The Regulatory Trinity Pt. VI

In our previous article, “Demystifying Securities Regulations in the Web3 Era,” we explored the ways traditional securities laws apply within the rapidly evolving landscape of digital assets.

Building on this foundation, this article delves into the evolving concept of Disclosure NFTs and their potential to transform how companies meet their disclosure obligations, enhancing transparency for investors. Additionally, we will examine how Galactica Network’s unique RegTech stack can facilitate and streamline this process.

Disclosure NFTs and beyond

Digital assets pose a unique challenge in securities regulation due to their lack of standardized form or definition. Unlike traditional assets, digital assets can take various shapes and structures, making it difficult for regulators to effectively classify and regulate them. This challenge arises from the wide range of use cases and the rapid pace of innovation in this field.

The SEC has categorized many Initial Coin Offerings (ICOs) as securities offerings, thereby subjecting them to federal securities laws. According to the SEC’s definition, a security is an investment contract where individuals invest money in a common enterprise with the expectation of deriving profits from the efforts of others.

According to this definition, a significant number of ICOs would be classified as securities offerings. Investors usually acquire tokens with the expectation of obtaining financial returns through the efforts of the company’s management team. Consequently, these ICOs are obligated to adhere to securities regulations, including SEC registration and the disclosure of relevant information to potential investors. However, there are proponents of ICOs who argue that they should be classified as utility tokens rather than securities.

ICOs (Initial Coin Offerings), along with other similar fundraising methods like IDOs (Initial DEX Offerings) and IEOs (Initial Exchange Offerings), offer companies a novel and innovative means of raising funds. However, these fundraising mechanisms have also been linked to a high level of risk for investors. The absence of well-defined regulatory standards and a centralized authority to oversee such fundraising activities have resulted in instances of fraud and abuse in the past.

Therefore, it is imperative to establish more comprehensive disclosure standards to safeguard investors. This means that companies carrying out such fundraising activities must provide detailed information about their business operations. This includes sharing financial statements, outlining the utilization of raised funds, and highlighting potential risks associated with the investment. In essence, these companies should provide a substantial amount of information akin to what is expected from companies operating under securities laws.

Furthermore, it is crucial for regulators to enforce disclosure standards, ensuring that companies furnish accurate and comprehensive information to investors. Regulators can play a vital role in protecting investors by providing guidance on best practices for issuers and monitoring compliance with disclosure requirements.

Some companies may try to circumvent securities regulations by devising tokenomics that are not in line with securities laws.This may involve issuing tokens designed to avoid classification as securities, despite possessing characteristics that resemble securities. Such actions can present legal and regulatory complexities for both the company and investors. In this vein, it would be advantageous for companies to issue tokens that are explicitly classified as securities rather than attempting to evade securities regulations. This approach would provide investors with a clear understanding of the investment opportunity and the associated risks, while ensuring that the company complies with securities laws.

This section summarizes proposals by Brummer (2022) [17] to enhance investor protection within securities regulation. The focus is on disclosure of NFTs followed by how the regtech stack of Galactica Network can be leveraged to further (and even automate) their application.

Documentation

dApps may improve their documentation by clearly indicating if they involve investment or provide financial services like credit markets. The information should be easy to understand and include comprehensive disclosures about the business model and user benefits, such as staking and LP rewards. Material risks, like losing funds, counterparty risks, scaling limitations, and failing transactions leading to monetary losses, must also be disclosed. Additionally, token economics and existing conflicts of interest between LPs, investors, and developers should be transparently communicated, along with a description of DAOs’ decision-making process, voting power formation, profit generation, and relevance to the DApp’s functioning.

Disclosure

Disclosure NFTs offer unique applications in the realm of decentralized applications. Firstly, the “KYC/AML NFT” facilitates whitelisting by providing users with non-transferrable NFTs as proof of passing KYC/AML checks, granting access to specific features within the dApp. Secondly, “Disclosure DAOs” enable members to submit disclosure principles and model disclosures, potentially receiving NFTs as recognition for their contributions.

The utility of “Disclosure NFTs” extends further as data wrappers for disclosure, proving ownership of digital assets. These NFTs can be embedded in smart contracts, creating new disclosure use cases for end-users and investors. For instance, an NFT could tokenize disclosures available for review, linking to off-chain disclosures hosted on external servers or distributed file systems like IPFS or Filecoin. Updates to disclosures could generate new tokens, fostering third-party communities to discuss and deliberate on token-delivered information in specialized chat rooms.

To implement these disclosure NFTs effectively, a robust tokenization thesis is necessary to justify the complexity and cost. One approach involves upgrading the functionality of “disclosure” as traditionally understood since the 1930s. Companies can utilize this proposed system by uploading their disclosures to websites and engaging readers with questions or interactive elements. Upon successful completion, the end-user or investor would receive a unique, non-transferable token as proof of their engagement with the disclosures, which could be stored in their digital wallet.

Use case 1: Providing disclosures to investors for automated investing

This use case involves a DApp built on the Galactica blockchain, utilizing a smart contract to regulate investor disclosures for automated investing. Projects seeking funding submit applications, which comprise of comprehensive documentation (detailing tokenomics, risks, business model, etc.) and an on-chain transaction for registering the application while privately disclosing information through ZKP.

The documentation is uploaded to the InterPlanetary File System (IPFS), and is required to meet security regulations. It can be updated via resubmission of the registration using a unique identifier (UID). The on-chain transaction includes the IPFS hash of the documentation, ensuring its authenticity and preventing tampering, and links the documentation to the transaction.

The founders’ unique ID, derived from their personal data in the zkKYC procedure, is provided. This humanID helps maintain a traceable on-chain record of previous applications to prevent fraudulent practices. Additionally, in cases where multiple investment DApps exist, applicants may need to submit their humanIDs for all these DApps.

There is an option for secret disclosures to selected recipients through encrypted channels, providing confidential documentation and personal details such as name and address in the ZKP. This could be useful for investors or legal authorities involved in Galactica’s fraud investigation process

Lastly, additional disclosures can be derived from zkCertificate data on Galactica, showcasing the founders’ reputation scores, educational qualifications, awards, and property holdings.

Use case 2: Attesting users’ eligibility for crowd investing platforms

This use case ensures compliance with security regulations for crowd investing platforms by attesting user knowledge and eligibility. After reading project documentation, users must pass an online test, receiving a NFT, certifying their understanding. This NFT can be issued as a zkCertificate to help maintain user privacy concerning their investment interests.

Users’ identities are verified privately and compliantly via zkKYC, with optional zkCertificates attesting personal details such as investor status based on net wealth.

The crowd investing platform, built as a smart contract on Galactica, requires users to provide a ZKP confirming that they hold a valid NFT/zkCertificate for their understanding of the project and have passed an age check based on zkKYC data. Further disclosures of being an eligible investor based on personal data in zkCertificates.

By embracing these innovative approaches and collaborating with regulators, we can pave the way for a more secure and transparent digital asset ecosystem, fostering investor confidence and supporting responsible growth in this rapidly evolving domain. Additionally, real-world use cases, like providing investor disclosures for automated investing, showcase the practical applications and potential benefits of disclosure NFTs in enhancing investor protection and engagement.

The Trinity Continues

As the digital asset landscape matures, the need for robust regulatory frameworks to protect investors becomes increasingly apparent, and in our next article, we’ll shift our focus to the crucial area of anti-money laundering (AML) and combating the financing of terrorism (CFT) in the context of digital assets.

We’ll be exploring how existing regulations can be applied and highlight the potential for new legislation to address the unique challenges posed by digital assets in safeguarding the integrity of the financial system.

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