a history o ---
inancial technology and regulation
Using the lens o --- history, A History o --- Financial Technology and Regulation illuminates
recent changes to the world o ---
inance. With lucid prose and the help o — concrete examples, Seth Oranburg helps readers understand the role o — technology in — inance today, including complex phenomena such as mutual — unds, cryptocurrencies, and the stock market itsel — . Chapters begin with basic principles and historical analogy be — ore describing complex digital-investment strategies and instruments. Readers will also gain an introduction to key concepts in — inancial regulation, learning how law and regulations prevented some — inancial crises while perpetuating others. Oranburg concludes with ideas about what’s next — or — inance and how the law should respond. This book will appeal to specialists and nonspecialists alike who are interesting in learning more about business, economics, — inance, law, and regulation.
Seth C. Oranburg is an award-winning scholar on Law & Entrepreneurship. His work on
Securities Regulation is published in multiple languages and selected as some o --- the best
articles in the --- ield. His scholarship is praised as in --- ormative, interesting, and easily
readable. He teaches Business Associations, Contracts, Financial Skills and Venture
Capital Law at Duquesne University.
Published online by Cambridge University Press Published online by Cambridge University Press A History o — Financial Technology and Regulation
rom american incorporation to cryptocurrency and crowd — unding
SETH C. ORANBURG
Duquesne University
Published online by Cambridge University Press University Printing House, Cambridge cb2 8bs, United Kingdom One Liberty Plaza, 20th Floor, New York, ny 10006, USA 477 Williamstown Road, Port Melbourne, vic 3207, Australia 314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India 103 Penang Road, #05–06/07, Visioncrest Commercial, Singapore 238467
Cambridge University Press is part o --- the University o --- Cambridge.
It --- urthers the University’s mission by disseminating knowledge in the pursuit o ---
education, learning, and research at the highest international levels o --- excellence.
www.cambridge.org
In --- ormation on this title: www.cambridge.org/9781107153400
doi: 10.1017/9781316597736
© Seth C. Oranburg 2022
This publication is in copyright. Subject to statutory exception
and to the provisions o --- relevant collective licensing agreements,
no reproduction o --- any part may take place without the written
permission o --- Cambridge University Press.
First published 2022
A catalogue record --- or this publication is available --- rom the British Library.
isbn 978-1-107-15340-0 Hardback
isbn 978-1-316-60730-5 Paperback
Cambridge University Press has no responsibility --- or the persistence or accuracy o ---
URLs --- or external or third-party internet websites re --- erred to in this publication
and does not guarantee that any content on such websites is, or will remain,
accurate or appropriate.
Published online by Cambridge University Press a history o —
inancial technology and regulation
Using the lens o --- history, A History o --- Financial Technology and Regulation illuminates
recent changes to the world o ---
inance. With lucid prose and the help o — concrete examples, Seth Oranburg helps readers understand the role o — technology in — inance today, including complex phenomena such as mutual — unds, cryptocurrencies, and the stock market itsel — . Chapters begin with basic principles and historical analogy be — ore describing complex digital-investment strategies and instruments. Readers will also gain an introduction to key concepts in — inancial regulation, learning how law and regulations prevented some — inancial crises while perpetuating others. Oranburg concludes with ideas about what’s next — or — inance and how the law should respond. This book will appeal to specialists and nonspecialists alike who are interesting in learning more about business, economics, — inance, law, and regulation.
Seth C. Oranburg is an award-winning scholar on Law & Entrepreneurship. His work on
Securities Regulation is published in multiple languages and selected as some o --- the best
articles in the --- ield. His scholarship is praised as in --- ormative, interesting, and easily
readable. He teaches Business Associations, Contracts, Financial Skills and Venture
Capital Law at Duquesne University.
Published online by Cambridge University Press Published online by Cambridge University Press A History o — Financial Technology and Regulation
rom american incorporation to cryptocurrency and crowd — unding
SETH C. ORANBURG
Duquesne University
Published online by Cambridge University Press University Printing House, Cambridge cb2 8bs, United Kingdom One Liberty Plaza, 20th Floor, New York, ny 10006, USA 477 Williamstown Road, Port Melbourne, vic 3207, Australia 314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India 103 Penang Road, #05–06/07, Visioncrest Commercial, Singapore 238467
Cambridge University Press is part o --- the University o --- Cambridge.
It --- urthers the University’s mission by disseminating knowledge in the pursuit o ---
education, learning, and research at the highest international levels o --- excellence.
www.cambridge.org
In --- ormation on this title: www.cambridge.org/9781107153400
doi: 10.1017/9781316597736
© Seth C. Oranburg 2022
This publication is in copyright. Subject to statutory exception
and to the provisions o --- relevant collective licensing agreements,
no reproduction o --- any part may take place without the written
permission o --- Cambridge University Press.
First published 2022
A catalogue record --- or this publication is available --- rom the British Library.
isbn 978-1-107-15340-0 Hardback
isbn 978-1-316-60730-5 Paperback
Cambridge University Press has no responsibility --- or the persistence or accuracy o ---
URLs --- or external or third-party internet websites re --- erred to in this publication
and does not guarantee that any content on such websites is, or will remain,
accurate or appropriate.
Published online by Cambridge University Press a history o —
inancial technology and regulation
Using the lens o --- history, A History o --- Financial Technology and Regulation illuminates
recent changes to the world o ---
inance. With lucid prose and the help o — concrete examples, Seth Oranburg helps readers understand the role o — technology in — inance today, including complex phenomena such as mutual — unds, cryptocurrencies, and the stock market itsel — . Chapters begin with basic principles and historical analogy be — ore describing complex digital-investment strategies and instruments. Readers will also gain an introduction to key concepts in — inancial regulation, learning how law and regulations prevented some — inancial crises while perpetuating others. Oranburg concludes with ideas about what’s next — or — inance and how the law should respond. This book will appeal to specialists and nonspecialists alike who are interesting in learning more about business, economics, — inance, law, and regulation.
Seth C. Oranburg is an award-winning scholar on Law & Entrepreneurship. His work on
Securities Regulation is published in multiple languages and selected as some o --- the best
articles in the --- ield. His scholarship is praised as in --- ormative, interesting, and easily
readable. He teaches Business Associations, Contracts, Financial Skills and Venture
Capital Law at Duquesne University.
