There’s been a lot of debate over whether Facebook’s proposed currency is really decentralized. It’s a big deal in crypto circles — and a debate often driven by individuals laying claim to what they view as “authentic” blockchain strategies that, not surprisingly, align with what they’re doing in the market.
For technologists, decentralization is the central feature of what many hope will be the major new infrastructure of the internet.The term evokes new peer-to-peer architectures for how data, identity and ultimately financial transactions can be operationalized — and records stored over many computers or “nodes” instead of in a central server.
With decentralization associated with a range of techno-libertarian values — including the dismantling of hierarchies and oligopolistic rent seekers — there are, to be sure, debates as to just how and whether Facebook’s cryptocurrency, Libra, fits the bill.
For some observers, Libra is not exactly a step in the right direction. After all, Facebook’s plan involves an association of some of the world’s most powerful technology companies to manage the currency, as well as future issuances and protocol upgrades. And the system is one that is highly permissioned. According to Libra’s White Paper, there will also be a finite number of entities — explicitly authorized by the association — to transact large amounts of fiat currency and Libra in and out of a reserve established by the association. These authorized resellers will integrate with exchanges and other institutions that buy and sell cryptocurrencies to users, and will provide these entities with liquidity for users who wish to convert from cash to Libra and back again.
On the other hand, Libra may end up more decentralized than some blockchains that are effectively commandeered by a collection of discrete mining pools.And with the association consisting of more than two dozen members, Facebook won’t be able to unilaterally make decisions for the entire system.
Input for regulators
Decentralization plays out differently for regulators, but still ends up being rather indeterminate. Which is problematic since decentralization informs decisions as to how blockchains should be regulated. Not because decentralization is a legal standard as such. It’s not. In fact, if you scour the thousands of pages of U.S. securities, banking and derivatives laws, decentralization never appears. Not once.
And, as the legal scholar Angela Walch observes in her paper “Deconstructing Decentralization,” in the few instances where it pops up in state law, such as in Arizona’s new fintech-oriented statute that uses the term ”decentralized” to define ”blockchain technology,” the term ”decentralized” is itself never defined.
Instead, decentralization’s importance lies in the input it helps provide for regulators tasked with determining whether or not any given cryptocurrency is a security, and thus should be subject to the panoply of rules memorialized under U.S. securities law.
First, decentralization touches on whether there is sufficient “reliance of others” that is prerequisite to a cryptocurrency being called a security. If an investor relies on others — as is the case where one purchases stock and depends on the management of the company that issues the stock — it’s more likely to be a security.
A second issue implicating decentralization is commonality — namely, whether, because all the investors are similarly situated, and the costs of information gathering are high, they are inclined to free ride on the information gathering of other investors. And consequently, because everyone is waiting on everyone else, insufficient information is generated. Securities regulation is viewed as solving the problem by forcing companies to disclose, even where informational markets may operate inefficiently.
But decentralization is also important for on-chain power dynamics, triggering regulatory consequences, a point emphasized last week by Elizabeth Baird, the Securities and Exchange Commission’s deputy of Trading and Markets. She was a speaker on a panel I moderated at Crypto Evolved, a big markets infrastructure conference in New York.
For Baird, decentralization is, at least in part, about informational asymmetries within blockchain operational systems. In short, if there’s a single party running a blockchain, power is highly centralized. And thus participants in such a system are more likely to face better informed actors who can exploit their informational (insider) advantages. On the other hand, if there is not a single, central party operating a transaction (or blockchain), that means power is more diffuse, reducing the need for government action.
That said, decentralization is approached through the tried and true concept of disclosure. As Bill Hinman, the SEC’s head of trading and markets, has noted, one of the key questions for determining if securities laws should apply is whether “there [i]s a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors?”
Bitcoin fits the decentralized bill; Facebook’s Libra on the other hand…
For these reasons, bitcoin has not really fallen into any kind of box whereby it was readily identified as a security. As a system launched anonymously, open to anyone, and with millions of users around the world, it serves as an exemplar of a truly “decentralized” system.
But returning to our initial observations: structural diffusion, as technologists are finding, is a notoriously difficult standard to apply. And legal standards just complicate things further. How much diffusion makes you “decentralized” such that there is no dependence to warrant a regulatory intervention?
