SEC hasn’t quashed blockchain innovation. Let’s keep it that way

Utility tokens that are pieces of future network technology represent real innovation, and the SEC should resist any urge to overregulate them. This article originally appeared in American Banker

In a recent report, the Securities and Exchange Commission stated unequivocally that blockchain-powered digital tokens can be securities. This finding could have serious consequences for the future of blockchain technology.

Digital tokens, built on the kind of open blockchain technology pioneered by bitcoin and ethereum, are sometimes used as naked instruments for sharing profits among investors in a common enterprise. Other tokens, however, are actual pieces of future network technology. Their creation and sale should be at least as free and clear from burdensome securities regulation as are crowdfunds on Kickstarter or web domain registrations.

Over the past year, developers have raised well over $1 billion by building and selling tokens to hordes of enthusiastic online purchasers. Today’s version of a dot-com-bubble maverick is a blockchain startup proudly announcing its upcoming “initial coin offering,” or ICO.

The SEC report doesn’t abolish ICOs. Instead, it describes how a particular now-defunct token effort from last summer, known as “the DAO,” was a security (that therefore should have fallen under the guise of securities regulation). It does so by employing the facts and circumstances of SEC v. W.J. Howey Co., a seminal Supreme Court case that is often used to determine if and when federal securities laws apply.

Using this test, the SEC has now begun cleaving the ICO world in half: Some tokens are going to be regulated as securities while others may not. Where the SEC chooses to draw that line over the next few years will mean the difference between offering reasonably calibrated investor protection, on the one hand, and crushing a nascent movement to democratically fund and build the core infrastructure of future internet technologies, on the other.

Tokens used as instruments for sharing profits among investors are securities by any other name. Based on the Howey test, they should be identified and regulated accordingly. But utility “tokens” that are pieces of future network technology are functional rather than profit-sharing. They represent real innovation, and the SEC should resist its urge to overregulate them.

How do utility tokens work? Cloud storage, a common web service, is a useful example.

By cloud storage we mean services like Dropbox or its industrial-strength competitor Amazon Web Services. Customers pay Dropbox or Amazon a monthly fee to store files on internet-connected hard drives that these companies own and maintain. Customers do this so that their files can be accessible anywhere that there is an internet connection. These services have turned out to be very profitable, but how did we get here? Companies like Dropbox and Amazon raised money from private investors to finance the development of their services, and the services were then built on private, company-owned infrastructure (server farms and data centers) that connects to the open internet.

A utility token, in contrast, allows clever developers to build an alternative network for cloud storage that is collectively owned, run and maintained by unaffiliated persons all over the world —just like the internet itself. Such an open network is typically peer-to-peer. Anyone can join the network either because they need storage or because they want to make available their excess storage to other parties. A network protocol would automate the process of matching storage buyers with storage sellers, guarantee that contracts for storage are fulfilled, and automate payments. Every interaction on the system would be validated and shared across the network with a blockchain, and payments would be made using a token that travels natively on that blockchain and has a fixed total supply, like bitcoin.

But if the end result were not stock in a behemoth company, like Amazon, that is awarded to its developers, who would build such an open network for storage and how would they be rewarded for their efforts? Such an open network is a commons, a shared public good. Without market mechanisms, it will be over-consumed and under-provided.

Instead of raising money from investors, the developers of a new open network can pre-allocate some of the tokens to themselves. Then, they can sell those tokens to people who expect that they will want to use the storage service once it is built, or to those who want to speculate about the future value of this decentralized storage solution. They could also retain some tokens, anticipating that they will increase in value if the network became popular. Either way, the developers are rewarded for their work even though they don’t end up as CEOs of a Fortune 500 company.

Storage is just one example. Bitcoin is an open, shared network for digital value transmission. Ethereum is an open, shared network for cloud computation. There will be other tokens for networked goods that we can no better imagine today than we could have imagined Google or Snapchat before they came on to the scene.

It has always been tough to raise money to build shared internet infrastructure. Indeed, the development of the internet itself was primarily funded through government grants. It has also been difficult to monetize an open internet platform without turning it into a gated community. That’s why email is increasingly an intermediated service that we access through Google, why Twitter is not profitable, and why more people post their thoughts and content to an easy-to-use and well-maintained platform like Facebook, rather than try to build their own web page or write their own blog.