Published online by Cambridge University Press Published online by Cambridge University Press A History o — Financial Technology and Regulation
rom american incorporation to cryptocurrency and crowd — unding
SETH C. ORANBURG
Duquesne University
Published online by Cambridge University Press University Printing House, Cambridge cb2 8bs, United Kingdom One Liberty Plaza, 20th Floor, New York, ny 10006, USA 477 Williamstown Road, Port Melbourne, vic 3207, Australia 314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India 103 Penang Road, #05–06/07, Visioncrest Commercial, Singapore 238467
Cambridge University Press is part o --- the University o --- Cambridge.
It --- urthers the University’s mission by disseminating knowledge in the pursuit o ---
education, learning, and research at the highest international levels o --- excellence.
www.cambridge.org
In --- ormation on this title: www.cambridge.org/9781107153400
doi: 10.1017/9781316597736
© Seth C. Oranburg 2022
This publication is in copyright. Subject to statutory exception
and to the provisions o --- relevant collective licensing agreements,
no reproduction o --- any part may take place without the written
permission o --- Cambridge University Press.
First published 2022
A catalogue record --- or this publication is available --- rom the British Library.
isbn 978-1-107-15340-0 Hardback
isbn 978-1-316-60730-5 Paperback
Cambridge University Press has no responsibility --- or the persistence or accuracy o ---
URLs --- or external or third-party internet websites re --- erred to in this publication
and does not guarantee that any content on such websites is, or will remain,
accurate or appropriate.
Published online by Cambridge University Press What has been will be again, what has been done will be done again; there is nothing new under the sun. Ecclesiastes 1:9
Published online by Cambridge University Press Published online by Cambridge University Press Contents
List o --- Figures page xi
Acknowledgments xii
Introduction 1
the --- irst era: the wild west
1 Under a Buttonwood Tree 7
The Nature o --- Corporations 8
Corporate Limited Liability 8
Corporate Investors 9
Corporate Risk and Reward 10
Corporate Fraud 11
Origins o --- the New York Stock Exchange 13
Free Incorporation 16
The Panic o --- 1837 17
The Free Banking Era 19
Return to National Banking 20
Bibliography 22
2 The Golden Spike 24
Financing the Railroads 26
Pre --- erred Stock 26
Financial Pre --- erences 28
The Gold Standard 29
Bibliography 30
3 Roar and Crash 31
The Ticker 31
Network E ---
ects 33
vii Published online by Cambridge University Press
viii Contents
Sel --- -Regulatory Organizations 34
Bucket Shops 34
Wash Sales 37
Investment Fever 37
Bibliography 39
the second era: electric light
4 A New Deal 43
A --- termath o --- the Crash 44
Keynesian Economic Theory 45
Brandeisian Regulatory Theory 46
The New Deal Securities Regulations 47
Bibliography 49
5 Computational Asymmetry 51
Pre-regulation Investment Advice 52
The Investment Company and Investment Company Act o --- 1940 52
Mutual Funds 53
Diversi --- ication 54
In --- ormation Costs 56
Transaction Costs 56
Agency Costs and Misaligned Interests 56
Computer Power 59
The Index Fund 62
Agency Costs in Index Funds 62
Mistakes Have Been Made 63
Regulation o --- Index Funds 63
Conclusions on Computational Investing 64
Bibliography 65
6 Silicon Valley 67
The Start o --- Startups 68
Early Origins o --- Venture Capital 69
Evolution o --- Venture Capital 70
Modern Venture Capital 75
Reg. D: Private Financing’s Sa --- e Harbor 77
Accredited Investors and Quali --- ied Purchases 78
Bibliography 84
Published online by Cambridge University Press Contents ix
the third era: social media investing
7 The Dot-Com Bubble 87
NASDAQ: The Tech Stock Market 89
Penny Stocks 89
The Dot-Com Bubble 91
The Sarbanes-Oxley Act o --- 2002 93
Bibliography 94
8 Social Media Activism 96
Direct Democratization o --- Corporate Governance 98
Internet Shareholder Voting 98
Regulation FD and Shareholder Collective Action 99
Corporate Gad --- lies 103
In --- luencers 104
Meme Investing 108
Bibliography 109
9 Cryptographic Theory and Decentralized Finance 112
Origins o --- Cryptography 112
Cypherpunks 113
Bitcoin 115
Satoshi Nakamoto: What’s in a Name? 116
Nakamoto’s Emails 118
Cryptocurrency: Private, Not Secret 119
Digital Currency’s Double-Spend Problem 121
Blockchain Technology 123
Investing in Cryptocurrency 123
Bibliography 124
10 Cryptocurrency Regulation 129
Who Regulates Digital Assets? 130
SEC Regulation o --- Crypto-Securities 131
Initial Coin O ---
erings 132 Regulation o — Cryptocurrencies 136 Cryptocurrency Markets 142 Constitutional Questions 144 Bibliography 151
Published online by Cambridge University Press x Contents
11 Crowd --- unding 153
Crowd --- unding’s Origins in the Dot-Com Era 153
The JOBS Act 157
Equity Crowd --- unding in 2021 157
Limited Fundraising 159
Lack o --- Resale Options 160
No Special Purpose Vehicles 162
How Crowd --- unding Could Work 162
Why Should We Care about Crowd --- unding? 169
Bibliography 172
Conclusion 174
Index 191
Published online by Cambridge University Press Figures
1.1 A private banknote issued by Allentown Business College Bank
in 1874 page 20
2.1 Replica o --- the Golden Spike 25
3.1 Western Union Ticker Model 3-A 32
3.2 Cover o --- Fame and Fortune Weekly, May 6, 1921, titled “A --- ter
a Golden State or Breaking a ‘Bucket Shop’ Combine” 35
4.1 Unemployed men queued outside a depression soup kitchen opened
in Chicago by Al Capone 45
5.1 A --- emale “computer” at Langley 59
5.2 Logarithmic increase in processing power, according with Moore’s law 61
6.1 The garage in Palo Alto, Cali --- ornia where the Hewlett-Packard (HP)
corporation began – and where some say Silicon Valley was born 69
6.2 The traditional startup --- inancing timeline 74
8.1 The Kodak price spike 97
9.1 Market share o --- the top --- i --- teen cryptocurrencies in February 2021 115
9.2 Illustration o --- public and private cryptographic keys 120
10.1 Regulation o --- Digital Assets 130
12.1 Financial crises, regulations, and the IPO market --- rom 1973 to 2020 188
xi Published online by Cambridge University Press
Acknowledgments
Thanks to my research assistants, Christian E. Hakim, Joseph R. Stead, and Sarah
D. Shumate-Connor, and to the Duquesne law librarians, Julie Tedjeske, Amy
Lovell, Chuck Sprowls, and Tsegaye Beru, --- or your invaluable contributions to
this book, and to Duquesne University --- or providing the resources to employ you
in this work. Thanks to the Classical Liberal Institute at New York University --- or
sponsoring my research and especially to its codirector Richard A. Epstein --- or his
mentorship and support. Thanks to my colleagues at Duquesne and elsewhere who
read and commented on my dra --- ts, including Lisa Bernstein, Pablo Echeverri,
Richard Heppner, Robert Miller, Wesley Oliver, and Ann Marie Schiavone.
