant client that also happens to carry the brand name of the very first client, we know that that is the most reliable entity with which to define Bitcoin. We know that the rules everyone must follow are encoded into the software and that the software development process must also be controlled by a single group in order to avoid a brand consensus failure (and legal risks to all involved). In essence, the choice of what constitutes Bitcoin needs to be forced on all users or the system fails. This, as we have seen, requires hierarchical governance, and I have concluded that at the top of these hierarchies sits the Bitcoin Core team. Bitcoin, in my view, is the BTC ticker symbol. BTC, in my view, is currently Bitcoin Core.

Is Bitcoin a Money Services Business?

Aside from there being a clear hierarchy in Bitcoin, it is also clear that this hierarchy is enforced by violence. The uncomfortable truth for Bitcoiners is that the system cannot function without this enforcement. Imagining how the system would fail is easy. If naming rights aren’t enforced across all third party services that use Bitcoin (BTC) anyone could simply start their own cryptocurrency exchange and sell a unit of a new cryptocurrency as BTC for the same price. Without brand enforcement there is very little cost in doing this and quite possibly a lot to gain if bitcoins are valuable. Of course the law of diminishing returns applies since the more people that do this, the more the value of the original Bitcoin is eroded until eventually a point is reached where nobody would know what the real Bitcoin was, rendering all version useless and sending them all to a price of zero. We know of course this won’t happen as victims of the fraud would resort to the courts and the courts would find in their favour. In order to find in their favour, they would have to define what Bitcoin is and according to my analysis above, I believe they would have to equate Bitcoin with Bitcoin Core.

This may all seem quite logical and inconsequential but the consequences for Bitcoin (and all other public blockchain protocols) could be enormous. For a period, I thought that blockchain communities were simply stumbling on the most efficient way to govern themselves. Far from viewing ownership of a brand being assumed by a development team as problematical, I viewed it as desirable to secure the brand against dilution and end-user confusion through politics. I saw no legal consequences in this since what users did with the software remained beyond developers’ control even if they staked claim to a brand. As long as the brand remained secure from political attack and the rest of the system governed itself via economic incentives, everything should be OK. I now see that this in fact far from clear.

Bitcoin and other blockchain protocols are not like other open source software networks. They are consensus systems that we have seen need to be actively administrated in order for the consensus to hold. If some entity doesn’t represent the brand and that this representation isn’t enforced through (the threat of) violence, the system collapses. A brand administrator is thus a vital part of the system.

Does this mean that the software developers can just change the rules for Bitcoin (BTC) as they wish? No probably not. If they attempted to dramatically changed the rules contrary to a social consensus of how Bitcoin works, they would most likely fail. The problem is there is very little social consensus on what constitutes Bitcoin apart from the recent consensus that Bitcoin Core’s rules will always be represented by the BTC ticker. There is agreement that it’s decentralised but there is no agreement on just how decentralised it should be. There’s agreement that there should be economic incentives but not total agreement on what form the algorithm should take. For some the 21m supply cap is untouchable but for others Bitcoin will become unstable without it. Some people say that the true Bitcoin is the chain with the most work, others say this is not the case.

