On Smart Securities and Blockchains or -

“How we got to the future.”

By Lior Zysman: Legal advisor and consultant to smart contracts startups. Runner-up at Consensus 2016 Hackathon with a charity DAO using dedicated hardware for disaster areas. Special thanks to Matt Chwierut for brianstorming with me, and to Izabella Kaminska for her comments!

TL;DR: Security — it’s an old concept that could be disrupted with the introduction of the blockchain, DAOs, and Oracles. Using smart contracts could make capital flow more efficiently to where it needed the most (ultimately lead to alternative economic structures). Crypto world could use its technology to create a fairer token trading environment and better corporate governance structures.

PROLOG: What is a security?

Security is literally a security. I paid you something, and now you owe me. It could be accompanied with a certificate that expresses the agreement, and sometimes a collateral is involved — but basically it’s a financial obligation from one party to the other.

The financial obligation is usually based on projected cash flow, that the parties wish to partner upon. With debt security, the purchasing party has a right to the principal amount, the agreed upon interest rate and collateral in case of a default. In equity security, the purchasing party enters into an agreement to own a stake in the company’s assets net its liabilities.

Another distinction, with implication on how to design crypto equity, is that securities could be public or private. A public security that anyone could trade or hold has a requirement to report the status of the underlying asset performance. If the security has to be sold publicly than the public should know. The company which holds such information has the responsibility to publish it.

A private security is different: it’s a deal that takes place between a limited number of parties, they can request information or not, as the public is not part of it. Selling a private security to the public is limited to accredited investors (basically net worth > $1M), as there is no public information about the company and the latter could afford to lose their investment.

It’s worth mentioning that the SEC (Securities Exchange Commission) just allowed this month to non-accredited investors to participate in such offerings as well (through the Jobs Act) - but only in a limited fashion. Funding Portal Wefunder.com published an ‘open letter to SEC’ warned about adverse selection because of these limitations, Fundersclub.com also warned about it, and chose not to register as a SEC Funding Portal. The reason is that startups with more than 500 non accredited investors are facing costly reporting requiremnts, if they cross $25M threshold in assets. Another example, is that only after one year holding the security, it could be sold in the open market (more about the law here).

THE EVOLUTION BEGINS: SMART CONTRACTS

Smart contracts are a different ball game. Smart contracts are code running on (usually) public blockchain, like Ethereum, and can offer the functionalities of securities more cheaply and more transparently than public securities — or even more privately, when encrypted on the blockchain (Oraclize.it encrypted queries). When encrypted Investments on the public blockchain could be limited to only certain investors, such as ones who adds value to the company, while still being transparent with other functions on the blockchain as handling funds.

Furthermore, securities based on public-blockchain smart contracts don’t require accreditation to purchase, so any ‘investor’ can buy one. Allowing anyone to invest with no discrimination (or one year holding limit) could potentially make the market more liquid and price discovery more efficient. Please check out Cato Institute’s paper that explains why the distinction between Accredited Investors vs Non Accredited investors is not effective. For the diligent readers, read economist John Kay’s excellent book “Other People’s Money”, where he claims over financialism is taking place with mainly banks trading between themselves instead of improving basic financial services.

For centuries, terms have been written on paper and enforced through force, governments, or courts. Smart Contracts could enforce some terms automatically — directly through code and run on a blockchain. A bond from the Dutch East India Company, dating from 7 November 1622

Ethereum (and soon Rootstock on the Bitcoin network) provide the building blocks for creating securities on the blockchain. Anyone can code a security, which is being executed by the blockchain. The Smart Security is essentially a ledger entry expressed through a token, and anyone who holds it can receive part of its revenue and use the token to vote on whatever the security represents. It’s crypto version of Bearer Stock. Back up the private keys (the blockchain password) and it’s yours to control — no Exchanges, DTCC or Transfer Agent stand in the way.

Here you go, to start your own publicly traded crypto organization, just create an address (the “bank account”), and code agreements to it (starting with the founders’ relationships sharing the control on the expenses and revenues). Now you can fund a project, execute it and compensate investors with just few lines of code. In the non-crypto world, it would cost you much .

It is worth noting that the (current) lack of regulation brings risks. The funds might not be FDIC insured, and there no enforcers, such as the SEC or FINRA. FINRA is a self regulatory organization, or “SRO”, owned by securities industry, and cooperates with the SEC the governmental agency, to create industry standards, oversee and enforce it. For example jailing people for insider trading. The legal system currently protects investors from getting scammed (even for crypto currencies), but we should have similar functions of those institutions in the crypto sphere itself. Vitalik Bluterin the founder of Ethereum already suggested decentralized courts on the blockchain that resolve disputes, Crypto holders can insure themselves peer to peer (instead of the governmental owned FDIC), and we could create our own industry standards instead of FINRA. Furthermore, with blockchain and smart contracts, we can improve the current system to be more efficient.