Thus determining whether Libra’s blockchain is “decentralized” — as a matter of market preference, or legal inquiry — is an inherently frustrating undertaking. Certainly, according to traditional metrics drawn from the Supreme Court’s 1946 Howey v SEC ruling, its degree of decentralization is, well, meh. Facebook doesn’t unilaterally dominate the system it’s creating, but it is the primary architect and key gatekeeper.
There’s a temporal dimension as well. Libra’s White Paper highlights the intent of Facebook to increase the Libra Association to 100 or more members, signaling a broader infrastructure and ultimately more diffuse power dynamics. But there’s no guarantee it will happen, or roadmap for it to happen, since members are reportedly not legally bound to maintain their memberships. Indeed, if the press and publicity (and regulatory scrutiny) associated with Libra turn decisively negative, there are few legal constraints keeping members from bailing out on the project altogether.
Bright lines can be a roadmap to arbitrage
Not surprisingly, there have been more than a couple calls for legislative interventions that would provide some kind of bright lines for the term decentralization. But I think that’s highly impractical: If anyone knows anything about securities law, the last thing one wants to do is provide a roadmap to arbitraging the rules.
Moreover, the ever-changing adaptability and complexity of blockchain systems are difficult, if not impossible, to capture with simple quantitative metrics. Crypto ecosystems are, as Walch again observes, animated by an array of ever-changing participants, including the developers who write and maintain the software code, the miners (or validators) who process transactions and add them to the common record, and the nodes, who send transactions to miners and maintain copies of the blockchain record.
With all this in mind, a tactical retreat back to Howey starts to look better than one might imagine. It’s indeterminate, but it’s at least functional, targeting not so much the name of things as it does certain economic functions or realities. In a world of ever-evolving technology, it may be the best tool regulators have.
Useful Background Research:
If you’re interested in learning more, it’s worth noting that there is a research group with some extremely well known names (Arner, Buckley, Zetzsche) publishing up a storm and thinking through how the big questions are conceptualized:
| Citation | SSRN Link |
| RP Buckley, DW Arner, DA Zetzsche & E Selga, “The Dark Side of Digital Financial Transformation: The New Risks of FinTech and the Rise of TechRisk”, forthcoming Singapore Journal of Legal Studies, in press, accepted Nov 3, 2019. | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3478640 |
| DA Zetzsche, DW Arner, RP Buckley & RH Weber, “The Future of Data-Driven Finance in Europe”, forthcoming Common Market Law Review (the second most highly ranked international law journal in the world by Google Scholar), in press, accepted Oct 6, 2019 | Not yet on SSRN |
| RP Buckley, DW Arner, R Veidt & DA Zetzsche, “Building FinTech Ecosystems: Regulatory Sandboxes, Innovation Hubs and Beyond”, in forthcoming special FinTech issue of the Washington University Journal of Law & Policy, in press, accepted May 31, 2019. | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3455872 |
| RP Buckley, DW Arner and DA Zetzsche, “Sustainability, FinTech and Financial Inclusion”, forthcoming European Business Organisation Law Review, accepted Sept 13, 2019. | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3387359 |
| RP Buckley, DA Zetzsche, DW Arner & RH Weber, “The Road to RegTech: the (astonishing) example of the European Union”, forthcoming (2019) Journal of Banking Regulation, in press, accepted April 13, 2019 (LP150100269). | Not on SSRN |
| DA Zetzsche, RP Buckley, DW Arner & L Fohr, “The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators”, (2019) 60 (2) Harvard International Law Journal 301-349 | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3072298 |
| F Panisi, RP Buckley & DW Arner, “Blockchain and Public Companies: A Revolution in Share Ownership Transparency, Proxy-voting and Corporate Governance?”, (2019) 2:2 Stanford Journal of Blockchain Law & Policy |
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3389045 |
| A Didenko & RP Buckley, “The Evolution of Currency: From Cash to Cryptos to Sovereign Digital Currencies”, (2019) 42:4 Fordham International Law Journal 1041-1094 | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3256066 |
| DW Arner, DA Zetzsche, RP Buckley & JN Barberis, “The Identity Challenge in Finance: From Analogue Identity to Digitized Identification to Digital KYC Utilities”, (2019) Vol 20 (1) European Business Organisation Law Review, 55-80 | https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3224115 |