Since Bitcoin Core now has an undisputed monopoly over the power to propose legislation for Bitcoin (BTC), if they don’t agree with you, your policy won’t be presented to miners and nodes for approval. If they are proposing a policy you don’t like, they can propose it in a way that enhances its chances of being passed and leave it sit there without a competing proposal on the books (see how European Commission has exercise powers far in excess of what EU Member States envisaged as a cause of its monopoly on policy proposals). If the legislation isn’t getting passed, they can force it through in the knowledge they cannot lose control of the brand. If miners or exchanges signal that they would prefer another client to assume the BTC ticker, Bitcoin Core can make the suitably vague populist declaration that “it is users that define what Bitcoin is” and encourage the legal action against the protagonists through use of the word “fraud”. Every business with paying customers now understands that this is a legal battle they can’t win because they understand that Bitcoin Core has always been Bitcoin (BTC) on their platform. Since there is no reliable way for users to express their opinion on which client they prefer to assume the BTC ticker as only one client can feasibly represent that ticker at a time, Bitcoin Core are judge and jury and executioner in deciding what users want. This is despite the fact of course that they can’t possibly know the consensus in a group of unknown size is in a governance system void of clear rules. It is they that decide what the consensus is. In sum, Bitcoin Core may have restrained power but it is the only entity in Bitcoin with any power at all. The only way I can see Bitcoin Core’s power been taken from them is with complete unanimity amongst users. In any large group of people this is impossible. This is especially the case if unanimity requires an active change in software in order to avoid a loss of funds. The fact of the matter is most members (of all groups) are politically passive and don’t follow the politics. As a consequence, in practice the only choice a politically active user has is to lobby Bitcoin Core or emigrate.

So to get to the question is Bitcoin a money services business in disguise, let’s first ask the question, if the Bitcoin Core team decide what Bitcoin is, do miners and nodes really matter? The honest answer I’d have to give that question is no. When one understands that Bitcoin can only work for everyone when one entity controls the brand, it also becomes clear that all the other rules in the system are subservient to this final consensus. It becomes clear that miners and decentralised consensus on the order of transactions are mere obfuscations of the reality that a trusted third party must administer the system and that that trusted third party (the keeper of the brand let’s call it) is reliant on the state in order to effectively administer it. In sum, it becomes clear that Bitcoin is nothing more than a convoluted version of E-gold. It is perhaps a mirage and a fraud as some have claimed. Unless they enable the trusted third party administrator to evade costly regulations, miners and nodes are a completely unnecessary cost in the system. The question is, does the existence of miners and nodes permit Bitcoin Core to arbitrage money services business laws? Everyone has always assumed they have but I am now very unsure. In fact, it is my suspicion that they don’t as generally in these cases the buck stops with the system’s administrators. Ultimately this is a question for a court to answer but it is clear that there is very much a discussion to be had on the matter. I hope this article starts the conversation.


Although I have concentrated solely on an analysis of Bitcoin, it is my belief that the analysis applies generally. The same forces apply to all. Public blockchains only work when there is consensus on who administers the brand. If the system is functioning without issue it means everyone is in consensus on who the administrator is. This doesn’t mean that everyone explicitly designated an administrator as many can be unaware of its existence. I am now certain there is a tacitly accepted administrator for every public blockchain however. If there wasn’t one, I believe the system would fail. If there is a breakdown in consensus over who the administrator should be in the future, the choice of who controls the brand must be forced. It is ultimately the state that forces this choice and it does so by designating a brand administrator. The obvious consequences of this are that contrary to popular belief there may in fact be a single point of responsibility for nation states to request compliance with their laws. If this turns out to be the case, the irony of Bitcoin Core’s appeals to the state to enforce naming rights is not lost on me. In discovering a single point of failure Nation States didn’t have to go looking for it. It came to them.

ICOs: Utility Tokens, SAFT & Secondary Markets

Up until this juncture it is no secret that ICOs have been a lawless free-for-all. Development teams with little more than a few-page PDF have been raising tens of millions or more without even so much as conducting KYC. Many point out that different jurisdictions have different securities and KYC laws but in the grand scheme of things these laws are actually quite uniform. They certainly will appear pretty standardised to ICO teams that up until now have completely ignored them. The laws are suitably standardised from what I can see that it’s actually possible to sum up what a security is in the western jurisdictions I have taken a look at in one sentence: Something is a security if it is a collective investment scheme in which profit from a pooled investment results from the work of a management team that is distinct from passive investors. Within this definition there is a subset which is the case where the investment is used to speculate with investors’ money. In this case investors are granted an extra level of security that offers further rights over a standard security in a vehicle known as a ‘fund’.


