Babbitt Column | The essence of DeFi governance tokens is securities

In an opinion I published not long ago, I believed that the token UNI issued by Uniswap is likely to be identified as a security by the SEC, so the Uniswap team is likely to be sued by the SEC (see my article "The SEC is likely to sue Uniswap"). Since Uniswap issued UNI, more DeFi projects have begun to issue their own governance tokens. However, the design of these tokens clearly has very strong securities attributes, so they are likely to be identified as securities by the SEC, which in turn leads to the SEC taking regulatory measures against these project teams.

This article conducts a simple analysis of some of the design factors of these current tokens based on the securities identification attributes proposed by the Howey Test to help readers understand why these governance tokens are considered securities.

First, let’s look at the 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 investment in currency is an investment in a common enterprise

• The profits generated are 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, free distribution is usually adopted, that is, ordinary users obtain these tokens by locking funds, providing traffic, or introducing users. According to this design, the way ordinary users obtain tokens is not to use currency to directly purchase. However, these DeFi projects usually have initial investors. Part of the tokens are allocated to these investors based on the investment of these initial investors. Such a way of obtaining tokens meets the definition of investment in the Howey Test.

In all current token designs, the total amount of tokens is fixed. The generation and circulation of tokens are very conducive to transactions, especially centralized matching transactions. Therefore, these tokens have the basis for appreciation through transactions. Although ordinary users obtain these tokens in a non-monetary way, all users who obtain these tokens have a clear expectation of appreciation. This meets the definition of profit expectation in the Howey Test.

Although DeFi applications do not require human participation and manual daily operation and maintenance, the construction of these systems is carried out by a dedicated team. In some documents issued by token issuers, it is clearly stated that part of the tokens are reserved for future employees, and the part given to the construction team is obtained in installments. Such an operating 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 dimension of promoters and third-party efforts in the Howey Test. Therefore, in general, all current DeFi governance tokens will be identified as securities by the SEC, 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 it will start, I will discuss it in another article.

In the past few years, there have been efforts to imitate the incentive mechanisms in the product design of Bitcoin and Ethereum. However, so far, there has not been a viable incentive mechanism without violating regulations. 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 these token designs is the pursuit of short-term quick success. In order to achieve the goal of quick success, the incentive for users must be based on the short-term rapid appreciation of the token. And this appreciation is achieved through centralized trading, so the design of the token inevitably has securities attributes. Such an incentive mechanism must attract speculative users and the funds they hold, and must not be users who are interested in the newly launched products or services themselves. In addition, also due to the need for quick success, such an incentive mechanism focuses on seeing results as soon as possible, so the release of tokens is highly inclined to the early stage. However, since the total amount of tokens is fixed, the effect of the incentive quickly decays, 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 foresee the cleverness of this incentive mechanism. But the success of Bitcoin proves the cleverness of its product design 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 essence of Bitcoin product design in terms of incentive mechanism has not been recognized by the market so far, let alone further development based on it. But I believe that given that the market has been exploring this aspect, I believe that a reasonable incentive mechanism will soon emerge.