“Decentralization” refers to the movement of supervision and decision-making away from a single central actor, and toward a dispersed network of actors. Such networks are facilitated by the use of blockchain technology and smart contracts, whose immutability and reliable automation allow dispersed actors to function without intervention of a trusted central party (such as a corporation or financial institution). The underlying trust and reliance embedded in these arrangements are thus transferred from reliance on people and institutions, to reliance on transparent technology. In the financial markets context, decentralization could potentially move a regulatory system traditionally focused on individual and collective human actions, toward one that is primarily concerned with whether technology is sufficiently transparent and functions as promised. This notion is particularly attractive in the context of cryptoassets (often referred to as tokens or cryptocurrencies in their various iterations) or decentralized finance (“DeFi”) entities, where moving away from central or coordinated actions may implicate threshold regulatory questions.
Decentralization’s Allure
Securities laws apply, and the SEC has jurisdiction, only where an instrument or a platform qualifies as a security. In the context of cryptoassets generally, as well as DeFi tokens and platforms, the SEC frequently determines this by applying a test articulated decades ago by the Supreme Court in SEC v. WJ Howey Co.[1] The Howey test analyzes whether a transaction involves (i) investment of money (or tokens or other value)[2], (ii) in a common enterprise (i.e., whether the fortunes of investors, and/or investors and issuer, are correlated), (iii) with an expectation of profit, (iv) from the entrepreneurial or managerial efforts of others (i.e., typically efforts of the issuer, promoter, or platform). In the contexts of both individual cryptoassets, and platforms, the SEC’s principal focus is on promotion and statements by issuers or platforms that could lead investors to believe they might profit by purchasing an asset or depositing their money with a platform. The SEC’s analysis in this vein often focuses on White Papers or marketing materials, but is sufficiently granular to consider the content of tweets, advertisements, and conference appearances.
Bill Hinman, former Director of the SEC’s Division of Corporation Finance, gave a summer 2018 speech that introduced the notion of decentralization, describing it as a means by which “a digital asset transaction may no longer represent a security offering” or an asset or platform “may not represent an investment contract [security].” Director Hinman’s analysis was relatively simple: if the network around a cryptoasset or DeFi Platform decentralized to such an extent that investors would not expect the offeror or promoter to perform the essential managerial or entrepreneurial efforts, an investment contract may no longer exist. And he pointed out that if that third party’s efforts were no longer driving the enterprise’s success, information asymmetries between that enterprise and its investors might diminish to the point where the protections of the securities laws were no longer necessary. This analysis is intuitively attractive for cryptoassets that began their lives as securities, perhaps because they were issued in a coin or token offerings whose proceeds were used to fund startup costs or they entitle the holder to profit from the success of an enterprise operated by others. It would be similarly attractive for DeFi platforms that might receive investor money – either as investments, or deposits on which investors expect to profit due to actions taken by others.[3] Where a DeFi issuer or platform becomes decentralized and would no longer be the party expected to take “essential” actions that generate investor profit, Director Hinman’s vision of a transition away from classification as a “security” might be realized. Rather than investor profit expectations depending on an issuer or platform’s future efforts, for example, the entity could become a self-perpetuating organism and investors’ focus may thus be primarily on software that incorporates an incentive system to drive decentralized actions by a user community.
Decentralization and U.S. Financial Regulation
Decentralization has potential implications under both the financial markets laws overseen by the SEC and CFTC, and financial crimes laws overseen by FinCEN and other Department of the Treasury components. FinCEN has been clear about application of AML controls to the sale, exchange, or transfer of decentralized cryptocurrency in exchange for other crypto or fiat currencies. However, open questions remain regarding decentralization’s effect under the financial markets laws, particularly the principles-based securities laws which have proven less capable of clarity and precision.
