DeFi in 5th-Grader Terms, the "Howey" Test, DAO Organization, Lightening Network, and One bitcoin is Going to the Moon

This week's newsletter revisits DeFi in 5th-Grader terms, introduces the "Howey" test, touches on how a DAO can be organized, introduces the Lightening Network, and shares the fun fact that at least one bitcoin is going to the moon. Don't forget to subscribe if you get something out of this newsletter. (As always, no legal or financial advice here.)

(04/04/22) "DeFi" stands for "decentralized finance." And that it what is: financial services offered in a decentralized manner.

Think of a bridge connecting an island to a mainland. Any vehicles wishing to go between the two have to do so by way of that central source. The bridge is like a traditional bank (or exchange, credit union, brokerage house, etc.). The two land pieces are like two customers. Just as the bridge sits between the two land pieces, a bank is an intermediary between two customers, such as a borrower and a seller.

Reminder: "centralization" is a phrase that most properly connotes authority. Traditional finance is generally regarded as centralized because of authority being centralized in an intermediary such as a bank or brokerage firm.

Now presume a large weather event happens and exposes a large mass of ground between the island and the mainland in such a way that people could now freely walk, bike, and drive between them. They no longer have to use the bridge. That would be akin to decentralized finance, where customers would not have to use a bank. (Just to be sure, I am in no way, shape, or form disparaging banks or other intermediaries--right now, just introducing a concept.)

Let's set aside all regulatory issues for this post. Decentralized finance is a broad term that refers to facilitating financial transactions that are not restricted to interacting with a central authoritative intermediary.

Think of borrowing and lending without a bank. For example, consider a community that willingly lends to borrowers directly. An arrangement might be proposed and codified into code on a blockchain to facilitate desired transactions. Or think of a group of people willing to provide liquidity to facilitate direct exchanges of cryptocurrencies.

Professor Kevin Werbach and David Gogel, both of the Wharton School, nutshell things nicely in this article:?https://lnkd.in/g2PNFdUQ.

He defines four requirements for something to be considered DeFi: (1) financial services; (2) trust-minimized operation and settlement on a blockchain; (3) non-custodial design; and (4) systems that are open, programmable, and composable. He also identifies six major DeFi categories — stablecoins, exchanges, credit, derivatives, insurance, and asset management — as well as auxiliary services such as wallets and oracles (external information feeds).?

I will examine DeFi in greater detail in other posts.

But to Clarify the Cryptic: decentralized finance generally refers to enabling financial transactions directly between users by replacing traditional intermediaries, like banks, with code, such as smart contracts, and recording the transactions on a blockchain.

(04/05/22) The "Howey Test" is the framework used to determine whether something is a security in the S.E.C. context.

Word to the wise: if offering chinchillas, whiskey warehouse receipts, oyster beds, and live silver foxes have implicated registration requirements, cryptopreneurs would benefit from being aware of the test.

The chair of the S.E.C., Gary Gensler, offered some prepared comments on Crypto Markets. See,?https://lnkd.in/eNzfaBx9. Although they are said to be his own views, they are worth reading. Several of his comments are worth repeating verbatim.

"The fact is, most crypto tokens involve a group of entrepreneurs raising money from the public in anticipation of profits — the hallmark of an investment contract or a security under our jurisdiction."

"When a new technology comes along, our existing laws don’t just go away."

Congress and the courts have "said, basically, to protect the public against fraud, to protect the public against scammers, people raising money from the public [have] to register and make basic disclosures with a cop on the beat: the SEC."

Is a coin, token, or other digital asset a security?

"The Supreme Court’s 1946 Howey Test, which was about orange groves, says that an investment contract exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others."

Lest you think the?S.EC. is newly broadening its definition to include modern digital snippets of code created out of nothing, Gensler notes: "Even before the Howey test, in the first several years of our federal securities laws, some entrepreneurs were notified that they had to register their offerings of chinchillas, whiskey warehouse receipts, oyster beds, and live silver foxes as securities offerings,?as 'the purported sale of the…property was merely camouflage and not the substance of the transaction.'”

"Issuers of crypto tokens that are securities must register their offers and sales of these assets with the SEC and comply with our disclosure requirements, or meet an exemption. Issuers of all kinds across a variety of markets successfully register and provide disclosures every day."

To Clarify the Cryptic: The Howey Test is used to determine is something is a security, and it is very broad. Anyone considering offering a governance, reward, or other form of digital token or coin would be well served to receive professional advice in connection with their endeavors.

(04/06/22) A DAO (pronounced "dow") is a blockchain-based organizational unit that exists all or in part as code with or without a complementary "off-chain" structure.

"DAO" stands for decentralized autonomous organization. Control is decentralized in that it is distributed across members as opposed to vested in a board of directors, for example. It is autonomous in that it exists as code and operates like a sophisticated vending machine or set of "if-then" statements that simply respond to inputs. It is an organization in that users associate themselves with the DAO by way of NFTs or tokens (often native tokens).