The Security Question

Are tokens securities? Well that’s the question on everyone’s lips isn’t it? Last month the SEC sent a shot across the bows in describing the DAO tokens as securities. One long-time observer of relevant experience has famously long been of mind they are but others think the situation is more nuanced. Some declare that utility tokens – tokens that are required to use an app – are not securities. CoinList, the engineers of the Simple Agreement for Future Tokens (SAFT) raise the bar a little higher in declaring that a utility token is only not a security if the protocol is built prior to token issuance. I’m not a lawyer, but I’m an economist with common sense and to me the situation is not nuanced. If the investment is used to develop the app the tokens are part of and if the tokens float in value from the original investment – and all bar one I’ve seen do – they’re securities. I’ll explain why.

The crucial point here from an economics point of view is that all these tokens form part of an open source software network which, like all open source software, does not accrue profit for its creators. If these tokens were issued by a business, like many online virtual currencies are for example, they could avoid being securities (but not money services business laws) as even if a profit was accrued from their issuance it could be redeemed via the company. The company of course is itself already a security represented through shares held by investors so designating the currency as a security would be unnecessary. This is analogous to the original Howey case if one thinks about it. In that case the orange grove was the security with its own currency called oranges (lets call it ONG for lols). Like in the previous example, there was no need to treat the oranges as securities as the investors are already protected via their security in the orange grove (after a judge said so). In both cases if the currencies themselves were issued directly to investors the situation could be different. In the case of the online digital currency, if it was floating on the free market and its price was affected by the actions of company management, then I think yes they probably would be securities – I’ll develop this point later. In the case of the oranges, it should go without saying that once they fall off the tree, their value is dictated solely by the forces of supply and demand so they cannot be securities subsequent to issuance.

In the case of crypto-currency issuance, we can see that no such prior security exists for investors. When money is invested that results in the issuance of a appcoin (utility token), no profit can be accrued via the free-to-use application the currencies (are supposed to) derive their value from. It is the currency itself that is the sole vehicle investors can expect to reap rewards from their investment – at this juncture I’m assuming they wish to reap rewards. Using the definition I provided earlier, I cannot fathom how that these currencies would therefore not be deemed securities. The only way the utility token defence would stand up to scrutiny in my book would be if the invested money wasn’t used to develop and market both the application and currency. In every single case I’ve seen thus far it has been however. ICOs are thus the fundraising element of business (profit-seeking) ventures in which the only element that can be securitised is the currency. The fact that this is the case should kind of really be obvious from a cursory look at the token sales themselves (but somehow isn’t to most including many lawyers). The Filecoin ICO, to take one example, didn’t offer shares in IPFS, it offered filecoins to investors. The founders themselves are rewarded with filecoins without staking money themselves. It is hoped that these tokens will accrue value due to demand created subsequent to development and marketing of the software and accompanying tokens. Does this not look like an awfully familiar arrangement? Imagine IPFS were a business and its investors and founders were issued shares in it. I’ll say no more.

There is of course one other obvious way these tokens may not be considered securities. They would not be securities if those funding the venture were doing so to donate money to a cause they believe in, expecting to wave their money goodbye. Funnily enough, this is exactly what most of these arrangements claim to be. It is explicitly stated in almost every offering that the ownership of the token confers no rights whatsoever to investors regarding the development of the software. Under such an agreement – I’m sure a judge would annul the contract – it is technically possible that the development team could actually decline to issue tokens at all. The fact of the matter is that at the very least a large majority of ICO investors are buying tokens in order to sell them at a profit subsequent to development of an application – and a healthy dose of marketing of course. That’s the underlying unspoken investment contract here the spirit of which I’d be shocked a judge didn’t acknowledge in court if it came to pass.

