The Hinman Test

For most companies and projects in the crypto sector, a big issue has been how to design their token and how to get it in the hands of users, validators/miners, and investors. As Joel explained in this post, you need all three stakeholders to create a well functioning crypto-token.

There is the Bitcoin approach, which is to allow anyone to mine the protocol and earn tokens.

There is the Ethereum approach, which is to do a pre-sale.

And there are many other approaches. The last time I looked there were over 2,000 crypto-tokens that are trading on various exchanges around the world and many more that are not yet trading.

There are plenty of considerations when you design a crypto-token but certainly one of them is figuring out how to avoid having it deemed to be a security in the US. Securities are highly regulated in the US, can only be traded on regulated exchanges, come with significant disclosure requirements (many of which make no sense for an open source project), and there are limits to whom you can sell them to and how.

Most token projects and companies look at Bitcoin and Ethereum and say “we want to be like them.”

So when William Hinman, director of the SEC’s Division of Corporation Finance gave a speech at the Yahoo Finance All Markets Summit on June 14, 2018 suggesting that Bitcoin and Ethereum were not securities and laid out an argument that they were sufficiently decentralized, it got a lot of people’s attention in the crypto sector.

The basic reasoning behind the decentralization framework is that if a project is truly decentralized and there is no central actor or actors, then there really is no “issuer” and there is no possibility that the central actor(s) can act on insider information or otherwise have information asymmetry.

The crypto industry has been pressing the SEC to codify this logic in a set of rules that projects and companies can follow. But the SEC has to date been unwilling to do so.

So the Blockchain Association has stepped in and taken a stab at codifying the Hinman Test. In a post they published today, they have laid out the basic arguments of Hinman’s Framework and then outlined how one could determine if a token project was sufficiently decentralized.

This is not as helpful as an SEC published set of guidelines, but until we get that (soon I hope), this will have to suffice.


Comments (Archived):

  1. Adam Sher

    In Joel’s post that you linked to, he spent almost no time discussing what users’ role is and a lot of time discussion the role of miners and investors. One take on the reason for that would be that the users are suckers.Something else from that post that rattled around in my head about the Miner | User | Financier model is that the financier role may obscure the relationship between Miner and User and create a severe negative distortion akin to our healthcare system’s Patient | Doctor | Insurance model does. Maybe you or someone can explain how that comparison is or isn’t applicable.On your point that a tokenized microeconomy is not a security. At the beginning, wouldn’t some ICO’s (i.e. formation of the microeconomy) support a small Miner | User | Financier economy and as such be subject to monopolistic or asymmetric forces?

  2. LE

    they have laid out the basic arguments of Hinman’s Framework and then outlined how one could determine if a token project was sufficiently decentralized.So who is responsible for validating and auditing [1] the representations made then that the test is passed (or whatever)? Who certifies that (nobody, right?). I don’t mean that the SEC says ‘it’s cool’. I mean what method does the SEC or anyone else use to make sure it actually is what it says it is?[1] Edit: Who does the due diligence on this? Who are you trusting?

    1. Adam Sher

      Wouldn’t there be central actors at the beginning?

    2. DJL

      Looks like the Government will have to get into the blockchain compliance business and write blockchain software for audits. Hmm. So much for decentralization.

  3. Pointsandfigures

    Nice discussion on his Medium post. Couple of knits I might haveThere are restrictions in commodity trading. For example if I run the operations of an oil company I can’t trade oil in the futures market for my own account. Commodities aren’t securities but that doesn’t mean there isn’t regulation. To generalize, commodity markets are industrial markets with fewer retail investors.The SEC is charged with protecting retail so I think they will continue to tread carefully on crypto. I might point to the Litecoin founder dumping all his Litecoin and then crying about it and saying he’s now more “unbiased and independent”. Doesn’t seem to hurt Warren. He owns a lot of his own stock Also seems like inside trading no?It’s a very tricky topic and I would like them to come up with principles to he’s to rather than hard baselines like the SEC does with other areas of regulation.