For example, say you wanted to unite a group of people to purchase a golf course (which is one real use, and one that Steph Curry is participating in,?https://lnkd.in/gJjmgcar).

Someone who starts the project could mint NFTs (nonfungible tokens, which are really just ownership records, like deed entries on a blockchain).

Users would then be allowed to acquire NFTs subject to whatever conditions are desired. NFT ownership could be a prerequisite for joining the DAO. Then, the DAO might create a native token. The more tokens users have, the more voting power they have.

Wyoming has gone so far as to officially recognize DAOs as an organization unit. A foundation can be created off-chain (e.g., off the blockchain) to implement the action items favorably voted on by users and made of record via the DAO. Wyoming is positioning itself as the most crypto-friendly stated in the U.S. See?https://lnkd.in/gBx9TXGY. (More on this in later posts.)

DAOs replace traditional corporate structures with smart contracts. Recall, there is merit in thinking of "smart contracts" as dumb code. That is an attractive concept to many. But those wishing to create one or more DAOs should be aware of a number of issues.

Illustrative issues with creating and running a DAO include whether their endeavors implicate SEC-registration requirements, whether their NFTs or tokens amount to securities, who is legally responsible for the actions of the DAO, how a DAO is created, how a DAO is dissolved, implications of the "code is king" notion such that nefarious acts might be characterized as authorized because the code allowed them, and, in reality, the genral sort of issues that typical companies need to be aware of.

To Clarify the Cryptic: Control over a DAO's actions is dictated by users, where concentration of control is usually dictated by the number of governance tokens users own.

(04/07/22) This is worth knowing: Bitcoin's "Lightening Network" sits on top of the underlying Bitcoin network to enable speedy and inexpensive transactions.

A few days ago, I wrote about why on-chain Bitcoin transitions usually take about 30 minutes to be trusted. That is not feasible for everyday transactions, especially micro-transactions, such as buying cups of coffee.

The native Bitcoin network is referred to as a "Layer 1" solution. The Lightening Network, sitting atop Bitcoin's network, is referred to as a "Layer 2."

The technology is not overly straightforward. In short, the Lightening Network handles many intermediate transactions off the underlying Bitcoin network, a.k.a. "off chain." The LN enables an interaction channel to be opened between two entities, directly or indirectly. For example, say a person wants to pay a food vendor. A channel can be opened between then on the LN. Any number of payments can flow to the vendor without being recorded on the Bitcoin blockchain, and very inexpensively, almost free.

If either party wishes to end the channel, they can, and the final net transaction will be recorded on the blockchain.

This is important because the Lightening Network stands to enable everyday transactions. I will provide the example of how many people paid for their lunch today at the BTC conference in Miami.

$10 in Bitcoin was added to anyone's wallet as a promo for downloading and testing it (here, the Exodus wallet). They order lunch and indicate they want to pay via the LN. The vendor presents a QR code on their smartphone. The user cans it via the Exodus app and confirms payment. About three seconds go by and boom, that's it, payment is made and with virtually no fees. Significantly, the traditional networks used by credit cards was not involved.

Aspects of the ecosystem being used in El Salvador leverage the Lightening Network.

To Clarify the Cryptic: The Lightening Network is to the Bitcoin Network sort of like what a company's sales records are to their tax records. A company generally does not report millions of transactions to the IRS. But it does report a level of rolled up revenue and aggregated costs. The analogy is not perfect. But LN allows for any number of transactions to be handled off-chain, quickly and cheaply. Its proponents describe it as a solution to Bitcoin's slow and expensive transaction costs.

(04/08/22) Fun-Fact Friday.

Generally, capital-B "Bitcoin" refers to the overall Bitcoin network and technology. Lowercase-b "bitcoin" refers to individual coins.

A common hype phrase to describe one's bullish outlook on a given asset is that is "going to the moon."

While I absolutely am not commenting on anything financially related to capital-B Bitcoin, apparently at least one bitcoin is slated to go to the moon. See?https://www.moonb.tc/.

The article states that BitMEX and Astrobotic are sending a unique physical coin to the Moon, loaded with 1 Bitcoin.

"The coin will be a registered payload on the Peregrine-1 manifest, and will remain in situ on the Moon’s surface until any enterprising soul goes to collect it. It will have a public vanity address allowing anyone interested to witness its redemption or add some Sats if you’re feeling generous." Id.

"Peregrine-1?is?Astrobotic's first commercial lunar lander due to launch in Summer 2022. It’s another giant leap in space travel and marks the first Western soft landing on the Moon since NASA's Apollo missions of the 1960s and ‘70s. The payload is occupying an official slot on the manifest. It will be the first-ever bitcoin to be on the surface of the Moon, with photographic evidence taken to prove it!" Id.

Some ideas seem out of this world. This is one of them.