There are plenty examples of evidence of this unspoken contract in the wild. Last year Ethereum suffered a consensus failure between its two main implementations Geth and Parity. This caused the price of Ethereum to take a battering. If one surveyed r/Ethereum for the subsequent few hours one would have been struck by the amount of angry posts from token holders seeking out those who were responsible for the large dent in their investment. As evidenced in the link above, those who were responsible engaged at finger pointing at each other in turn. In another example, Joey Krug, the founder of Augur has recently taken the position of Chief Investment Dude with Pantera Capital. This has led employees of a firm that has initiated a number of ‘not-a-security’ ICOs (and is now I hear in the process of launching Consensys Capital to invest in more of these schemes) to question his commitment to Augur investors even going so far as to use the word ‘fiduciary’. Oh the irony! Common sense tells me that if issuers and investors behave like management and shareholders in a business enterprise, a court will duly find they have equivalent rights and responsibilities even if we’re talking about an unconventional contract that doesn’t represent a claim over a company – the infamous quacks like a duck test. Common sense is not something one finds very often in a bubble market drunk on gains unfortunately.



The SAFT, in fairness, does involve an actual promise. This promise is to deliver tokens at a future date once the protocol is built. Oddly enough the SAFT advertises itself as a security. Now again this contract was written by lawyers, and again I’m not a lawyer, but a simple agreement for future tokens sounds a hell of a lot more like an advanced/pre-paid purchase order contract than an investment contract to me. The focus here is on the tokens themselves so I won’t labour on this question but I welcome the thoughts of any lawyer that may read this.

So after the SAFT formalises a promise to deliver tokens in the future, and investors are waiting for said tokens, their money is put to work developing the software and marketing it – which is of course what will create demand for the tokens in the future. As I said above, in practice, investors are in the business of buying and selling tokens for profit and the level of profit (or loss) an investor can expect emanates primarily from the work of the development team that programmes the software. Speculators and outside forces of course can also affect the price of the tokens but the same is true for equities. The fact the tokens float on the free market won’t give issuers and developers a free pass when one of these arrangements ends up in a court room.

This unspoken profit-seeking contract between issuer and investor is not acknowledged in any way by SAFT yet it continues long after the SAFT has been terminated. So although the CoinList folk at least make some attempt to acknowledge the existence of the state – which in the crypto-currency space is a very big deal – they get it horribly wrong in representing the SAFT as an investment contract when it looks an awful lot like a purchase order contract for tokens which represent the focus of the actual investment contract between issuer and investor. It therefore for me, merely represents the latest attempt in a long list of verbal gymnastic contracts between token issuers and investors that attempt to circumvent securities laws.

Once the tokens are delivered what rights do holders have? According to the SAFT none at all, as it was merely an agreement to deliver tokens. It would be foolish to think that if there were any impropriety in management of the project subsequent to the delivery of the tokens, such as the team neglecting to fix a bug, or if one was introduced via a protocol upgrade, that the token holders would simply lie down and accept a market crash. There would – as I have already mentioned we’ve seen in practice – be uproar and if this resulted in a court case, the judge would quickly become aware that the token holders are profit-seeking investors and that the profits were fundamentally derived from the work of the issuing/developing/managing party, i.e, the judge would become aware that the tokens are securities and that the SAFT merely represents a poor attempt at obfuscating this reality.

The only way I can see this situation becoming a little less crystal clear than I have made it out to be is if over the course of time the original issuers and developers step aside from the project and others join it and work on it for free after the initial funds have run out. If the developers then made a mistake, or acted with malice for personal gain, their fiduciary responsibilities are far from clear. I wouldn’t like to be the judge adjudicating on that one. Thus far we haven’t seen this situation as all the ‘foundations’ that have raised funds (and haven’t been hacked), are currently stacked with years of funding due to the inflated market.