I’d elaborate, instead of forming a new failure point regulator as FINRA, we can create an industry standard similar to how MIT License works (intellectual property framework for open source projects) where anyone (seeking funds in our case) could adopt it or choose not to. For example, an Anti Insider Trading (AIT) Standard, in which main contributors of open sourced projects should associate their addresses (even just as pseudonymous), so other investors would know when those people are cashing out (sometimes, not a good sign).[update: Lisk.io shared founders’ addresss, and other related addresses when it’s token started trading]

The DAO aims to be the first Decentralized Autonomous Organization

IS THE FUTURE HERE ALREADY?

The recently launched “The DAO” is a good example to new business models hiding in the trustless crypto world, with innovative approaches that have never-been tested before. It’s a Decentralized Autonomous Organization (=“DAO” although the autonomous part is in question, because of human touch), which basically is a crypto investment club, where members makes investment decisions together. Currently there is a proposal for a Universal Sharing Platform which would provide return through IoT products automatically sharing profit with the DAO. The token trades on the transparent Ethereum blockchain (here’s everyone who invested in the DAO and more about the ‘Regulatory Agenda for DAOs’)

Ah-ah! The first real crypto-equity crowdfunding, vote and get share in profits in crypto projects. The DAO raised $150M (5/19/2016) in uncommitted capital for investments (everyone can claim their ether before any investment takes place). The DAO could potentially replace the Ethereum Foundation with its contribution to the ecosystem. One might call it the ethereum automated version for the bitcoin core developers, DAO itself could be seen as a concept to compensate open source contributors.

It was done through great coding and an innovative conceptual approach. For instance, to claim your ether before an investment you can use split function, which allows investors to pull their funds out of the DAO into a new DAO. This eliminates the possibility of a 51% attack, where the majority vote to distribute 100% of funds to itself therefore robs the minority through voting. The code allows the minority to split, leaving the majority with only with his own funds to rob. Maybe we need such function in politics as well…

Relationships inside an organizations are defined by their by-laws, a binding legal contract between the company (or the DAO), its shareholders (equity holders!) and between the shareholders themselves. But there’s still a challenge ahead to translate shareholders relationship into code (that would be executed autonomously on the blockchain). For example in the split function, already invested funds are left as old-DAO tokens representing the minority’s rights in the profit. Now the Majority is left with enough voting power to issue more of it to itself for free, therefore diluting the (former) minority’s rights (like Mark Zuckerberg has done to Eduardo Saverin).

The solution in the non-crypto world is that the minority would still have participation rights, as pro-rata rights, to keep their investment. In a crypto autonomous world, a technological approach could be used to solve it. Each investment would then be in a form of SPV Smart Contract (special purpose vehicle) with the funded company acting as curator (or a has a multi signature right) in that address. Then, further funding or the creation of more tokens (that represents dividend rights) by the majority could be done with the SplitDAO, and the target company approval (that has to act in good faith or it could be prosecuted. %51 attack for dilution is now disabled.

Investors learned that lessons the hard way, by a long history of doing businesses with dilution of participation rights in later rounds, and other investment structures tricks (the book is full with examples). Savvy business persons could take advantage of it and gain control over funds from unaware investors.

But it‘s an opportunity for smart securities to create much simpler world of contracts. What you see is what you invest. Maybe equity investments should only take place at pre-seed stage, and use crowdfunding to validate public’s demand for the idea (sort of kickstarter embedded with a prediction market). Further investments down the line should be directly connected to cash flows or projected return on investment (ROI).

Market cap of digital currencies, are we going to have the same with DAOs? (source: Coincap.io 2/14/16)

SCI-FI, UNTIL IT’S JUST SCI

Smart securities are the future version of financing that is tailored to specific needs and able to track its performance and adjust to it. One example is funding a google adwords campaign directly through a dedicated smart contract. The repayment of the security is based on the revenue growth attached to such campaigns. The security is flexible so the funding is dynamic to find the right formula of that campaign: static funding to accumulate feedback and then accelerated in cases of success (traffic>N). The smart security is expressed using a non human Oracle , a code that interacts with outside data points — measures traffic, and releasing fundings for it based on the predetermined criteria.

In that case investments would go more accurately to where they’re most efficient. That example could work with much needed projects, such as transportation: smart security would adjust itself based on the success of the projects, therefore only the most efficient would recieve further funding.

The security might not only source its funding from the investor crowd, but distribute tokens through a faucet (or a bot that automatically distributes tokens). The value is what the community attach to the token when they agree on a consensus protocol (in other words — by the market). For example starting transportation projects with tokens: The neighbors would have the highest incentive to gain control on such project, and the market will play it part in discovering how desirable the suggested project is.

To the advanced crypto economics class — What would be the preferred consensus algorithm for the above mentioned neighborhood transportation example (neighbors as delegates in a proof of stake model)? Could A.I. (artificial intelligence) connect to the surrounded data to make a better decision than the neighbors and the market (auto prioritize and even dynamically re-structure projects)? I would rather see the new bank being a bot, that would distribute back all revenue it generated, based on a predetermined criteria, for example underfunded transportation projects in Africa.

If all of that sound a little futuristic, well it’s the future itself, and maybe it’s just around the corner.