Decentralization’s precise impact under the securities laws has been uncertain since it was first raised. Prior to Director Hinman’s speech, the case law does not appear to have considered decentralization in depth (understandable, since without the use of relatively recent technologies, it is difficult to imagine an entity functioning without central direction). And the SEC has not filled the void of this bare record, since its messaging on applying the securities laws in the cryptocurrency and DeFi spaces has been delivered piecemeal, in the form of enforcement actions and guidance documents that have introduced relevant considerations but omitted discussion of how to properly weight or apply them.
This piecemeal delivery is compounded by the lack of law – whether statutes, regulations, or otherwise – regarding decentralization and its impact. Looking for clues in caselaw that has considered related concepts is similarly unproductive. For example, in McCoy v. Hilliard, the U.S. Court of Appeals for the Sixth Circuit considered an investment scheme to pool investor funds, purchase interests in barges, and manage those barges on investors’ behalf. To determine whether this arrangement involved an investment contract, the court considered both its economic reality (i.e., whether the scheme’s operation required management by a central party), and the relative expertise of the parties (i.e., whether investors or other parties possessed the knowledge and expertise such that their efforts – rather than solely the issuer’s – might be viewed as essential to generating investment returns).[4] The Courts of Appeals for the Second, Fifth, and Tenth Circuits have employed similar analysis in past cases. While not conclusive on decentralization and its impact, these holdings nonetheless underscore that such an impact does exist. They further illustrate that courts considering this impact when analyzing whether a particular arrangement qualifies as an investment contract security under Howey will weigh the various parties’ efforts, together with their capacities to play central, versus supporting, versus passive roles. The logical next step is for a court to definitively contrast those characteristics that establish an arrangement as an investment contract with a central party exerting relevant efforts under Howey, versus a decentralized arrangement that is beyond Howey’s reach because the essential efforts are those of uncoordinated parties acting in their own self-interest, whose only common thread may be shared participation on the same network or platform.[5]
Retreat and Inaction
The notion of decentralization as an antidote to tripping the Howey test gained popularity in the cryptocurrency and DeFi communities after Director Hinman’s speech. Much ink was spilled conjecturing how decentralization could be achieved and by what metrics it could be measured, but it was met largely with regulatory silence. In March 2019, then-SEC Chair Jay Clayton responded to congressional correspondence on the topic, but confirmed only that he also believed an instrument’s character as a security could change over time, catalyzed by decreased reliance on the efforts of others. And since Director Hinman departed the agency in December 2020, it seems any SEC focus on the securities law implications of decentralization may have left with him.
Former Director Hinman was back in the spotlight after Ripple cited his 2018 speech as evidence supporting its fair notice defense to the SEC’s enforcement action against it. At the SEC’s behest, Hinman gave a June 2021 Declaration in the SEC v. Ripple case to clarify both that his 2018 speech expressed only his personal views (rather than SEC policy), and he had given this standard disclaimer contemporaneously with the speech. Ripple later won the ability to depose Director Hinman (over the SEC’s strenuous objection). Because SEC v. Ripple is unresolved, its impact on cryptoasset regulation (and the impact of any information obtained from former-Director Hinman), remains to be seen.
The SEC has never published guidance on decentralization, whether before or after Director Hinman’s 2018 speech. Indeed, since Ripple raised the concept in early 2021 in defense of the SEC’s lawsuit against it, senior SEC officials and staff have shied away from any comment on the concept. The SEC’s failure to issue guidance initially, is perhaps best understood as stemming from its view that no official position had ever been articulated on decentralization. And since decentralization and the Hinman speech had become an issue in an active litigation matter, the agency would understandably want to avoid being “on record” with inconsistent positions on the topic). But no matter how understandable the silence might be, the SEC cannot so easily “unring the bell” on this topic and it has created a void where none should exist.