Secondary Markets

Another feature of the SAFT worth noting is that only accredited investors are permitted to participate. In the US – to take a sample jurisdiction – such a restriction can grant a security issuer an exemption from registering their security with the SEC if their funding is less than $5m under Regulation D rules or under $50m under Regulation A+ rules. It is worth noting however that this restricts trading in secondary markets. This means that since Filecoin exceeded both limits under registration exemption rules, the only way it can currently be exempt from registering as a security is via rule 506 of Regulation D. The issue here would be that the tokens, by the looks of things, would be deemed ‘restricted securities’ that cannot be traded freely on secondary markets. Since the intention is to list filecoin on exchanges subsequent to the development of the protocol I believe at that stage the venture will step over the line of non-compliance with US securities laws (and everywhere else in the west too) and join the ranks of the thousands of non-compliant securities I believe are out there on non-compliant securities exchanges.



Maybe I’ve gotten everything horribly wrong. Maybe the Ethereum Foundation, Tezos, Kik, Filecoin, we-do-our-very-own-howey-test Poloniex, Kraken, Bittrex, et al are getting solid legal advice and they’re A OK. And maybe this sounds pretty arrogant coming from a layman with zero legal training but I’m pretty sure I’m not wrong. The quality of legal advice these predominantly young technologists are receiving (if they’re receiving any) is abominable and I hope this will be the saving grace of the well-intentioned ones which as far as I can see constitute the majority. Thus far the SEC has only ruled the DAO tokens were securities and has recently called two projects regarding their activities one of which yesterday announced they giving up the ghost. Maybe the regulators themselves have also been blinded by all the media hype and new paradigm jargon. Regardless, I think it is only a matter of time that the penny will drop with the powers that be that the token doesn’t have to explicitly offer some sort of profit-sharing in an enterprise in order for there to be an unspoken promise of profit. This promise being the offer of an early entry to a deflationary currency party that attracts new buyers with a shiny new open source decentralised application. That’s the real deal that’s struck here and issuers and investors alike know it. If they know it, the SEC will eventually know it too as sooner or later one of these unspoken arrangements will hit the rocks. Given there are now a few ICOs every day, and regulators’ resources are limited, I’m guessing they will go after some high profile cases to send a message but mainly focus on a cost-efficient attack on the exchanges that are the lifeblood of all these investment contracts.

If I’m right in my predictions winter is coming to the crypto-currency market and it will not see spring until it grows up and gets compliant. I’ll leave the necessary conversation regarding the compatibility of compliant securities with public blockchains for another day.




Unbundling Trust in Blockchain Ecosystems

The trustlessness attributed to public blockchains is a mirage. Trust or in other words, counterparty risk, not only still exists, but often exists where stakeholders can’t easily identify it. In this post I will attempt to extrapolate where trust lies in the blockchain ecosystem and subsequently draw conclusions as to what trade-offs are made in migrating from legacy systems.


Satoshi Nakamoto introduced Bitcoin to the world as a peer-to-peer system for electronic cash. His proof-of-work solution to the double spend problem inherent to digital currency was designed with the goal of removing trusted third party intermediaries from electronic payments. His method is clever but exceedingly inefficient with enormous resources required to secure transactions and by corollary the money supply. Nakamoto, according to his writings, felt the cost of fraud and mediation that arises from the possibility of reversible transactions outweighed the cost of achieving consensus across many nodes. The resilience of the Bitcoin network as a result of its decentralised structure without a trusted third party guardian is indisputable. It has been enormously successful in facilitating regulatory arbitrage payments, which has given it a floor as a store of value and ergo an attractive investment in the eyes of many. In addition, many other blockchains that secure other forms of contractual relationships have emerged, most notably, Ethereum – a blockchain that was built to secure any type of contractual relationship. The replacement of the centralised third party with machine consensus lead many to call blockchain protocols ‘trustless’ systems, a term which is now often diluted to ‘trust-minimised’ systems. In this post I will interrogate the veracity of this statement.


