This article contrasts the SEC’s definition of blockchain with the purist view, and explains why the differences matter for ICOs, cryptoventures, and distributed ledger technology adoption.
September 29, 2017 was a pivotal date for all of us who serve in a fiduciary capacity in the United States as jurists, attorneys, investment advisors. This watershed moment was about blockchain technologies, and with the reveal on a Friday the gravity of what occurred may take a bit of time to seep into the collective consciousness and mature into meaningful guidance.
So what happened last Friday? The SEC is trying to digest blockchain technologies, ICOs, and cryptoventures, giving us an operational definition of blockchain in its 24-page complaint against Recoin LLC, et al., which alleges various acts of fraud under the Securities Act. The SEC definition will set the tone for how the courts define blockchain and laws touching on the blockchain/distributed ledger industry are interpreted.
What makes a distributed ledger a blockchain is hotly debated by even the most illuminated minds in the blockchain space. Specifically, the concern with the SEC definition is that the differences in consensus protocols are given short shrift. Perhaps the SEC does not yet appreciate the differentiation between consensus protocols.
It is likely that the legal definition of blockchain will be calcified to allow for the use of the term “permissioned” blockchain. Over time, perhaps the definition will include some recognition of the differences in, and the significance of, consensus protocols. The SEC still has the opportunity to refine its definition in its brief to the Federal District Court of the Eastern District of New York, and the Court has its turn to settle its definition of a blockchain. The last thing a cryptoventure wants is the SEC or token holders alleging fraud. At the moment, the SEC is not showing that it is examining cryptoventures under a nuanced definition of ‘blockchain.’ The SEC is alleging that REcoin was out of bounds because although promised, “individuals who transferred funds to Zaslavskiy during the REcoin ICO were given nothing—certainly not a designation of any purported REcoin token on any blockchain.” While cryptoventures may celebrate in the short term the SEC does not have a nuanced definition, those who hope to accelerate widespread appreciation and adoption of blockchain technologies will want the SEC to have a honed fraud filter.
Many of the first minds in this space hang their heads in frustration because, in their view, institutions and venture capitalists misapply the term “blockchain” so that the revolutionary features of this technology are implicitly promised by those promoting a ‘blockchain’-based venture, but are actually unavailable in the promoted technology. We are certainly watching a bubble form in the investment market for “blockchain” based ventures. After the bubble bursts, perhaps we will come to an agreement about what blockchains are and are not.. At the moment, however, we have divergent definitions.
Examining the SEC’s Definition of Blockchain, Line by Line
Let’s examine the SEC’s definition and examine it under the concerns of the blockchain purists:
A blockchain is a type of distributed ledger, or peer-to-peer database spread across a network, that records all transactions in the network in theoretically unchangeable, digitally recorded data packages called blocks.
This is big. The SEC picks up an essential point, that blockchains are a subcategory of distributed ledger data structures. Too often, consumers and venturists conflate the two to suggest that blockchain technologies and distributed ledger technologies are synonymous. The SEC appears to define a “distributed ledger” as a “peer-to-peer” database spread across a network.
The SEC also tells us that a blockchain “records all transactions in the network in theoretically unchangeable, digitally recorded data packages called blocks.” It is interesting here too that the SEC choose to not use the term “immutable,” which purists do associate with true blockchains. Instead, they use the term “theoretically unchangeable.”
Each block contains a batch of records of transactions, including a timestamp and a reference to the previous block, linking the blocks together in a chain. The system relies on cryptographic techniques for secure recording of transactions.
The SEC complaint references “mining,” when alleging that REcoin gave explicit references to mining activity (presumably to entice investors) though there was no mining activity. The SEC’s definition of blockchains, however, does not explicitly reference mining. Instead, the definition references “cryptographic techniques for secure recording of transactions.” It is a presumption that the SEC’s definition implicitly references mining. The wording is ambiguous—is the SEC referring to Proof-of-Work as a protocol that enhances the validity of the recorded transactions and makes the ledger immutable? Or is the SEC referring to hashing as a one-way encryption technique of sorts (though encryption is, by definition, two-way)? Where does Ethereum’s Proof-of-Stake protocol fit in?