    1. Richard

      The idea that that we should roll back investor protection – because the issuance /accounting is done via a distributed ledger – is absolutely insane. How many times do we need to learn the same lesson that when it comes to controlling criminal activity of the 1/10th of one percent – WALLS are needed – Many insider traders of public equities have gone to prison for far less than what has taken place in the crypto place this past few years. The idea behind regulated public equities is we the public do not have to vet every investment for potential fraud.

    2. Richard

      Woe is me! Why can’t the SEC change definitions and its mandate to protect investors. Well at least we have the NY Regulaltors in our pocket.

  4. bogorad

    I find it pretty hilarious that people pushing for revolution are also seeking rules and validation from the very industry they set out to destroy. It’s like that old meme where young Che and Fidel are laughing in amusement, and the caption says “..and they say ‘you need permission to do that'”.

  5. DJL

    So here is the problem I see:”Therefore, according to this best available SEC guidance, if a token network does not rely — or transitions to stop relying — on a small, centralized group of people, tokens on that network are not securities and, therefore, disclosure rules meant to protect investors should no longer apply.”This tells me that when a token is being launched, it will need to meet all of the SEC requirements (and thus dramatically increase the cost and burden.) But later on, if the network is successful, the restrictions will be “lifted”. So you are going to pay the regulatory “price” no matter what happens.What am I missing?

    1. Adam Sher

      Isn’t it always possible that a small, centralized group of people could harness enough process power to exert control? Or a cartel of miners…

  6. kidmercury

    the rules put forth only add confusion.also, it may help to distinguish between tokens and coins. as i’ve understood it, tokens exist on top of existing blockchains and thus often do not need to concern themselves with the inner workings of miners. a lot of ERC20 tokens on ethereum are like this. coins have their own blockchain like bitcoin, ethereum, EOS, cardano, etc. i’d appreciate it if anyone thinks this understanding is incorrect.i don’t see how the issuer of a token who issues it either freely or through services performed (not distributed via sale) has anything to worry about, even if hte token has financial value. if i give you a picture of my grandmother and you create a derivatives contract for this picture, i don’t see how that makes the picture issuer culpable. i think there are many token projects that would fall under this paradigm, and i don’t see how they could be viewed as in violation of securities laws anywhere.or is this interpretation incorrect?

  7. William Mougayar

    Good to see the Blockchain Association target that SEC statement, and call them to follow through on it. I wrote the same thing on December 12th in my year end CoinDesk piece, but there is a warning here: prematurely decentralizing governance just to pro-rata conform can actually hurt some projects more than benefit them. Some projects have been faking decentralization. That’s why we need the SEC to further define exactly what they mean by that Hinman statement if they stand by it. Even Chairman Clayton repeated it in a recent interview in early December.…“A few months ago, via a speech by one of its commissioners, the U.S. Securities Exchange Commission (SEC) gave a sliver of hope to the viability of tokens. When the network on which the functioning token or coin is sufficiently decentralized, the SEC said the underlying token is not a security, because the existing U.S. Securities Act regime adds little value, due to the lack of central actors.But there is no point rejoicing about that statement because the SEC offered no path to get to that stage, other than to start creating tokens as a security.To date, the SEC has publicly recognized only two such tokens as not securities: bitcoin and ethereum. While this was a positive development, it leaves a huge cloud of doubt and uncertainty over the many other bonafide tokens that deserve a similar acknowledgement.”

  8. Frank W. Miller

    Abuse by those that control the trading of the tokens is only one facet of this which is what these rules seem to focus on. What about rules for those that manipulate the market through other means, like spreading rumors, or non-brokers who act on information they receive prior to it getting out and affecting the price? The level of distribution in the mechanics of the trading these tokens may be necessary wrt regulation, but it it not sufficient.