Guardians of the Ledger

It is indisputable that a trusted third party has huge scope to censor and in some cases reverse transactions. Satoshi, and subsequent blockchain developers have sought to make the possibility of reversing transactions highly infeasible through carefully designed economic incentives. The assumption of Nakamoto consensus, is that the cost for a malicious miner to attack the system vastly outweighs the benefit in attacking it as long as the majority of miners are honest. However, a coordinated majority of over 51% of miners can, with little cost, engage in double spend attacks, censor transactions and even dispossess users of their bitcoin through the erasure of accounts from the ledger. This hasn’t occurred up until this point as miners, as a group, have further rationalised that their long-term investment in mining equipment would be threatened by engaging in such attacks, since investors would likely lose confidence in the currency given it is its censorship-resistant qualities that gives it value. It is this rationality that keeps a majority of miners honest, thus far ensuring Nakamoto’s assumption is held. In other words, the reason miners don’t engage in these attacks is that they don’t want to damage their commercial interests. If one considers it, this forms a large part of why we trust centralised third parties not to break contractual agreements too. If they betray customer’s trust, they can be punished by the courts and/or damage their business image and consequently their profits. We therefore trust both miners and known trusted third parties to act rationally (in the social sciences meaning of the word) and secure our transactions and funds.

Satoshi only considered miner behaviour within the scope of the protocol rules he defined. However, since a majority of miners determine the valid chain, they can collude to enact a protocol change or prevent other proposed changes. Since protocol changes are likely to be far more subjective and open to debate, this places great power in the hands of the mining interest group. Other newer blockchain consensus algorithms have taken this into account in introducing definitive financial punishments for unilateral miner political action beyond a possible depression of the asset price. Regardless of the system however, overcoming an unrepresentative mining political force requires community action to hard fork the software to remedy it. Whether this remedy is regarded as theft or just punishment is down to politics as opposed to any codified law. Further, the remedy relies on diverse stakeholders overcoming the collective action problem, which is never an easy task to accomplish. In these cases where a user-initiated hard fork of the software is required, all users need to update their software or else risk losing funds from transacting on the wrong chain. Consequently, users have to trust themselves to be a lot more vigilant in blockchain ecosystems. This has led some to describe the blockchain space as a caveat emptor environment. If the Bitcoin mining majority choose to repeat the action/attack, the only defence the user base has is to initiate an algorithm change in order to allow new miners into the system and prevent a recurrence of the attack. Collectively deciding on this may be extremely time consuming and challenging leading to a period of great uncertainty and risk for the network(s). In the future proposed plans for Ethereum, such algorithm changes would not be required as long as the deposit forfeitures miners may incur act as a sufficient disincentive. None-the-less collective action to remedy the situation is still required. In legacy systems on the other hand, victims of malicious third parties rarely have to organise a group into collective action as generally a remedy can be found within the institutions of the state. Victims simply have to report the crime to the police who will then use their resources to investigate and remedy the matter if they can.

The problem with founding systems on economic incentives alone is that it is likely impossible to account for every incentive every actor possesses. Satoshi (Bitcoin), Vlad Zamfir, Vitalik Buterin (Ethereum), and many others, have attempted to account for the rationality of actors in terms of fiat profit and loss on mining equipment or the asset required to stake. Of course, this is all they feasibly can account for. Bitcoin’s and to a greater extent, the economic assumptions of Ethereum’s proposed model, are thus likely hold if you consider the BTC/Fiat or ETH/Fiat pairs in a vacuum. The problem is, in the real world, they don’t exist in a vacuum. The stakeholders involved can have any number of competing economic interests that may incentivise them to act maliciously and thus incur a fiat loss on a particular blockchain asset in return for higher gains elsewhere. Evidence of such competing incentives already exists simply by looking at the blockchain space alone. For example, since the Ethereum network permits multiple currencies, at one point, the validating majority may have stood to gain more by altering the ledger to protect an investment they had made in another token. This alteration need not always be for the benefit of the network as a whole even if it did appear to have strong support on this particular occasion. In other circumstances miners may also realise their gains before any collective remedy could be coordinated. Further there are murmurings the dominant player in Bitcoin mining has substantial holdings of ether. In a market where capitalism is the only law, it is therefore far from a remote possibility that miner/validator attacks would occur. In fact, if one employs the same rational choice theory Satoshi did on a broader spectrum, it is entirely expected that they would occur. When privacy technology becomes more prevalent and attacks less risky for the perpetrators (if deemed illegal), we may even see an increase in their amount and see them occur on higher value blockchains. If the attacks were solely inter-chain, one might rationalise that eventually they would end up damaging the space as a whole and would possibly cease. However, this is far from a certainty and one can unquestionably not discount attacks from forces external to the blockchain community in any event.

