Security it’s an old concept that could be disrupted with the introduction of the blockchain, DAOs and Oracles. Smart contracts could make capital flows more efficient and remove present capital flow obstacles. Decentralized capital flow could ultimately lead to alternative economic structures.

Prolog

Security is literally a security. I paid you something, and now you owe me. A security could be accompanied by a certificate that expresses the agreement, as sometimes a collateral is involved – but basically, it’s a financial obligation from one party to the other.

A bond from the Dutch East India Company (Vereenigde Oostindische Compagnie), dating from 7 November 1622

The financial obligation is usually based on projected cash flow that the parties wish to partner upon. With debt security, the party has a right to the principal amount payback, the agreed upon interest rate and collateral, in the case of default. In equity security, the party entering into an agreement to own a stake in the company’s assets net its liabilities.

Sometimes securities are public, sometimes private. Public security that anyone could trade or hold has a requirement to report the status of the underlying asset performance. If the security has to be sold to the whole world than the whole world should know the status of the underlying asset. The company which holds such information has the responsibility to publish it.

The case for private securities is different. It’s a deal that takes place between a limited number of parties. They can request information or not, as the public is not part of the equation. Selling a private security to the public is limited to accredited investors, as there is no public information about the company and the later could afford to lose their investment. The SEC recently allowed non-accredited investors to participate in such offerings as well (the Jobs Act), but with a limited nature in the context of a Funding Portal. In fact, Wefunder.com published an ‘open letter to the SEC’ warning about adverse selection because of these limitations. Fundersclub.com also warned about potential issues and chose not to register as an SEC Funding Portal for that reason.

The Evolution Begins

Smart contracts are a different ball game. Because it’s a code running on (usually) public blockchain, it can have the functionalities of securities while making them cheaper and more transparent. They can be even made private when encrypted on the blockchain, as Oraclize.it did by encrypting its queries. Smart securities, at this time, make no discrimination between investors such as the above mentioned accredited and non-accredited types. Cato institute’s paper explains why the distinction between Accredited Investors vs Non-Accredited investors is not effective. For the diligent readers, read economist John Kay’s excellent book “Other People’s Money”, claiming that we are in an over-financialism state where, mainly, banks are trading with each other instead of improving basic financial services.

Smart Securities are essentially a ledger entry expressed by a token, and anyone who holds a token can receive part of the crypto-revenue and use the token to vote with.It is the crypto version of Bearer Stock . Back-up the private keys, a strong blockchain password and it’s yours to control. No Exchange, DTCC or Transfer Agent would get in your way. Ethereum (and soon Rootstock on the Bitcoin network) provide the building blocks for creating securities on the blockchain. Anyone can code a security, which is being executed by the blockchain.

On the other hand, the funds might not be FDIC insured, and there is no big brother that oversee the market (to fight insider trading for example) as SEC and FINRA. While the legal system may protect you against scams (even for crypto currencies), we may need similar overseeing functions as the SEC or FINRA in the crypto sphere. For example Crypto holders can insure themselves peer to peer, and Vitalik Bluterin the founder of Ethereum even suggested decentralized courts on the blockchain to resolve disputes. Alternatively, the industry could police itself. FINRA itself is a self-regulatory organization own by the securities industry (and cooperates with the SEC the governmental agency). The crypto world could create a better and more efficient version of FINRA harnessing technology and reputation systems. For this to become reality an industry standard should be published, similar to the MIT License (intellectual property framework for open source projects). For investors, it is important to know when insiders are cashing out (not a good sign). For example, an Anti-Insider- Trading (AIT) clause, in which main contributors of open sourced projects should disclose all their crypto addresses, would be difficult to enforce.

How to start a crypto organization

To start your own publicly traded crypto organization, you just create an address (the “bank account”). Then you attach and code a smart contract to it (the founders’ relationships sharing control on the expenses and revenues). Now you can fund a project, execute it and compensate investors with just a few lines of code. In the old world, here is the cost of starting a business in Europe and North America.

The DAO aims to be the first Decentralized Autonomous Organization

Is The Future Already Here ?

