The latest episode of “Money Reimagined” brought hosts Sheila Warren and Michael J. Casey together with Dr. Chris Brummer as a featured guest to discuss securities law in blockchain technology and Dr. Brummer’s new whitepaper, “Disclosure, Dapps, and DeFi.”
Dr. Brummer is a professor at Georgetown University Law Center and the founder of a major fintech policy conference. He was also a member of the Biden-Harris transition team. His website indicates that he has also worked with a number of global regulatory bodies on financial technology issues, from the CFTC to Finra to ESMA, the European securities regulator.
The arc of the conversation was as historical as it was technical, and extended a conversation originally launched on his Medium blog. During the 1930s a series of Congressional hearings gave birth to what we know today as US Securities Law. The hearings began after knowledge of a cycle of systemic abuse, in which corporate officers and family members were found profiting through trading in their company stock and engaging in tax avoidance schemes.
Since the 1930’s, one of the major tenets of US securities law has been disclosure. Fast forward to 2022, and those laws remain unchanged, even as the industries they aimed to regulate have evolved considerably. Rapid technological advancements have given rise to a new world of finance in which terms such as cryptocurrency and decentralized finance (‘DeFi’) offer regular appearances.
Existing disclosure rules are at odds with blockchain technology. The details disclosed often don’t address the things an investor needs to know to invest intelligently in a crypto project. Securities disclosures also result in enormous amounts of information that no one tends to read.
What is a security?
According to Dr. Brummer, a security is the product of a Supreme Court decision called SEC v Howey which led to the Howey Test. It is not a steadfast rule which states that if you have x, y, or z, you have a security. Instead, it is a multi-pronged analysis. Once each prong within that analysis is satisfied, you have a security.
Under the Howey Test, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
Challenges faced due to current disclosure systems
The Howey test states that when all four prongs have been satisfied a company has to disclose information. The challenge is that while US securities law has been growing over the last 70 years, disclosure has evolved into a system where it is meant to be filed and not read.
Legacy systems such as the EDGAR database within the SEC house several hundreds of pages for each set of disclosure. Those disclosures are meant to be read by institutional investors, and financial analysts, but not the average person. It only becomes relevant to the average person if something goes wrong in case of fraud or misrepresentation in those disclosures.
And it’s not just disclosure delivery. When you bring in DeFi models, the substantive requirements of securities law disclosure don’t map on to the needs of a blockchain. Standard disclosure requirements ask about, or are premised on, corporate governance, whereas if you’re investing in a cryptocurrency or digital asset blockchain governance is far more relevant. They ask about dilution with common equity whereas you actually may want to know about how a governance token works.
Disclosure NFTs
The EDGAR database has its fair share of problems. It has been hacked before, and it is regularly faces technical issues. In one of the most high-profile prosecutions, the system was hacked in October 2016 but did not disclose the hacking to the public until September 2017.
In his latest whitepaper, Dr. Brummer proposes a novel solution to disclosure delivery systems – programmable disclosures. In a programmable disclosure one would be able to tokenize not just disclosure but also one’s interaction or engagement with the disclosure, and by extension create new use cases that can be designed to enhance technological literacy
Non-Fungible Tokens (NFTs) can be recorded on a blockchain as a digital representation of ownership. Dr. Brummer argues that we can tokenize disclosures that are off-chain and use NFTs as a delivery mechanism to an investor. There are, however, several technical challenges to this proposition, due to the high cost of gas fees on a blockchain.
Dr. Brummer’s next proposition is even more radical. Earlier disclosure delivery systems were aimed at passively delivering disclosures by storing them in a database. “What if you could create a website off-chain, have someone engage with that disclosure, and gamify that experience, either through a test or a game of some sort?”, he asks. Then, if you pass the test or win the game, you could receive a disclosure token placed in the wallet of the person who passed the test. Through this mechanism you’re creating a credential of an investor receiving a disclosure but also of having engaged with it.
Disclosure DAOs
Dr. Brummer also discussed the possibility of leveraging different kinds of communities and engagement processes, in a way to get past the substantive challenge of analog rules that aren’t working for the investors in the space. To this end, a decentralized autonomous organization (‘DAO’) is a great prospect.
Participants could create tax-exempt, nonprofit DAOs designed to promulgate disclosure frameworks, tokens, and compliance tools. Different individuals could then submit disclosures, whereas winning disclosures could create several rewards for those individuals.
DAOs can help facilitate integration and unlike other kinds of off-chain bodies they foster an environment of transparency, where different kinds of processes can be automated, saving you a degree of operational costs.
Industry Response to Dr. Brummer’s Whitepaper
Hosts Sheila Warren and Michael J. Casey were interested to know about the broader industry’s response to Dr. Brummer’s novel ideas.
According to Dr. Brummer, he has heard from individuals from staffers of members of Congress, as well as curious regulators, and many others. He believes that all kinds of stakeholders, including policymakers, are awakening to the realization that the current technology stack is analog and outdated.
Constructively adopting new tools introduces much more durability, flexibility, and responsiveness to the rulemaking process, and it gives regulators as well as founders additional tools in terms of – on the founder’s side- differentiating their dapps and protocols from others and for the regulators – a better understanding of their requirements.
Dr. Brummer’s whitepaper, “Disclosure, Dapps, and DeFi”, is forthcoming in the Stanford Journal of Blockchain Law and Policy.
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