Those wishing to hold crypto-currencies are thus involved in a constant guessing game of which blockchain is currently the most attack-resistant and as seen from the Bitcoin example above, this need not necessarily be the most valuable one. Far from it. All blockchains, all economic actors and all blockchain assets exist in an almost completely unbridled free market. If there’s one thing free markets do very effectively, it is prevent monopolies from forming meaning the blockchain space is likely to remain in a constant state of flux. Many network maximalists argue that the network effect will result in one network becoming dominant, but due to the fact blockchains depend on economically incentivised actors for their very utility, I have become highly sceptical this would be the case. Unlike in the case of value agnostic (no redistributory effects) network protocols such as HTTP or TCP/IP, there is simply too much opportunity for well-organised players to profit from disrupting any potential network hegemony. This is especially the case given how difficult it is for blockchains to scale (decentralised structure) and upgrade (require consensus) to respond to technological advancements from competing alternatives. The only way I can see one network triumphing and delivering an equivalent level of stability (trust) to that of legacy commerce and financial systems, is in the case of one winning over the collective minds of international governments. However, if we’re relying on governments to tell us which blockchain is ‘the blockchain’, this naturally begs the question, why go to all the trouble of game theory and decentralisation in the first place?

It could be credibly argued that users actually have to trust miners and validators more than they have to trust known third parties. In the blockchain space you trust transactions to be executed and your funds to maintain value due to economic incentives. If you are a party that was unlucky enough to accept a crypto-currency for goods and services on ‘the wrong chain’ in the case of a fork, you have to trust the purchaser to be honest and reimburse you. In legacy systems you trust your transactions will be executed and your funds not to be stolen due to economic incentives AND punishment through force by the institutions of the state. Additionally, since systemic changes that create global risk aren’t required to remedy individual attacks, the value of the asset in question isn’t likely to be affected by the dispute.


Software Developers

If you transact on the internet it goes with out saying that you employ computer software to do so. When you transact in legacy systems, you do so through the proprietary software silos of trusted third parties. The proprietor thus has fiduciary responsibility with the users’ data and assets. If something goes wrong, they are accountable. Since blockchains are permissionless systems, anyone can write a software implementation for a particular blockchain. Anyone else can download this client and use it without engaging in a formal contract with the developers. This provides quite a lot of scope for programmers to write a malicious client that can steal people’s assets. Again this adds to the caveat emptor environment that open blockchain systems induce. As in the case of malicious miners and validators, it may be difficult if not impossible to hold the thief to account in such a situation.  Further, Ethereum permits people to write applications that actually exist on the blockchain. If there is a bug, intentional or otherwise, the results can be catastrophic. Due to the division of labour in society, most users don’t have the knowledge to perform due diligence themselves and therefore must trust the developers and the people auditing them. As in the case of the DAO hack, bugs may not be spotted and assets lost as a result.

