SEC Orders and Forks Aplenty — Distributed Counsel 19

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SEC Reaches Settlement with EtherDelta’s Former Non-Owner 

In big SEC news number 1, the Commission has procured a settlement and admission of wrongdoing from the guy that used to run EtherDelta.  EtherDelta is a “decentralized” exchange, which means that, theoretically, no one controls it. Traders are matched autonomously using smart contracts on the Ethereum blockchain.  

Decentralized Exchanges or “DEXs” have captured the imagination for two reasons: (1) they follow in the ethos of disintermediation and decentralization that animates much of this sector and (2) if no entity controls a DEX, it cannot be regulated and cannot be shut off.  This for some is very exciting indeed. To the SEC of course, a truly high-functioning DEX is a tish more brackish because, conceptually, the exchange is the best place to regulate.  Think about all the shitcoins (I’m allowed to use this word because Roubini put it in his Congressional testimony) out there in all the countries the SEC can’t touch.  There is no way to police all of this even if you wanted to and the SEC doesn’t.

If you cut off access to the exchanges through regulation, the incentive to create the shitcoin in the first place disappears. No market, no money.  It is a variation on the internet poker theory of regulation–don’t try to shut down all the poker sites, just prohibit the banks from transacting with them.  The problem is that it is hard to prohibit an exchange from doing something if truly no one controls it.

Thus far, DEXs have mainly operated at the margins, failing to capture significant interest from traders due to inherent limitations and low volume.  Here is a fairly concise overview of some of the challenges. But complacency is not an option.  So the SEC brought an action and procured a settlement from the founder of EtherDelta.  The order is available here.

Of note, the SEC did not shut down EtherDelta.  Go ahead and take a look if you dare.  The Respondent in the SEC action is an individual, Zachary Coburn, who used to control EtherDelta.   He agreed to cease and desist from committing securities violations.  But he had already sold EtherDelta to foreign buyers. (See Order at para. 6).  So immediately, questions emerge: (1) if EtherDelta was a true DEX, how could Coburn sell an interest in anything; and (2) why would the SEC target a guy who used to “own” a DEX as opposed to the current operators, besides the obvious fact that they are located in China?

As to the first issue, I have no idea what the sale of EtherDelta to foreign buyers looked like, but I imagine it was something like an assignment of the right to collect fees–the order provides that “[p]latorm fees paid by USers were held in an Ethereum address identified as the ‘fee account’ in the EtherDelta smart contract . . . .”  (Order at para. 22 n.17.) It is unclear whether a separate legal entity ever existed. In posts on Reddit, “Coburn explained that: [a]t a high level, EtherDelta functions just like a normal exchange and [l]ike any other exchange, EtherDelta has an order book of resting orders. However, unlike a traditional exchange, [t]here is no exchange owner holding your funds. Hence, [EtherDelta is] decentralized…. Centralized exchanges won’t be able to show you verified business logic [in a publicly verified smart contract].”  (Order at para. 21 (internal quotations omitted).) Pro tip: if you are not going to register your exchange with the SEC, please don’t say it functions “just like a normal exchange and like any other exchange.” This is the sort of thing that gets brought up in settlement conferences.

Second, is this so bad for Coburn?  He is out of the business by all accounts, so the cease and desist is not all that bad.  He no doubt has made a tidy penny for his efforts and he has only been fined around $400,000.  This is the rough equivalent of fining me $100 and ordering me to cease and desist from playing shortstop for the Tigers.  Painful, yes, but I will do it for the love of the game. This feels like a win for him.

The legal analysis in the Order is unsurprising–even a cursory review of the securities laws would tell you that a smart contract that allows for the sale and purchase of literally hundreds of tokens is probably an exchange under the Exchange Act, and as such would need to be registered under most circumstances.  EtherDelta most certainly was not registered, and thus operated in violation of the law. (See Order at para. 27.)  

