Why Bitcoin is a security

A 101 on separating conflicting economic incentives

Recent discussion on whether cryptoassets qualify as securities (“investment contracts”) or pass as functional assets (“utility tokens”) has focused on details like expressed intent (“It’s a cryptocurrency!”) or favored status of buyer classes (“private presale”). Those are side skirmishes.

The bigger question is whether the setup of the asset contains an implicit or express promise that the buyer will, under favorable conditions, reap private returns beyond the initial investment.

Btw, this is an economic analysis, so the Howey test only serves as a guideline. Other jurisdictions have implemented a variety of similar tests and guidelines to safeguard investors. This is of course not legal advice.

For starters, almost all economic entities can be seen as production functions. Resources are allocated, combined, repurposed, and applied to the benefit of the participants: to add value.

This goes for the traditional manufacturing plant just as much as for, say, the Roman Catholic Church, a household, or indeed any nation state. It also goes for blockchain-based entities.

The one obvious exception to this is the market, or more exactly: the economic abstraction of a market. Unlike productive entities, markets don’t accrue or allocate capital, they simply facilitate exchange to maximize, under ideal conditions, combined producer and consumer surplus.

As I’ve discussed before, real marketplaces differ significantly from this economic abstraction, especially under current conditions where algorithmic matching of supply and demand has become a time-critical, IT-intensive endeavor. Most marketplaces have turned into enterprises.

The key question for us is then to determine whether a blockchain-based entity with the express purpose to facilitate exchange (that is, a “cryptocurrency”) operates mostly as an abstract market, or as a market-as-enterprise.

Enterprise and corporation are frequently used synonymously, but enterprise is an economic term and corporation is a legal term. Most, but not all enterprises are incorporated. Not all corporations are also enterprises (economic undertakings).

Blockchain-based entities, if they are incorporated at all, usually employ constructs that hold the legal structure at arm’s length from the production function. This shouldn’t bother us. (Even the Howey test speaks of enterprises, not corporations.)

The absence of a de jure control structure (a hierarchy) doesn’t mean there is no control at all, and the express intent to “decentralize” (a much abused and confused term) doesn’t mean control is not concentrated. Empirically speaking, it usually is.

The first thing we should look for to determine if Bitcoin or any other cryptocurrency operates as an abstract market or a market-as-enterprise is whether we can identify residual claimants.

Abstract markets have no till, so nobody can cup their hands to receive what’s left in there once normal business is done. Enterprises do, and especially for-profit enterprises allocate the residual (the “E” in A = L+E) to the investors, roughly according to their share of total investment.

The Bitcoin production function, just as an example for a “first generation” cryptocurrency, is actually pretty straightforward. Things get a bit more complicated with “second generation” bells and whistles like so-called smart contracts, but not much.

Bitcoin creates and accounts for ownership changes in a virtual asset also called bitcoin (note capitalization). It does this in a somewhat roundabout but intriguing way, and has been quite reliable for almost ten years, at least on a computational level.

The actual effort is outsourced, partly unremunerated, but the heavy lifting, the “mining“, is paid for, also in bitcoin. Bitcoins are freely exchangeable against other virtual or real assets. This happens in exchanges: markets-as-enterprises external to the Bitcoin network.

One thing that speaks in favor of Bitcoin as an abstract market is that there is indeed no central till. All bitcoins are immediately on creation transferred to the winning miners (who also receive bitcoins already in circulation from transferring parties).

So absent a till we should look into whether markets clear — all surpluses go to sellers and buyers — or whether a residual value remains which can be reaped by holding on to bitcoin as an investment instrument (a security), and whether this investment opportunity is indeed deliberate.

The answer to both questions is unambiguously Yes — both conceptually and empirically.

Bitcoin has gone through a series of Malthusian cycles due to the conflicting attention and congestion effects baked into its issuance scheme. In the process it has outclassed most reference assets, in particular “stable” “fiat” currencies like the US Dollar.

Whether this is purely speculative or based on a sustainable and expanding stream of transfers is hotly debated, but clearly transfers are being executed and paid for at any price level.

[Fwiw, the Google search history and exchange rate for bitcoin are highly correlated, although causality isn’t quite clear. Typically for Malthus cycles there are two dynamic processes — attention and congestion — feeding off each other.]

Whether the Malthus cycle was deliberate or just an accepted side-effect, the ultimate goal: significant value appreciation shared widely among bitcoin holders (“hodlers”) is not contested.

It has been understood at least since Hal Finney’s back-of-the-envelope calculation and is used both to promote and to point to the long-term success of bitcoin. Long term value appreciation at the cost of high volatility is seen not as a bug but as a feature.

This is of course the behavior of a highly speculative investment asset with a long-term return horizon, not of a currency which has among other things the tasks to reliably signal value via a price and to circulate at high velocity to facilitate economic activity.

I write about how technology shapes the world we live in.