If decentralization actually has the legal effects Hinman described, then the SEC's silence – theoretically speaking – does not matter. As a matter of law, with or without published guidance, a truly decentralized entity would fall outside the legal mandates of the securities laws, and thus outside SEC jurisdiction. But the SEC’s continued silence on decentralization makes it increasingly unlikely that the agency will have the lead role determining how the law develops around this concept. It also frustrates the legitimate pursuit of truly decentralized network models by those entities capable of achieving them. The practical results of this dysfunctional morass include: (i) entities seeking to achieve decentralization must determine their own paths for doing so and for judging when the goal has been met; and (ii) any court confronting the question of an entity's decentralization and its legal effects will be free to make such a determination without reference to existing SEC guidance or regulations. Such a court may be influenced by the conundrum the SEC has created through its inaction, as entities seeking to decentralize must “fly blind” and bear any regulatory consequences of doing so, subject to the SEC’s post-hoc determinations of where they have misstepped. Also persuasive to a court may be the circularity problem that both Director Hinman and various academics have identified, namely, the securities laws would seemingly not apply to (i) decentralized, self-sustaining crypto issuers or platforms, nor to (ii) projects whose proprietary cryptoassets are in widespread use on decentralized networks similar to Bitcoin, but the ability to achieve either of these statuses depends on the project’s ability to escape regulatory sanction as it achieves this level of decentralization.[6]
So the SEC’s failure to speak on the topic may actually work to its detriment, if, a court operating in this vacuum adopts an industry-friendly decentralization analysis that becomes the majority view nationwide. Alternatively, the SEC may lose the initiative if any of the currently-pending legislative proposals that flesh out the framework for proving decentralization, or reallocate regulatory oversight of this space to other agencies, is adopted.
The Outlook
While an ideal world in which the SEC issued fulsome guidance or enacted new regulations governing decentralization might be preferable, its continued silence means all potential outcomes remain viable. But the present situation is unsatisfying from a clarity perspective, and any entity pursuing a decentralized model either must move forward under constant uncertainty, or must take the initiative through a so-called pre-enforcement challenge to the SEC’s current legal regime, with uncertain results. Prospects for such challenges may be bolstered by recent Supreme Court rulings that have potentially made available various legal challenges against the SEC and its authority. The SEC continues to hold the upper hand at the present time due to the power differential it enjoys over private entities, and all participants in the crypto and DeFi spaces must continue proceeding with care. But due to the shifting sands of legislation and judicial action, the SEC’s continued regulatory monopoly in this area may no longer be assured.
[1] , 328 U.S. 293 (1946).
[2] When analyzing DeFi platforms, an “investment” might be made by purchasing a cryptoasset that is not itself a security, but which promoters of the platform market as having ability to generate potential returns due to actions they pledge to take. Such a scenario typically might involve a purchased cryptoasset being deposited into a wallet carrying a “yield” feature that promises a percentage return by facilitating the depositor’s lending, staking, or providing liquidity with that cryptoasset (earning monetary rewards or fees in the process).
[3] Decentralization’s impact on “note” securities under the test from Reves v. Ernst & Young, 494 U.S. 56 (1990), is less certain. Reves’ test focuses less on the behavioral elements that predominated in Howey, but instead begins by presuming that any note exceeding nine months’ maturity is a security. That determination may still be rebutted by showing (1) it bears a strong family resemblance to seven types of instruments determined not to be securities: mortgage notes, consumer financing notes, small business financing notes, notes secured by character loans to bank customers, short term accounts-receivable notes, notes based on open-account debt incurred in ordinary business, or notes based on commercial bank loans for current operations; or (2) by applying four-factor balancing test that considers (i) the motivations of the purchaser and seller of the note and their views of it as a security, illustrated most starkly if the note is being sold to finance a business and is being purchased on expectation of receiving a return, (ii) whether the note’s distribution plan involves trading for speculation or investment, (iii) whether the investing public considers the note a security, or (iv) whether mitigating factors (such as presence of an alternate regulatory scheme) indicates the protections of the securities laws are unnecessary.
[4] See McCoy v. Hilliard, 940 F.2d 660 (6th Cir. 1991).
[5] Various ideas have emerged about who might be deemed responsible for any regulatory compliance burdens in truly decentralized networks, with possibilities ranging from those funding such projects to those responsible for the software coding that is their technological underpinning.
[6] SEC Commissioner’s Hester Peirce’s proposed three year safe harbor from securities law compliance aims to address this.
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