Decentralization Is the Enemy of Fair Markets

Crypto winter continues with no end in sight, a result of the rampant speculation that drove the capital inflow of 2017 and the beginning of 2018 through ICOs. As time went on, the market realized that a lot of ICOs were bad investments, and so the market slowed. Prices fell.

Even taking out the scams, the bad actors, and the frauds that absconded with the money they raised, we were still left with entrepreneurs that, good business idea or no, often raised more money than they knew what to do with. $20M raised in an ICO without a working product? How many founders could turn that set up into success without falling into the pitfalls of overspending?

The issue becomes more convoluted when you consider how many companies failed to convert the money they raised into fiat before the prices of crypto dropped. With so much money moving around, eventually US regulators stepped in, and the market slowed further. Should we have been surprised?

Why US regulators care about crypto

The bottom line is that in the eyes of the SEC, most tokens today are securities, and their method of sale and consumer behavior with those tokens both reflect that. However, though the SEC issued the DAO Report in July 2017, the first time the SEC publicly articulated their stance on an ICO, most in the market ignored the SEC and their ensuing statements until the spring of 2018.

Then the first wave of subpoenas arrived, and people began to pay attention. “What’s the big deal?” crypto believers cried. “If I have something I want to sell, and I find someone that wants to buy, why should anyone be able to stop us?” And so they argued for a free market: let the crowd decide whether a project had worth and what the price of its token should be. That, they said, is fair enough.

But it’s worth remembering that free markets are also what led to the SEC’s creation through the economic crash of 1929 and the ensuing Great Depression. At that time, retail investors were swarming to the stock market after a high-growth decade throughout the 1920’s. Over $120B was borrowed as investors took on loans in order to buy stocks.

When the market began to fall, some investors found that 10x more shares had been sold in a company than what they were led to believe, others that the stocks they purchased were in a business in shambles. Their investments were worthless, their money lost.

It became clear that retail investors needed to be protected from those that would take advantage of them for their money. And so the SEC was born with a singular purpose, to protect investors and ensure fair markets, and the Securities Act of 1933 was passed, which required companies to make public disclosures about their business and financials before selling securities, such as stock or debt, in their business to the general public.

Thus, it was inevitable that the SEC would come after companies that mislead investors or failed to make the required disclosures when selling securities to investors, even if those companies were unaware that they were selling securities. And so enforcement actions like those that Paragon and Airfox faced this fall occurred, and in 2019 there will be more.

But what about the other half of the SEC’s mission: ensuring fair markets?

Are decentralized markets fair?

Part of the beauty of crypto assets is that there is so little friction in the trading of those assets, that if someone owns a token they can trade it at will on numerous platforms. Because these platforms are decentralized and there are no middle men, there are also little to no fees, which is even better for investors.

However, there is a dark side to these markets, which was detailed in the New York Attorney General’s report in September. In essence, these platforms do not have users’ best interest at heart. Pump and dumps, wash trading, lack of proper custody and security measures, no anti-money laundering or know your customer processes, insider trading and more are all issues on the majority of current trading platforms.

These circumstances create opportunities for crypto entrepreneurs to recreate the Enron scandal from 2001, in which Enron executives falsified their financials to boost their stock price. When word came that the regulators were coming, many Enron executives were able to sell off their stock before the price fell. The retail investors who owned Enron stock were blindsided and lost their investment as the price plummeted in the wake of the scandal.

How many conspired to inflate the price of tokens for profit, and did the exchanges even care when they stood to make a profit themselves over the increased trading volume regardless of its intent?

In their current form, decentralized markets do not have their incentives aligned with their users, so while the low fees have given them an early edge in adoption, they are not poised for accelerated growth.

2019: embracing centralization

However, there are signs that securities markets will change in the future. EtherDelta’s settlement with the SEC and the FBI’s seizure of 1Broker both point to regulatory correction and that these decentralized markets need regulatory oversight and centralized functions.

For example, how could a decentralized exchange handle Rule 144, a securities law that makes sure a company’s executives or primary shareholders can’t sell off all of their shares at once? There would need to be both a KYC program that identifies users as well as trade volume monitoring so the platform could understand how many shares are being sold. Neither can be done without a central source of authority.

In 2019, we will see a step away from decentralized solutions for securities. Instead, we will see the appearance of centralized marketplaces that are registered broker-dealer ATSs and the implementation of security token standards, including Harbor’s R-Token, Securitize’s DS Token, and ERC-1450, which my team at StartEngine has built. All of these standards have broken the peer-to-peer transfer function, so every transaction requires approval from an on-chain or off-chain database prior to execution.

The reality is that decentralization and securities regulation are incompatible. The benefits of blockchain technology with these markets is not one of radical reinvention, but of more efficient back-ends, smaller margins, and lower fees. It may not be the revolution people talk about, but these are still significant wins for both companies and investors.

StartEngine is a leading equity crowdfunding platform that has helped 250+ companies raise over $80M. We are also currently raising capital. Join the nearly 3,500 StartEngine Owners who have already invested in us. Invest in StartEngine here.

For more information, view our Offering Circular.