Above all, thanks to my wi --- e, Talia DeFrancesco Oranburg, and my mother,
Penny Oranburg, both o --- whom not only supported me during the production o ---
this book, but who also read dra --- ts, made edits, and provided comments. I am so
lucky to have you all in my li --- e. Thank you.
xii Published online by Cambridge University Press
Introduction
The end is nigh --- or --- inancial regulation. The --- inancial revolution will not be
televised; rather, it will be liked, shared, tweeted, and direct messaged. Data tech-
nology, such as “apps” --- or cellular phones, may prove to be as trans --- ormative --- or
investing as the telegraph or even the Internet. But --- ew people understand how these
technologies impact investing. This book explores the legal dynamics and rami --- ica-
tions o ---
inancial regulations in the digital age and o —
ers readers a detailed, but digestible, account o — corporate — inance history. It pairs lively narrative with brie —
applications o --- economic theory. This provides readers with the historical context
and theoretical --- ramework needed to understand the true nature o ---
inance today – and where — inance is trending. This book — ocuses on the impact o — technology on investing in regulated markets. It identi — ies how legal regulation is lagging behind technology, leaving ordinary investors and main street entrepreneurs without sa — e and pro — itable — inancial options. The current regulatory apparatus is vastly expensive and causes huge wealth disparities. Instead o — providing — or a land o — equal — inancial opportunity, the system protects entrenched interests at the expense o — newcomers. These problems demand that scholars and policymakers study our distended — inancial regulatory system and work to re — orm it. Our story o — U.S. corporate — inance un — olds in three eras. The — irst era began with the rati — ication o — the Constitution in the 1790s and ended with the Great Depression in the 1930s. The second era began with the Securities Act o — 1933 and ended with the Great Recession o — 2007–2008. The third era began with the emergence o —
Bitcoin in 2008 and continues to this day. We are living in the third era o --- corporate
inance. With this timeline in mind, we can see qualities that are particular to each o — these eras. The — irst era is characterized by unbridled capitalism, rugged individualism, and western expansion. In the — irst era, there were many — inancial markets across the young nation, but they were relatively disconnected. Then, technological advances, including the railway and the telegraph, inexorably intertwined the nation o — states into an economic union. By the time that the last continental territory, Arizona, was 1 https://doi.org/10.1017/9781316597736.001 Published online by Cambridge University Press 2 Introduction
admitted as a state on February 14, 1912, a vast network o --- roads, rail, telephone lines,
and power grids knit the United States together as a single economic entity.
Un --- ortunately, that interconnectedness also meant that any --- inancial crisis would
be o --- national proportions.
The second era was characterized by a centralized command-and-control
approach to securities regulation. This began when this nation --- ell into the Great
Depression, which provided the impetus --- or sweeping political and economic
change. This international economic crisis created political instability across the
globe. Americans looked to Uncle Sam --- or help in this desperate time as socialism
and communism swept across Europe. The U.S. --- ederal government responded by
dramatically increasing in size and scope. President Franklin Delano Roosevelt
created a plethora o --- new --- ederal agencies, including the Securities and Exchange
Commission (the SEC). To pay --- or this growing --- ederal bureaucracy, the maximum
ederal income tax was increased — rom about 3 percent in 1932 to over 50 percent by 1944. As Washington, DC, increasingly became America’s political center, New York City increasingly became the locus o —
inancial activity in the United States. Yet amid this period o — centralization and consolidation, an intrepid group o — risk- seekers began developing its own sel — -regulated band o — venture capital investing – an investors’ club limited to the a —
luent. The New York Stock Exchange rose in the East as Silicon Valley rose in the West. Meanwhile the middle o — America did reasonably well. For a time, corporate pro — its seemed to — low to a rising middle class. But by the 1990s, investment had changed. Most public stock were owned by large
irms, not people. The dot-com era was the last hurrah — or public stock markets. A — ter its excesses crashed in Y2K, regulators once again tightened the screws on domestic stock markets. In the third era, however, geographic limitations — all away as the Internet increas- ingly makes — inancial markets ubiquitous and accessible to all. Rising social con- sciousness about wealth inequality and popular notions o — Startup Nation and Silicon Valley have brought about a renewed interest in democratizing entrepre- neurship and investment, while a growing distrust o —
ederal regulators and central- ized banks has brought “cypherpunk” culture – which combines cryptography and anarchy – into the mainstream. Now, anyone can participate in exotic, unregulated
inancial products, like cryptocurrencies, initial coin o —
erings, and decentralized autonomous organizations. The recent rise o — “metaverses,” which are persistent online worlds that have their own societies and economies, is — urther hastening the demise o — any e —
orts to centrally control — inance. In our third era, — inancial law has — allen — ar behind — inancial technology. Federal laws that regulated communications about investment opportunities that were dra — ted during the Great Depression no longer make sense in the digital age. For example, the legislative history o — the Securities Act prohibits — raudulent advertising, but these concepts do not easily map onto a social media world where “in — luencers”
https://doi.org/10.1017/9781316597736.001 Published online by Cambridge University Press Introduction 3
promote companies through “buzz” and “likes.” Further, new technologies allow us
to write sel --- -en --- orcing contracts that eliminate the need --- or courts o --- law and lawyers.
Judges continuously and emphatically struggle to --- it the square peg o --- modern
communication into the round hole o --- traditional advertising and business
practices.
