Understanding Token Economics — Part 2
Exploring compliance considerations in the development of a tokenomics strategy.
DISCLAIMER: I am not a lawyer and any ideas explored in this article should be discussed with professional legal counsel before implementation.
Protocols and token-governed ecosystems must make many crucial decisions when implementing tokenomics. Besides the mechanical ones described in Part 1, The actions a team must take to ensure they can continue building and operating depend mostly on their time horizons, with short-term projects allowing for much more leeway than long-term ones.
Let’s start off by thinking about the hazy crypto regulatory space in the context of a “gray area,” which is a constantly shifting zone of poorly defined regulatory requirements.
Generally, it takes years for courts to react to things that happen within the gray area, and since crypto-specific regulation hasn’t been well defined, there’s a lot of decision making left up to teams and their counsel. The challenge here is that doing anything overly risky can cause your organization to become totally invalidated, but making the correct decisions can allow your project to significantly disrupt existing markets.
This process is called regulatory arbitrage, and is a battlefield on which innovation and regulation fight to create precedent. Teams who are trying to exit in a short period of time may tend toward the risky end of the spectrum for the sake of short-term market penetration, while teams with long time horizons will be extra cautious to ensure they can achieve their long-term goals.
The SEC’s Perspective
In crypto, making compliance decisions is even more challenging due to the unwillingness of organizations like the SEC to help teams create a real framework for understanding their perspective. Using a ‘regulation by enforcement’ approach, the SEC has sought to establish precedent by punishing select actors with lawsuits in lieu of creating the documentation and resources necessary for teams to refine their compliance strategies.
This approach has stymied innovation in the US, but has allowed the SEC to become the most important voice in the room, as one false move could stop an organization in its tracks.
Let’s take a high level look at what guidance we’ve got from them so far:
- Teams should ensure that their tokens have a clear utility beyond investment purposes
- Teams should avoid marketing their tokens as investments
- Teams should ensure that their tokens are not primarily dependent on the efforts of others for their value
To put simply, any demand for a token should be a function of its utility and any effort to increase awareness of a token should be grounded in that utility and the utilities of the platform it governs. Abiding by these points of guidance will allow your community’s token to retain its status as a ‘digital asset commodity’ and enjoy the relaxed regulatory requirements therein as defined by the CFTC.
A much anticipated regulatory framework is also coalescing in the EU called MiCA, which proposes a new classification for “crypto-assets” and associated regulatory requirements. This is especially exciting as it will create a documented set of guidelines for teams to follow as they seek to engage European markets.
MiCA is focused on transparency and governance, and would ensure companies doing business in the digital asset space have adequate resources and licensure to operate. Teams working within the MiCA framework will need to focus on satisfying the following requirements:
- Authorization: Issuers of crypto-assets, such as cryptocurrency exchanges, would need to be authorized by a national regulatory authority in the EU.
- Disclosure: Issuers of crypto-assets would be required to provide clear and concise information about the nature and risks of the crypto-assets.
- Governance: Crypto-asset issuers would need to establish and maintain effective governance arrangements to manage conflicts of interest, among other things.
- Capital Requirements: Crypto-asset issuers would be required to hold a certain amount of capital.
Though not yet implemented, these requirements reflect many of the industry’s expectations, and give us a good idea of what a real regulatory framework for cryptocurrency in the US might look like in coming years.
The Challenges Facing DeFi
The most difficult part about working in DeFi is that very little of the clarity provided from the SEC, CFTC, or MiCA applies directly to decentralized infrastructure or smart contracts.
Regulatory bodies generally assume crypto organizations are for-profit businesses with centralized infrastructure doing business in centralized spaces. DeFi projects, however, often exist as public infrastructure managed by their users through non-profit entities, with most of the management of crypto-assets being non-custodial and automatic.
Given this reality, the prime directive of DeFi developers is to ensure they are following existing regulatory guidelines to ensure their team can create an efficient solution for users without crossing any regulatory lines.
Adding to this challenge, the efficiency and utility of DeFi platforms is directly correlated with the depth of its liquidity and number of users it has, so creating incentive structures that can serve these needs while avoiding the marketing and mechanical pitfalls described by the SEC and MiCA can feel like walking a tightrope.
The most important consideration for teams designing tokenomics is the users who receive incentives and how. The most obvious pitfall for new DeFi teams is issuing incentives to holders or stakers of their native token, which can easily cause that token to fail the Howey Test, which is touted by the SEC as their primary means of classifying crypto assets.
Let’s think through the Howey test through the lens of single-token staking:
- Issuing yield to token holders, no matter the denomination, would classify purchases of the token as an investment of money.
- Because token holders are pooling their resources to accrue this yield, the behavior could be classified as common enterprise.
- Depending on the token issuer to distribute yield or further adoption of the protocol would constitute relying on the efforts of others.
- Issuing staking rewards or yield would tie an expectation of profit to the token.
To ensure these lines remain uncrossed, we often see teams distributing tokens directly to users of the platform and to liquidity providers instead, which provides a benefit to their protocol without the clear-cut violation of the Howey test. This is because providing incentives to service providers and users of the software is totally natural, and any beneficiaries are taking on risks that are vital to system operations.
With these facts in mind, developers can design tokenomics systems capable of increasing utility and adoption of a DeFi protocol without putting their organization at risk of regulatory capture.
Maintaining compliance within DeFi is a major challenge with no easy solution. Following in the footsteps of top teams in the space and staying as ahead-of-the-curve as possible is important. Studying precedent, moving with the herd, and taking the safe approach is often the best way to keep your organization operational.
Using the ideas explored in this article and the previous one, our team seeks to propose a tokenomics system for the $OATH ecosystem in Part 3 which can facilitate sustainable long-term adoption for the ecosystem.