The Angina Begins
A blockchain can be shared and accessed by anyone with appropriate permissions.
If the purists did not have angina before, they have it now. Many people in this camp believe strongly that the feature that makes “blockchain” revolutionary is that there is no need for federated or centralized entities. In this view, a true blockchain network has full nodes that are peers who all have the opportunity to mine, or participate in the process by which blocks of transactions are created, verified by consensus, and added to a proof-of-work blockchain. Mining in proof-of-work protocols like that of Bitcoin’s blockchain requires the expenditure of energy to solve a cryptographic puzzle. The more entities that mine, the more energy-expensive (and hardware expensive) it becomes for a mining entity to add its proposed block to the blockchain. Participation is incentivized; the wallet associated with the node that beats all others to the first block accepted by the blockchain receives tokens in exchange for its energy expenditure. The security of the blockchain being “theoretically unchangeable” or theoretically tamper-proof comes from this open, gamified, and incentivized mining process in which any node has the opportunity to write to the blockchain. Bad actors, or those who would overwrite one or more blockchain blocks that were previously accepted as valid, would have to expend enormous amounts of energy to outpace every other mining entity in the network combined. Because all peers have copies of the ledger and can optionally store even overwritten data to reference, the ledger is tamper-proof.
Permissioned read/write access means that distributed ledger network is not truly a “peer-to-peer” network. Having permissioned/federated entities in a distributed ledger network generally makes the network both less tamper-evident and tamper-proof.
The Bitcoin blockchain is an example of a “non-permissioned,” or public and open access blockchain. Anyone can download the Bitcoin open-source software and join. All participants share a single view of the Bitcoin blockchain, which is updated when Bitcoin network participants reach a consensus on the validity of transactions under review.
Purists will argue that blockchains are per se “permissionless.” For them, if a distributed ledger is permissioned, it cannot be a blockchain. The Bitcoin blockchain is considered a true blockchain.
‘Permissioned’ or private blockchains are modifications to that model and require permissioned servers to be approved to participate on the network or to access particular information on the blockchain. Blockchains or distributed ledgers can also record what are called smart contracts, which essentially are computer programs designed to execute the terms of a contract when certain triggering conditions are met.
The SEC has landed on a definition which includes both permissioned distributed ledgers and permissionless distributed ledgers in the term “blockchain.” This is not surprising, nor is it necessarily the result of a misinformed view. There are lots of market opportunities and reasons for enterprise permissioned distributed ledgers, as there was always market appetite for permissioned systems in general. These ventures use the term “permissioned blockchain” intentionally and purposefully. After all, the transactions are batched in blocks that are linked to each other. So, there is a chain of blocks, and some kind of consensus protocol. But is that sufficient for a blockchain, really? And what ‘blockchain’ is the SEC referring to when it references “the blockchain”?
Beyond the Bubble
The public does not yet have degree of understanding or the attention span to be as discerning as the hardcore purists. The cognitive leaps it takes to grok that “permissions” and “trust” are not positive terms, that the degree of “security” positively correlates with distributed read/write access is too great to communicate in a pitch deck for most VCs or on a sleek website soliciting token buyers. Pre-bubble burst, the white papers of market-moving ventures will set the tone for how enterprises, jurists, and the consuming (and investing) public will understand blockchain technology. After the bubble bursts, the pendulum will swing back a bit towards the purist’s view at least enough so that some ventures will communicate better where they are on the spectrum of truly permissionless and trustless systems. Already, we see middle layer solution ventures that acknowledged the benefits of both permissioned and permissionless networks, and aim to bridge best of both by the use of their technologies.
Blockchain technologies are the aim of the current gold rush, and the snake oil salespeople are on every corner, polluting a landscape that truly has some revolutionary ventures. The SEC’s lens on blockchain ventures and ICO activities will help deter some bad actors. The SEC’s depiction of what blockchain technology entails, however, may not be robust enough to prevent a cascade of bubbles from forming. The purists will have their distributed cries of “I told you so” as the dust settles.