How do we --- urther the dual goals o --- regulation – encouraging the generation o ---
capital while protecting investors? What legal regime would --- it with the --- lexible and
varied nature o --- investment and in the Third Era economy? How do we balance the
bene --- its o --- less regulation with the potential costs o ---
raud and corruption? Is there an e —
icient amount o — regulation, and, i — so, how do we calculate it? By studying the history, theory, and reality o — corporate — inance, this book — inds that, in general, the costs associated with overregulation are vastly underestimated. But the solution is not random deregulation. While reverting to an era o — deregula- tion may seem appealing, the truth is, some regulations are more necessary than others. The question becomes, which regulations should be increased, and which should be diminished? When this question is presented to regulators and policy makers, history shows that very wealthy investors and long-established companies have an oversized impact on the regulatory process. The result are — inancial policies that perpetuate and even increase wealth inequalities, without preventing — inancial crises that are devastating
or ordinary investors and small businesses. This untenable problem causes Americans to lose — aith in capitalism – even i — our current system is really bureau- cratic cronyism masquerading as — ree-market capitalism. The solution requires a reevaluation o —
inancial technology and its regulation.
https://doi.org/10.1017/9781316597736.001 Published online by Cambridge University Press https://doi.org/10.1017/9781316597736.001 Published online by Cambridge University Press The First Era
The Wild West
Published online by Cambridge University Press Published online by Cambridge University Press 1
Under a Buttonwood Tree
In 1792, a hand --- ul o --- would-be stock traders gathered underneath a buttonwood tree on
Wall Street in New York City. They signed an agreement, known as the Buttonwood
Agreement, that would one day grow into the New York Stock Exchange, which is by --- ar
the world’s largest stock exchange today. But, in those days, in --- ormation travelled slowly, so
markets were regional. The --- ederal government was small, and it lacked the resources to
police --- inancial practices in the vast and growing new nation. Citizens were mainly le --- t to
end — or themselves. In this Wild West o — rugged individualism, expansion, and industrial- ization, many stock markets came and went. Small and o — ten shady operations, known pejoratively as bucket shops, let people bet on stock prices without actually selling the stock itsel — . It might be demonstrated that the most productive system o —
inance will always be the least burdensome. – Alexander Hamilton, Federalist Paper No. 35
Most students o --- American history know that our Constitution is based on a strong
belie --- in protecting personal liberty. Indeed, the original Thirteen Colonies that
ormed the United States o — America declared their independence — rom England on July 4, 1776, to secure their inalienable rights to “Li — e, Liberty, and the pursuit o —
Happiness.” Capitalism is a --- orm o --- personal economic liberty, and the Constitution
contemplates a capitalist society. To protect capitalism --- rom social control by the
states, the commerce clause was ensconced in the Constitution.
But the wealthy, landowning Founders surely thought di ---
erently about capital- ism and corporations than we do today. In early America, corporations could only be organized by introducing a private bill in the state legislature, which needed to be passed and signed into law by the governor. Accordingly, there were only six — or- pro — it incorporations in colonial America by 1789. Indeed, the lucky — ew who success — ully lobbied the legislature to grant a corporate charter received an e —
ective monopoly. For this reason, early corporate charters were also known as “patents.” Today, a patent re — ers to the exclusive right granted by a sovereign state to commer- cialize a certain product or to employ a certain process. In colonial days, obtaining 7 https://doi.org/10.1017/9781316597736.002 Published online by Cambridge University Press 8 Under a Buttonwood Tree
the state’s permission to create a corporation was tantamount to an exclusive right to
conduct that line o --- business under the corporate --- orm.
the nature o --- corporations
Modern corporations can be --- reely --- ormed by --- iling some simple --- orms. But why
do people --- orm corporations? And why do governments permit it? The answer to
this --- undamental question requires a little discussion on the nature o --- the
corporate --- orm. The --- ollowing sections provide a brie --- review o --- key corporate
concepts.
corporate limited liability
Corporations are entities that exist separately --- rom the people who --- orm them and
the governments who charter them. Some have even gone so --- ar as to say that
corporations are people, but that is not precisely true. However, corporations do
have certain rights o --- their own, rights which are not derived --- rom the individual
rights o --- their progenitors. Corporations may own property and even have limited
rights to --- ree speech. And, since they have an existence that is separate and inde-
pendent --- rom any particular human being, they can e ---
ectively exist — orever. These characteristics make corporations power — ul vehicles — or the agglomeration o — great wealth. As states increasingly allowed individuals to — orm corporations at will, the corporate — orm drove economic development in early America. The key reason people choose to concentrate wealth in corporations is because investors in corporations cannot lose more money than they invest. This is a concept called limited liability, and it does not exist when a person pursues a trade without a corporate — orm. For example, imagine that Bob, a builder, spends $200 in materials to build a storage shed — or Carry, who pays Bob $300 — or his work and materials. Now Bob has an additional $100 thanks to his work. But what i — the shed collapses due to a de — ect in Bob’s work, destroying Carry’s goods stored there, worth $500? Carry can sue Bob — or $300 to rebuild the shed plus $500 to replace the goods. Bob is now $700 worse o —
than be — ore he started because he has unlimited liability — or injuries caused by his work. What i — Bob — ormed a corporation instead? Imagine that Bob invests $200 in Bob Corp., and Bob Corp. spends $200 in materials and pays Bob $100 in salary to build a shed — or Carry. Bob receives the same $100 that he would have received i — he did the work — or Carry directly, but the result — or Carry is quite di —
erent. When the shed collapses, Carry sues Bob Corp. — or $800, but, a — ter paying — or materials and Bob’s salary, Bob Corp. is broke. Carry cannot recover anything — rom Bob Corp., and Bob is not personally liable — or the injuries caused by Bob Corp. Carry cannot recover
rom Bob — or the injuries caused by Bob Corp. because Bob, an investor, has limited liability.
https://doi.org/10.1017/9781316597736.002 Published online by Cambridge University Press Corporate Investors 9
I --- this result seems un --- air, consider a third scenario where Irina, who is not at
all involved in the operations o --- Bob Corp. and knows nothing about building
sheds, invests $200 in Bob Corp. Should Irina be personally liable --- or Bob’s
shoddy work? What i --- Carry’s shed is destroyed by a --- oreseeable natural disaster,
like a heavy snow --- all in Boston in February, or an un --- oreseeable event, like an
earthquake in Washington, DC? I --- you are still not sure, take this hypothetical to
its extreme example: suppose 20,000 people each invest $0.01 in Bob Corp.
Should all 20,000 o --- those investors be personally liable to Carry --- or her $800
claim?
This simple example highlights several --- undamental issues with corporations
that will run throughout this book. First, limited liability is necessary to attract
outside investors to a business enterprise. I --- investing $0.01 in a single share o ---
Bob Corp. made you personally liable --- or their entire debt, would you risk
losing tens o --- thousands o --- dollars --- or the opportunity to make a --- ew cents? O ---
course, you would not. When you buy Bob Corp. stock, you only risk losing
your penny investment, because investors in corporations have limited liability.