What was surprising was the sophistication of the analysis.  Not the securities law, mind you. Of course the SEC knows that stuff cold.  It was all the blockchain stuff–mostly the, dare I say, Wallacian footnotes–that wasabsolutely nailed by the Commission.  There is the paragraph long explanation of the Ethereum blockchain at footnote 10. The de rigeur  citation to Szabo’s Smart Contracts, from 1994 (natch), in footnote 6. Basically, every word in paragraph 10.  

The SEC gets it now, so watch out. Coburn probably helped them.  (See Order at 29 (noting that Coburn’s cooperation “facilitated the staff’s investigation involving an emerging technology”).)


Speaking of which, in big SEC news number 2, the SEC issued some guidance on Friday.  There is a lot to unpack in this and others have done a better job than I would so I will just leave you with the most important quote. 

These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.

What two matters you ask?  That would be Airfox and Paragon, both of whom agreed to (i) pay penalties for failing to register their ICOs with the Commission; and (ii) compensate investors if they elect to make a claim.  What this means in practice is that investors will get their money back, if there is any money left. In case you had not noticed, the price of Ether is down a bit from the ICO heyday.

Many believe this is the start of a reckoning.  A full unwinding of all ICOs that will resemble the Nika riots.  

But if this were true, if nearly every ICO had to be unwound, it is hard to see a realistic path forward. Many, indeed most, investors were anonymous.  They sent Ethereum or Bitcoin from their addresses and received a token in return. There is no assurance these accounts are still controlled by investors.  Nor of course is it realistic to presume that most of these ICO promoters could return the funds if they wanted to do so. They have likely been spent on development, or misspent on conferences and lambos . . . whatever, there is no money.  

In short, there are no easy solutions, and if this really is the SEC’s determined course of action, it is hard to account for the delay.  

Forks Aplenty

Bitcoin Cash forked again, this time as a result of a clash of egos (really, really big ones) and philosophies concerning the one true Bitcoin.  As you will recall, Bitcoin Cash began as a hard fork from Bitcoin in 2017, when a debate concerning block size (and other stuff) proved irreconcilable.  Now the fork is forking.

In the green corner are Roger Ver and Jihan Wu, the CEO of Bitmain.  They are supporting Bitcoin Cash ABC. Their fork will make some rather subtle changes to the Bitcoin Cash protocol to allow more flexibility and the execution of certain types of smart contracts.  In the blue corner is Craig Wright, the Australian who has claimed to be Satoshi Nakamoto. Wright favors a fork that is being called Bitcoin SV (which stands for Satoshi’s Vision). According to Wright, this fork will go back to first principles, the original Bitcoin, without any of the ostentatious frills like . . . well I’m not sure, but this SV stuff will be the pure breed, that I promise you.  

To avoid controversy, I will offer a generalized religious analogy because those always go well (note this is just my impression from Twitter): Bitcoin ABC seems like a spunky, progressive Episcopal club.  The kind where the pastor joins the congregation for beers after the service and they all run a 10k together. Bitcoin SV seems like that sect of Catholicism where the priest only speaks Latin with his back to the congregation and you’re expected to flagelate yourself.  

Wright is claiming that he will actually attack the Bitcoin ABC chain by using the hashpower he controls (miners he controls) to essentially take it over the chain.  This is called a 51% attack, and it works. Time will tell if he has the horses, but the whole thing is ugly and not a good look for the sector right now. There is enormous outside pressure already.  I hate football analogies, but this is a false start on third and 20.

Facebook Replies

In the last installment of Distributed Counsel, Tim Cook laid down the gauntlet.  “Well, the faculty have answered, and answered with vigor” (bonus points for identifying the quote).  Facebook is going full Android. This by itself is almost meaningless; wake me when there is a Facebook mobile feature that is Android-specific (or at least iPhone incompatible), so that the experience is measurably richer for Android users.

Buterin Interview

Breaker Mag had a great interview with the “high-priest” of Ethereum.  Too short for me (so many more questions to ask the guy) but there are some gems here, especially the insights regarding (reluctant) leadership.  

As always, thank you for reading.

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