In a recent post, I argued that the Uniswap team is likely to be sued by the SEC, because its token UNI is likely to be identified by the SEC as a security. Since Uniswap launched UNI, more DeFi projects have started issuing their own governance tokens. But these tokens are clearly designed to have very strong characteristics in security, and therefore are likely to be recognized as securities by the SEC, which in turn will lead the SEC to take regulatory action against these project teams.
In this paper, according to the security identification proposed by Howey Test, some simple analysis is made on some design factors of these governance tokens to help readers understand why these tokens are identified as securities.
First, let’s look at the dimensions defined for securities in the Howey Test:
1. It’s an investment of money
2. It has an expectation of profit generated from the investment
3. The currency investment is invested in a common enterprise
4. The resulting profit is derived from the efforts of the promoter or a third party
Firstly, in current designs, tokens are usually no longer used for public fundraising to avoid being identified as securities. On the public side, it is usually given away for free, in which ordinary users get these tokens by locking up funds, or by providing liquidity, or by referring users. According to this design, the way that ordinary users receive tokens is not through direct purchase by currency. However, these DeFi projects usually have initial investors. Part of the token is allocated to other investors based on the initial investor’s investment. And such a method of token acquisition conforms to Howey Test’s definition of investment.
Secondary, in all current designs of tokens, the amount of tokens is in certain. The generation and circulation of tokens are very conducive to transactions, especially for centralized matchmaking. So these tokens have a basis for appreciation through trading. Although ordinary users receive these tokens in a non-monetary way, all users receiving these tokens have a clear expectation of appreciation, which conforms to the definition of profit expectations in the Howey Test.
Thirdly, although the application of DeFi does not require human involvement and does not require manual day-to-day operations, these systems are built by dedicated teams. In some issuers’ documents, it was made clear that some of the tokens were reserved for future employees, and that part for the construction team was obtained in installments. Such a business team clearly conforms to the Howey Test definition of normal business.
Fourthly, the current operations of governance tokens are also in line with the Howey Test’s dimension of efforts by promoters and third parties.
Therefore, in general, each DeFi governance token currently will be recognized as a security by the SEC, and there is a high probability that the SEC will take regulatory measures. As for whether and when the SEC will actually take enforcement action, I’ll discuss that in a separate article.
In the past few years, there have been efforts to mimic the incentives of bitcoin and Ethereum. But so far, there has not been a viable incentive system that does not violate the rules. The current designs of governance tokens in DeFi projects are another attempt at this. Unfortunately, these designs are still not feasible. A fundamental problem with these designs was the pursuit of short-term results. For that purpose, the incentive mechanism must be based on the short-term rapid appreciation of tokens. This appreciation is achieved through centralized trading, so these tokens are inevitably securities. What these incentives attract are speculative users and the money they hold, but not users who are interested in the new product or service itself. Moreover, because of the need for quick results, such incentives would focus on early results, so the release of tokens is highly skewed towards the early times. However, there is a certain amount of it, the effect of incentives will diminish quickly, and it will not have lasting effects.
An important part of the design of Bitcoin is its incentive mechanism, and perhaps even Nakamoto himself did not anticipate the subtlety of it. But Bitcoin’s success does prove the ingenuity of its design and its incentive mechanism. Even if Bitcoin was released today, it would not be considered as a security and would not be suspected of a violation. Therefore, I believe that the essence of the design of Bitcoin’s incentive mechanism has not been recognized by the market, let alone further developed on its basis. But I believe, given the way this has been explored in the markets, a reasonable incentive mechanism will soon emerge.
Article from Gu Yanxi, Founder of Liyan Consulting
Translated by Yang(Milian Tech)