Second, limited liability externalizes the risk o --- corporate --- ailure onto other
people. This is the part o --- the equation that seems un --- air to Carry. But some
concerns about externalizing risks may be mitigated when you think more critically
about the entire situation. First, Carry is aware that Bob Corp. is a limited liability
entity because it has “Corp.” in the name. Indeed, corporations are required to
include a su ---
ix like corporation, incorporation, or company to signal to consumers that they are limited liability entities. Second, with this knowledge, Carry can negotiate — or a lower price or — or other protections. For example, Carry can demand that Bob Corp. obtains insurance be — ore doing the work, or she can hire someone else who will do the work — or more money but will not have limited liability. But these solutions can be limited, especially when a corporation is a monopoly, such that Carry has no alternative choice. And, sometimes, these so-called corporate externalities spill over onto society in general. What i — Carry’s shed — ell not on her property but instead toppled onto and damaged the house o — Ned, her neighbor? Ned will have no recovery against the broke Bob Corp. a — ter the — act, and Ned may have no opportunity to protect himsel — be — ore the — act (although — inancial products like insurance can mitigate some o — these risks). As we will see throughout this book, the issue o — limited liabilities versus corporate externalities is at the heart o — many struggles regarding corporate — inance and securities regulation.
corporate investors
Many people assume that corporate investors are ordinary people like themselves.
But nothing could be --- urther --- rom the truth. Over 80 percent o --- investors in public
stock markets (like the New York Stock Exchange and the NASDAQ) are massive
institutional investors who might control large blocks o --- stock and have power --- ul
https://doi.org/10.1017/9781316597736.002 Published online by Cambridge University Press 10 Under a Buttonwood Tree
voting rights. In private markets, more than 99 percent o ---
unding comes — rom wealthy accredited investors, including angels and venture capitalists. In theory, corporations attract investors in part because o — their structure, which separates ownership and control. The investors who buy stock, called stockholders, technically own the corporation, but the board o — directors (who are appointed by the stockholders) has authority and controls the corporation’s actions. Shareholders have limited rights under corporate law to control a corporation that they own, but shareholders can negotiate — or contract rights o — control. Contractual control rights (like the right o — shareholders to prevent the company — rom issuing more stock, to obtain — inancial in — ormation about the corporation, to prevent other shareholders
rom selling the corporation’s stock, or to have a representative on the board o —
directors) are o --- ten --- ound in private stock purchase agreements. For public com-
panies, shareholders have to --- ind other ways to corral management, perhaps by
manipulating public opinion.
In practice, investors throughout the ages have --- ound it use --- ul or necessary to
maintain some control over corporate management.
corporate risk and reward
Setting aside --- or a moment the debate on limited liability versus corporate external-
ities, we can next examine what people receive when they invest money into
a corporation. People generally do not simply give their money to corporations,
expecting nothing in return. In return --- or their investment, people receive
a “security.” In Part III, The Third Era, we will discuss some o --- the new and exotic
orms o — securities and investment contracts, but, — or now, we will start with the most
amiliar security: common stock. Stock, at its most basic, just re — lects a percent o —
ownership – a “share” – o --- a corporation. Investors buy stock because stock value
increases as the worth o --- the company increases. For example, Alexander Hamilton
ounded the Bank o — New York (BNY) (today, BNY Mellon) in 1792, and he raised money by initially selling 500 shares o — BNY stock to investors. Imagine that BNY sold 125 shares o — its common stock to its — ounder, Hamilton, — or one dollar per share, totaling $125. Then, Mr. Hamilton would own 25 percent o — BNY. Today, BNY is worth about $54 billion, so Mr. Hamilton’s 25 percent would be worth about $13.5 billion. Even accounting — or in — lation, that is a 4,500,000 percent return on investment. Mr. Hamilton’s investment in BNY turned out to be quite good. O — course, things do not always go so well. Most corporations — ail, and 25 percent o — $0 is zero. Sometimes businesses are pro — itable, and sometimes they go bust. But that is the nature o — risk, and, as they say, no risk, no reward. A corporation can — ail — or many reasons, but one particularly troublesome reason is because the corporate managers commit — raud. Consider the Enron Corporation. In early 2001, its managers – whose pay is based on revenues – claimed the corpor- ation had annual revenues o — nearly $101 billion. But, in December 2001, it was
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revealed that the number was basically --- abricated. The stock price tumbled --- rom
$90 per share to $0, and Enron declared bankruptcy. Shareholders lost their entire
investment, and 20,000 people lost their jobs. The risk o ---
raud is a particularly troublesome risk — or investors, but — raud also creates social harm that justi — ies its regulation. Brie — ly reviewing a theory o — social utility is help — ul in understand- ing why.
corporate --- raud
Society must permit some amount o --- risk in order to obtain some rewards. But as we
will see the law protects people --- rom the risk o ---
raud more than — rom other business risks. Why? Because — raud, unlike other business risks, always produces a negative e —
ect on social utility or wel — are. Social utility is an economics concept that roughly equates to worth or value. In — act, economics uses the concept o — utility to predict (or “model”) how people will act based on their expected value — rom a set o — choices. Generally, people are assumed to make choices that will increase their own value, or utility. In other words, economics applies an intrinsic utility — unction as a mathematical mechanism to model how people will behave when presented with a choice. Moreover, i — we can determine how people will generally act given a set o — choices, law can constrain those choices or change the relative costs and bene — its o — those choices to produce a socially desirable result. For example, imagine that Jill is cold, and she would increase her utility (her own value) by one i — she burns old newspapers in her — ireplace. But the smoke — rom the
ire is noxious to her neighbor Kyle, whose utility will decrease by ten i — Jill burns the newspapers. I — le — t to her own pre — erences, Jill will burn the newspapers, because that will increase her utility, even though the net e —
ect on the utility o — this tiny society o —
Jill and Kyle is overall decreased by nine. This presents an economic problem called
a negative externality. A negative externality or “external cost” is an economic
activity that imposes a negative e ---
ect on an unrelated third party. Internal costs and bene — its plus external costs and bene — its combine to equal the total social cost or bene — it — rom an activity. This is also known as social utility or social wel — are. When external costs exceed internal bene — its, laws may be required to prevent this eco- nomic activity — rom taking place and causing a net loss to social wel — are. We see laws designed to increase social wel — are in many contexts. For example, water pollution laws that prohibit a textile — actory — rom discharging toxic dyes into a public lake are intended to curb negative externalities — rom clothing production. Taxes on cigarettes that discourage people — rom smoking are designed to reduce negative externalities — rom tobacco consumption. Applied intelligently, laws could be used to ensure that people willingly engage in economic activity only when there is an expected net bene — it to social utility. Fraud, however, does not produce any net social value. Rather, it serves only to trans — er wealth — rom one person to another. Moreover, the — raudster will spend some