The recently launched “The DAO” is a good example of the new business models hiding in the trustless crypto world. This is a never-previously-tested innovative approach. It’s a Decentralized Autonomous Organization (sort of, there is still human touch), which is basically a crypto investment club. Members make investment decisions together, expecting a return from a Universal Sharing Platform, a network of smart contracts for products distributing part of their revenue back to the DAO. The token trades on the transparent Ethereum blockchain(here’s everyone who invested in the DAO and more about the ‘Regulatory Agenda for DAOs’)

This is the first real crypto-equity crowdfunding: vote and gets shares of profits in crypto projects. Now you can attach value to open source projects, and The DAO raised $130M (5/18/2016) non-committed capital for investments. It is non-committed because everyone can return their DAO token and claim back their Ether before any investment takes place. The DAO could potentially replace the Ethereum Foundation with its contribution to the eco-system, and one might call it the Ethereum Automated version for the bitcoin core developers.

How The DAO works

The DAO was done through great coding and an innovative conceptual approach. For instance to claim your Ether before an investment you can use split functions. This eliminates the 51% attack, where the majority vote to distribute 100% of funds to itself, and therefore robs the minority through voting. The code allows the minority to split, leaving the majority with only its own funds to rob. Maybe we need such function in politics as well.

Challenges

Relationships inside an organization are defined by their bylaws, a binding legal contract between the company (or the DAO), its shareholders (equity holders!) and between the shareholders themselves. But there’s still a challenge ahead to translate shareholders relationship into code (that would be executed autonomously on the blockchain). For example in the case of a split, funds already invested are left as old-DAO tokens, the minority’s rights in the profit. Now the Majority is left with enough voting power to issue more DAO tokens to itself for free, therefore diluting the (former) minority’s rights (like Mark Zuckerberg allegedly did to Eduardo Saverin).

The solution in the offline world is that the minority would still have participation rights, as pro-rata rights, to keep its investment. In the crypto autonomous world, each investment could be in a form of an SPV (special purpose vehicle) with the funded company acting as a curator or with a multi-signatory setup. Then the creation of more tokens that represent dividend rights is available only with the target company’s approval which is held liable by its clients and business partners. In general, investors learned the hard way, thanks to a long history of past experiences, about participation rights in later rounds, and investment structures complexities. Savvy business persons could take advantage of it and gain control over funds from unaware investors.

Another option would be for smart securities to at least live in a much simpler world. What you see is what you invest. Maybe equity investments should only take place at the pre-seed stage, through crowdfunding just for testing the waters and see the public’s demand for that idea. In that case, it would be like a Kickstarter for equity embedded with a prediction market. Further investments down the line should be directly connected to cash flows or projected return on investment (ROI).

Market cap of digital currencies, are we going to have the same with DAOs? (source: Coincap.io 5/18/16)

Practical examples

Smart securities will enable financing tailored to specific needs, to track its performance and adjust to it. One example is funding a Google Adwords campaign directly through a dedicated smart contract. The repayment of the security could be based on the revenue growth attached to such campaigns. The security is flexible so the funding is dynamic: static funding to accumulate feedback and accelerated in cases of success (traffic is >N), to find the right formula of that campaign. The smart security is expressed using a non-human Oracle — a contract defining desired traffic outcome of the campaign, and releasing fundings for it based on determined criteria.

In that case, investments would go more accurately to where they’re most efficient. That example could work funding supply chain. Using smart securities could adjust itself based on the success of the projects and therefore fund only the most efficient paths.

The security might not only source its funding in the investor crowd but could be itself a faucet or a kind of bot. The value is what the community attached to it. Using the transportation example, the value could be voting rights in the project. The transportation asset owners would pay the highest price to keep their rights of transportation. And therefore, any voting tokens given to a developer would be with a value attached to it. For example, the transportation asset owners would pre-mine 80% of the pool of tokens and distribute 20% to the market while each voting right also has a part in the profits of that transportation project.

To the advanced crypto economics class — what would be the preferred consensus algorithm for the neighborhood transportation example (who and what constitutes mining)?

The impact of A.I.

Autonomous organizations may one day be based on A.I. This would enable the prioritization and to dynamically re-structure projects. The new investment banker will be a bot.

If all of that sound a little futuristic, that’s just because it’s the future itself.

Author: Lior Zysman

About the author: Lior is a attorney and legal advisor to companies in the blockchain space. Special thanks to Matt Chwierut !