There’s an old saying in tech diaspora that “software is never finished”. The blockchain space is not unique in this regard, the only difference being that protocol changes require strong consensus amongst many stakeholders in order to avoid a damaging fork. However, As mentioned above, what constitutes a protocol improvement is entirely subjective. This means upgrades will often be political. Since this is the case, upgrades are best viewed as pieces of political legislation. Analogous to national parliaments, in the blockchain space any member can initiate a ‘bill’ and if it gains enough support, it will pass. As mentioned above, miners and validators have tremendous power in vetoing legislation, a veto which can only be overcome through their overthrowal by the polity. However, software developers have governance power in this regard too, they have the power to initiate legislation. For a long time this power was largely neglected by political scientists in analysing political decision-making systems. However it is now known to be a very powerful position to occupy if the proposer has good information of the global preferenential set of voters. They can thus position the legislation in a space where it is likely to get passed.  The enormous success of the European Commission in achieving consensus amongst competing EU Member States with varied interests solely from its ability to ‘bat first’, is an excellent example of this power. Again, due to the division of labour problem, in the blockchain space there are actually very few people with the ability and understanding to enact protocol improvements. The cult of personality that thus surrounds influential developers provides them with huge scope with which to shape the future of the protocol. If they collude with a majority of miners/validators, they are placed in an even more dominant position. Ordinary users must therefore have great trust that they have the interests of the whole protocol at heart.

In sum, compared with legacy systems, it can be objectively stated that users must have far greater trust in those developing the software they use to transact on in the blockchain space.


Conclusions and Thoughts

Trust is something that envelopes everything thing we do. If we reduce our reliance on it in one way, we increase it in another. In the blockchain space, it is clear that trust isn’t removed but rather reassigned. The risks and costs of fraud and mediation in legacy systems are merely replaced with risks and costs of economic incentives and collective governance in anarchy. It is clear that despite these systems being built to have no central authority, the natural order of things has dictated that informal hierarchies have indeed emerged. It is also true that when hierarchies exist, trust becomes a fundamental part of the relationship between the governors and the governed.  For this reason, some have declared miners and developers to be fiduciaries, which naturally places them on the very same standing as a trusted third party in legacy financial systems. However, since they are not as easily held to account as traditional fiduciaries, one can only come to the conclusion that the reassignment of trust in the blockchain space comes at the expense of ordinary users.

The only truly discernible way risk appears to be clearly reduced for a particular type of user in the blockchain space, is for those users engaged in illegal activity. Public blockchains are resilient to government censorship as they are governed by diffuse actors and cryptography as opposed to the institutions of the state. They are thus highly resistant to government influence. If one wades through all the blockchain hype and rewinds the clock to observe the context of the Bitcoin whitepaper emerged from in 2008, it is actually quite obvious that this conclusion is the case. In 2007, there were two main digital currencies, the Liberty Dollar and E-gold. The former was shut down by Federal prosecutors and their creators indicted for various crimes, and the latter had begun actively assisting authorities in prosecuting criminals using E-gold. Despite this, in 2009, subsequent to the release of Bitcoin, E-gold was shut down and its owners also indicted. When Bitcoin is released a year later by an anonymous persona, as a decentralised system with no central authority for governments to censor, one doesn’t have to read between the lines as to the intentions of the creator: he wanted to create something that couldn’t be shut down by powerful adversaries. The removal of the much-maligned trusted third party – and its replacement with proof-of-work and a distributed ledger – wasn’t and end in-and-for itself, it was merely the means through which he wished to achieve his ultimate goal. In other words, fraud mitigation may not really what he was hoping to prevent; it was likely to have been government censorship. Trust is assigned according to a threat model and the threat Satoshi wished to counter above all else was the government. If he believed no nation state regime would attempt to eliminate Bitcoin, I don’t believe he ever would have designed the blockchain.

When this key point is understood, one can infer that if the government isn’t in your threat model, you may prefer to choose  a federated ledger with a USD-backed token as opposed to a blockchain with its scaling limitations and governance risks. There are also plenty of tools – both cryptographic and legal – available that are very effective at minimising third party counterparty risk. I must emphasise that this conclusion isn’t a denigration of blockchain technology. I find it a very interesting and worthwhile field of study. However, I do believe its future is likely to be the new British Virgin Islands as opposed to the new Wall St.