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e ---
ort in conducting the — raud. This is bound to reduce social wel — are. Recall that social wel — are is the total value that society has. The smallest possible society would consist o — just two people. Let’s say that Harry and Sally comprise all o — society — or purposes o — this illustration. Harry has $10 and Sally has $100, so the total social wel — are is $110. Consider the — raud situation — irst. Harry spends his entire net wealth o — $10 on bottling and marketing a — ake health tonic, which he sells to Sally — or her entire new wealth o — $100. Prior to the — raud, Harry had $10, and Sally had $100, so our little society had $110 in social wel — are. A — ter the — raud, Harry has $100 and Sally has zero (she now has no money and no cure, just a worthless bottle o —
ake health tonic), — or a total o — $100. While Harry has gained $90, Sally has lost $100. Society is thus $10 worse o —
in this — raud scenario. The consequences o —
raud are even worse when you consider what else Harry might have done with his time and money i — he were not working on de — rauding Sally. Perhaps Harry could have spent his $10 developing a cure — or Sally’s disease instead o — scamming her. I — Sally values the cure to be worth $200, and she pays Harry $100 — or it, then she would end up with a wel — are or value o — $200 (which is how much she values the cure she now has). Harry would have used his $10 in wealth and e —
ort to end up with $100. In this scenario, the total social wel — are is Harry’s $90 plus Sally’s $200, — or a total o — $290. Society is thus $190 better o —
in this scenario. The little society illustrates an important concept called opportunity cost, which is the loss o — potential gains — or alternative action that were not pursued. I — you simply compare the — raud scenario to the status quo, that is, the situation be — ore the — raud, you will estimate a $10 reduction in social wel — are. But when you consider what else Harry might have done with his time, such as creating a cure — or Sally’s illness, you add the opportunity cost to this equation and — ind that Harry’s — raud made society $200 worse o —
as compared to the alternative situation. Corporate — raud — alls into the textbook de — inition o — an economic concept called “rent-seeking.” Fraud is akin to the — t. Fraudsters seek to increase their share o —
wealth, or “rents,” without creating any new wealth --- or society. Rather, they waste
some o --- their value to e ---
ectuate a wealth trans — er — rom others to themselves. They are social-value leeches who cause total social wel — are to go down not only by spending time and money on de — rauding others but also — rom the opportunity cost o — not spending that time and money on things society needs and wants. But
raudsters are not irrational. Rather, rent-seeking behavior, although sel — ish, is rational. Fraud is not the only waste — ul behavior in — inancial markets. In regulated markets, obtaining regulations that bene — it onesel — is a result worth pursuing through rent- seeking, even i — this results in a regulation that is a net negative — or society at large. Lobbying is a classic example o — rent-seeking behavior, where a business will lobby
or grants, — avors, subsidies, or international protection.
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The theoretical notion o --- rent-seeking was developed conceptually by the “ --- ather
o --- economics,” Adam Smith. He wrote a qualitative analysis in 1776, which was
explicated by Gordon Tullock’s de --- initive 1967 paper, The Wel --- are Costs o --- Tari ---
s, Monopolies, and The — t. Simply put, rent-seeking behavior lowers social wel — are because the actors who engage in rent-seeking divert their energies to pursue trans — ers o — already realized resources instead o — creating new ones. Fraud is likewise an economic “waste” o — e —
orts. Fraud diverts wealth but it does not create wealth. Moreover, the — raudster destroyed wealth inso — ar as his e —
orts could have been put to productive use, creating wealth — or society. Rent-seeking theory — ocuses on the opportunity costs o — engaging in activities that produce a “zero-sum” game (or in some cases, a negative-sum game), rather than a positive-sum game. Corporate — raud is a classic example o — rent-seeking. Although
raud is usually illegal, people commit — raud to increase their own personal wealth. This requires e —
orts by — raudsters to commit and per — ect their cra — t, rather than devoting time to activities that contribute to society. Corporate actors who engage in the — t divert realized resources or assets to increase their own wealth, rather than, — or example, investing that time and energy in securing more — unding, developing a new product, or — ocusing on the growth o — the company. When corporate actors engage in — raud, they simply seek to increase their personal share o — wealth, or “rents,” without creating any new wealth. We can readily relate these concepts to — inancial activity. Now, Harry is a partner at Harry Investment Company. Instead o — searching — or investment opportunities, he spends his time creating — ake reports, so his client Sally does not notice him syphoning part o — the pro — its into his own personal account. Society is worse o —
because o --- Harry’s actions because society must commit to mitigating these actions
in the --- uture, not to mention the opportunity cost o --- Harry actually doing his job and
inding good opportunities — or Sally to invest in. For these reasons, — raud is not a risk that investors should bear. Protecting investors against securities — raud is one o — the primary responsibilities o — securities regulators, and it is especially important where — raud can have negative externalities to society at large. Un — ortunately, as we will see, securities regulators have gotten themselves into the business o — “protecting” investors but also against normal business risks, which has caused many problems in — inancial markets. Indeed, sometimes regulation has the unintended consequence o — harming the people it was designed to help.
origins o --- the new york stock exchange
Since it can be di ---
icult to evaluate business risk, many people hire specialists called brokers to help them invest in corporations. This creates a demand — or pro — essional organization and institutions who deal in the trade o — stock. The story o — sel — -regulated organized stock markets in America begins on May 17, 1792, when twenty- — our brokers
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and merchants met under a tall buttonwood tree on Wall Street in Lower Manhattan.
There, they signed a short document, now known as the Buttonwood Agreement, in
which they agreed to terms --- or buying and selling stock:
We the Subscribers, Brokers --- or the Purchase and Sale o --- Public Stock, do hereby
solemnly promise and pledge ourselves to each other, that we will not buy or sell
rom this day — or any person whatsoever, any kind o — Public Stock, at a less rate than one quarter per cent Commission on the Specie value and that we will give a pre — erence to each other in our Negotiations. In Testimony whereo — we have set our hands this 17th day o — May at New York. 1792.
Note that this simple document is actually a --- orm o --- securities regulation, in that the
Buttonwood Agreement governs how people can buy or sell stock. But the Buttonwood
Agreement is a private contract, not a law passed by Congress or a regulation promul-
gated by a governmental agency. How can a private contract be a securities regulation? It
can because organizations can sel --- -regulate, and thus potentially obviate the need --- or
governmental regulation. Such sel --- -regulatory organizations (or SROs) are discussed in
more detail in Chapter 3, but, --- or present purposes, it is enough to recognize that the
New York Stock Exchange originated as a sel --- -regulated organization.
