Gu Yanxi: The essence of DeFi governance tokens is securities


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From the analysis of Howey Test, DeFi governance tokens will all be recognized as securities by the SEC, so they have a high probability of being regulated.

Original title: “The essence of governance tokens is securities”
Written by: Gu Yanxi, founder of the American Liyan Consulting Company, a researcher and practitioner in the blockchain and encrypted digital asset industry

In an opinion published not long ago, I believe that the token UNI issued by Uniswap is likely to be recognized by the SEC as securities, so the Uniswap team is likely to be sued by the SEC. Since Uniswap issued UNI, more DeFi projects began to issue their own governance tokens. However, the design of these tokens obviously has a very strong security attribute, so they are likely to be recognized as securities by the SEC, which will lead the SEC to take regulatory measures against these project teams.

This article analyzes some of the current design factors of these tokens based on the securities identification attributes proposed by the Howey Test, and helps readers understand why these governance tokens are identified as securities.

First, let’s take a look at several dimensions of the definition of securities in the Howey Test

  • It is an investment in currency
  • There is an expectation of profit from this investment
  • This currency investment is an investment in an ordinary enterprise
  • The resulting profit comes from the efforts of the promoter or a third party

In the current token design, tokens are usually no longer used for public fundraising to avoid being identified as securities. For the public, the free distribution method is usually adopted, that is, ordinary users obtain these tokens by locking funds, or providing traffic, or introducing users. According to this design, the way for ordinary users to obtain tokens is not to use currency to make direct purchases. However, these DeFi projects usually have initial investors. Part of the token is allocated to these investors based on the investment of these initial investors. Such a way of obtaining tokens is in line with Howey Test’s definition of investment.

In all current token designs, the total amount of tokens is certain. The generation and circulation of tokens are very conducive to transactions, especially centralized matching transactions. Therefore, these tokens have a basis for appreciation through trading. Although ordinary users obtain these tokens in non-monetary ways, all users who obtain these tokens have obvious expectations of appreciation. This is in line with the definition of profit expectations in the Howey Test.

Although the application of DeFi does not require human involvement and manual daily operation and maintenance, the construction of these systems is carried out by a dedicated team. In the documents of some token issuers, it is clearly stated that some of the tokens are reserved for future employees, and the part for the construction team is obtained in installments. Such a management team obviously meets the definition of an ordinary enterprise in the Howey Test.

The current operation of governance tokens is more in line with the dimensions of the efforts of promoters and third parties in the Howey Test. Therefore, in general, all current DeFi governance tokens will be recognized by the SEC as securities, so there is a high probability that the SEC will take regulatory measures. As for whether the SEC will actually take enforcement measures and when they will start, I will discuss them in another article.

in the past few years. There have been efforts in the market to imitate the incentive mechanism in the product design of Bitcoin and Ethereum. But so far, there has not been a viable incentive mechanism without breaking the rules. The governance token design in the current DeFi project is another attempt in this regard. Unfortunately, these designs are still not feasible. A fundamental problem in the design of these tokens is the pursuit of short-term quick success. In order to achieve the purpose of quick success, the incentives for users must be based on the short-term rapid appreciation of tokens. And this appreciation is achieved through centralized trading, so the design of tokens inevitably has security attributes. Such an incentive mechanism must attract speculative users and the funds they hold, and must not attract users who are interested in the newly launched products or services themselves. In addition, also due to the need for rapid development, such an incentive mechanism is most focused on taking effect as soon as possible, so the release of tokens is inclined to the early stage. However, since the total amount of tokens is fixed, the effect of incentives will quickly decay, and such an incentive mechanism will not have a long-term effect.

An important part of Bitcoin product design is its incentive mechanism. Perhaps Satoshi Nakamoto himself did not anticipate the ingenuity of this incentive mechanism. But the success of Bitcoin proves the ingenuity of the design of its product and the incentive mechanism contained therein. Even if the Bitcoin product itself is released today, it will not be considered a security and will not be suspected of violations. So I think that the design essence of Bitcoin products in terms of incentive mechanism has not been recognized by the market, let alone further development on its basis. But I believe that, given that the market has been exploring this aspect, I believe that a reasonable incentive mechanism will soon appear.