Astute observers might also notice that the terms o --- this sel --- -regulation bene --- it the
traders who signed the Buttonwood Agreement, at the expense o --- those who are not
a part o --- this small investors’ club.1 We would expect an agreement such as this to
increase the average price that an investor would pay a stockbroker in commissions,
which in turn would have the e ---
ect o — decreasing the number o — trades that are ordered and limiting the number o — people who can a —
ord to participate in the stock market. O — course, the signatories would counterargue that such an agreement is necessary to maintain quality and stability in this emerging stock market. We see throughout — inancial history these arguments — or economic inclusion versus coun- terarguments — or market quality. Generally, the arguments — or quality and sa — ety have prevailed, but the unintended consequence o — such regulations is that the people who are excluded — rom the regulated market — ind alternative ways to partici- pate in unregulated and o — ten unsa — e markets. More troubling, it is usually the poor and unin — ormed who are lured to the danger o — unregulated markets when they are shut out — rom over-regulated ones. The Buttonwood Agreement introduced another key theme: economic crises prompt — inancial regulation. The Buttonwood Agreement was signed just months a — ter the Financial Panic o — 1792, a — inancial crisis caused in large part by easy- lending policies o — the — ledgling Bank o — the United States. This trope – — inancial innovation, boom, bust, then regulation – repeats throughout the eras o — corporate
inance.
1
The Buttonwood Agreement would most likely be illegal today because it --- orms a cartel whose
members agreed on minimum prices, which violates the Sherman Antitrust Act o --- 1890.
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In those early days, very --- ew corporations existed. The only stocks available were
or insurance companies and banks, including the Bank o — the United States, the Bank o — New York, and the Philadelphia Contributionship — or the insuring o —
Houses --- rom Loss by Fire. But the New York Stock Exchange (today known as the
“NYSE”) was primed to become the largest stock market in the world, thanks to
a massive increase in the number and type o --- corporations in America early in the
irst era o — corporate — inance.
Rise o --- Corporations in America
In the colonial period, the right to --- orm a corporation was only granted in special
instances via a complex process that included lobbying the state legislature. As
a result, there were only six --- or-pro --- it corporations chartered in America by 1790.2
Despite the massive hurdles required to --- orm a corporation in the early years o ---
the United States, a --- ew lasting corporations were --- ounded in this period. Many o ---
them were banking corporations. Such banking corporations can create systemic
risks that impact many people beyond the corporation’s shareholders. For this
reason, even today, banking corporations are treated quite di ---
erently — rom regula- tion corporations. It is perhaps in — ormative that banking corporations in the early United States were
ormed by some o — the most power — ul men o — that era. Their competing commercial interests — ueled political rivalries, and occasionally turned deadly. A — amous incident in history illustrates how tightly banking corporations and politics were intertwined in this early era. On July 11, 1804, Alexander Hamilton set out — rom Manhattan be — ore dawn. He rowed through the morning mist across the Hudson River to meet Aaron Burr in Weehawken, where the two were to have a duel. Hamilton was the — irst Secretary o —
the Treasury and --- ounder o --- the Bank o --- New York, who --- amously said that “the debt
o --- the United States . . . was the price o --- liberty.” Burr was the third Vice President o ---
the United States and --- ounder o --- the Bank o --- the Manhattan Company, which is
JPMorgan Chase today. Hamilton and Burr warred about politics, business, and
inance, but public insults made the rivalry personal. Observers disputed who shot
irst, but, when the smoke cleared, the — orty-seven-year-old Hamilton lay mortally wounded. This deadly display o — machismo between two — ounding — athers o —
2 “During the days o --- colonial government there were in all but six o --- these o --- strictly American
origin or character. They came in this order: (i) The New York Company --- or ‘Settleing
a Fishery in these parts,’ 1675; (2) The Free Society o --- Traders, in Pennsylvania, 1682; (3) The
New London Society United --- or Trade and Commerce, in Connecticut, 1732; (4) The Union
Whar --- Company in New Haven, 1760; (5) The Philadelphia Contributionship --- or the insuring
o --- Houses --- rom Loss by Fire, 1768; (6) The Proprietors o --- Boston Pier, or the Long Whar --- in the
Town o --- Boston in New England, 1772.”
Simeon E. Baldwin. American Business Corporations be --- ore 1798, 8 THE AMERICAN HISTORICAL
REVIEW 448, 450 (1903).
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Democratic capitalism captures the rugged individualism o --- this early period o ---
American expansion and investment, the --- irst era o --- corporate --- inance.
ree incorporation In the 1830s, state law began to “democratize” corporations, making their — ormation available to an increasingly broad swath o — the population. Several states began to allow a much wider range o — American entrepreneurs to incorporate through standardized processes, which diversi — ied the corporate — orm. By 1850, the United States chartered at least 13,000 corporations. This expansion continued to modern times. In 2011, over 5.8 million active corporations — iled tax returns with the Internal Revenue Service. As corporations increased in number, so did corporate — inance increase in import- ance to the United States. Governments, like people, invest money in various assets. In the early 1800s, France did not own any corporate stocks, England invested 3 percent o — its total assets in corporate stocks, and the United States had about 10 percent o — its total assets in corporate stocks. By 1850, the United States increased its corporate stock holdings to 18 percent o — its total assets. The national inclination to invest in business corporations was likely a result o —
the Federalist-capitalist perspectives, as expressed by --- ounding --- athers, including
Alexander Hamilton, John Adams, James Madison, John Jay, and many others. The
Federalist party --- ormally organized in 1792 and dissolved in 1824, but in that brie ---
period it made a lasting impression on American democracy and the economy.
But the --- ounders’ ideals o --- individual liberty through --- ree markets and limited
government were constantly attacked by those who wanted the government to
actively advance the rights o --- the common man against a corrupt aristocracy.
Initially, the anti-Federalists, including Patrick Henry, Samuel Adams, and
George Clinton, opposed rati --- ication o --- the Constitution in order to preserve states’
rights against the threat o --- an imperial presidency. While the anti-Federalists --- ailed
to de --- eat the Constitution, they succeeded in passing the Bill o --- Rights, which
limited the powers o --- the newly --- ormed United States central government.
The debate between centralized versus decentralized power un --- olded in other
dimensions as well. In particular, the Federalists tended to be bankers and mer-
chants, whereas the anti-Federalists tended to be landowners and --- armers, who were
generally in --- avor o --- landed interests over moneyed interests. These di ---
erences in philosophy and allegiance were evident when Andrew Jackson, the — irst President who openly rejected Federalist policies, was elected on March 4, 1829. Subsequently, he removed all — ederal — unds — rom the Bank o — the United States, and he permitted the nation’s — irst bank charter to expire in 1836, thus ending America’s — irst central banking experiment. Privately owned bank corporations, however, quickly expanded in number and size during this early period o — liberalized incorporation. From 1790 to 1835, the
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number o --- state-chartered banks increased --- rom 3 to 584, and the total lending power
o --- the American banks rose --- rom $3 million to $308 million. Although the --- ederal
government no longer had its own bank a --- ter 1836, Uncle Sam owned an enormous
amount o --- stock in private banks. Indeed, most o --- the stocks owned by the United
States government during this period were bank stocks. These banks used the
invested --- unds to lend money – that is the --- unction and purpose o --- banks, a --- ter
all – but what were the uses o --- these loans? It appears that some o --- the loans were
used to charter yet more new banks. These new banks, in turn, issued more loans,
potentially --- or investment in even more banks. Banks were thereby engaging in
a leveraged investing.
the panic o --- 1837
Leveraged investing has been accused o --- causing --- inancial crisis throughout history.
To understand the merits o --- these accusations, one must --- irst understand what
leverage means in the context o --- corporate --- inance. Investments that are purchased
with borrowed money are “leveraged.” Investors who purchase stocks using bor-
rowed money can obtain a higher return on capital, but the practice exposes the
leveraged investors to greater risk.
Think o --- leveraged investment in the --- ollowing way. You can use your own money
to buy one share o --- stock --- or $100. I --- the stock value goes up to $110, you gain $10. I ---
the stock value goes down to $90, you lose $10. But what happens i --- you invest using
borrowed money, also called trading on margin? I --- you have a 50 percent margin,
you can invest $100 o --- your own money and $100 o --- borrowed money to buy two
shares o --- stock. I --- the stock goes up to $150, you gain $100, because you gained $50
times two shares (minus interest payments --- or the loan). I --- the stock --- alls to $50,
however, you lose your entire $100 investment, and you still have to pay interest to
the bank. Even worse, i --- the stock goes down to $0, you lose your entire investment,
and you owe the bank $100, plus interest. Be --- ore the stock price goes that low, the
bank will demand that you make a margin call, meaning you must put up more cash.
With margin trading, investors can lose more than their entire investment, and
banks take some o --- the risk.
Margin investing was extremely prevalent in the early nineteenth century. As
a result, seemingly pro --- itable investments could be wiped away overnight. And that
is precisely what happened during the banking boom o --- this time. In hindsight, the
banking boom o --- the 1830s was a bubble – akin to the great real estate bubble o ---
2007–2008.
Upon his reelection in 1933, Jackson began removing --- ederal --- unds --- rom the Bank
o --- the United States to state banks. This began the decentralization o --- the
U.S. banking system. Jackson also began paying down the national debt in an e ---
ort to — urther limit bankers’ power over the country. When the — ederal accounts were tallied on January 1, 1835, the nation was no longer in debt. As the economy
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continued to improve, and as Jackson increased the rate at which the --- ederal
government sold o ---
its land, the — ederal Treasury had a surplus going into 1836. How could paying o —
the national debt lead to a — inancial crisis? It may seem counterintuitive, but a surplus can be as harm — ul as debt, given the wrong policies. The administration’s anti-Federalist policy led them to deposit that — ederal surplus in a number o — state banks. The — ederal government had little control over these state banks, who used the deposits to make new loans. Meanwhile, the — ederal Treasury prepared to distribute much o — the surplus back to the citizenry. Jackson sponsored the Distribution Act o — 1836, which authorized the Treasury to lend the surplus to state government — or capital improvement projects. Jacksonian Democrats advanced
inancial policies that made land available easily and cheaply. This policy could
airly be characterized as populist: common people – — armers, mechanics, and laborers – — avored the notion o — easy access to capital. These policies resulted in easy loans and cheap money, but instead o — helping the common people in the long run, this led to a depression that hit common people the hardest. State o —
icials boosted impossibly ambitious canal and railroad projects. The loans were never repaid. As unsound projects went bust, banks quickly reigned in lending, but it was already too late. Many o — the 584 state banks were impossibly overextended. Not only did they lend money at low rates to state and local govern- ments that seemed increasingly unlikely to ever repay these loans, but the banks had also inadvertently overexposed themselves to the stock market and to systemic risks. Easy lending policies made it possible to use one bank’s notes as investment into other banks’ even more speculative ventures. The high rate o — leverage meant that banks were overexposed to signi — icant stock market risk. When the Bank o — New York realized it was overextended, it tried to correct by raising interest rates and scaling back lending. Investors, however, were no longer able to borrow money to pay — or margin calls when stock prices declined, — orcing them to sell at a loss, which drove stock prices down even lower. The downward spiral continued until the Panic o — May 10, 1837, when banks in New York City stopped making payments. A sustained period o — unemployment and de — lation persisted until 1944. President Martin Van Buren, Jackson’s successor as the leader o — the (Jacksonian) Democratic party and anti-Federalist politician, lost his 1840 reelection bid to William Henry Harrison o — the Whig party, which was built on remnants o — the Federalists. Although history keeps showing that populist — inancial policies may be econom- ically unsustainable, promises o — easy loans and cheap cash remain attractive to many people, and we will see how these policies have led to more recent — inancial disasters. Apparently, we have not learned — rom this crisis that government policies designed to encourage easy lending practices can result in — inancial catastrophes. When governments encourage lending to particular sectors, this creates distortions that ampli — y the e —
ects o —
inancial crisis. Whether the intention is to improve American in — rastructure or to encourage American home ownership, using — iscal
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policy as a tool --- or social change o --- ten creates perverse incentives that lead to
unintended consequences.
In the Panic o --- 1837, banks were highly leveraged in speculative investments, the
political party in power lost control o --- the White House, and ordinary citizens – most
o --- whom were not invested in these banks – lost their jobs and their savings. Banks
and wealthy investors externalized risks onto society at large. As banks --- ailed, people
and corporations who depended on banks – such as --- armers who borrowed money to
buy seed and repay the loan --- rom pro --- its o --- the resulting harvest – lost access to the
capital they needed to survive. Many plantations went bankrupt, which in turn
reduced the --- ood supply and raised --- ood prices. Higher --- ood prices a ---
ected almost every American, especially the least wealthy. In the end, — inancial engineering most seriously harmed the people it was intended to help. And the populist backlash against the corporate — orm was — ierce. Although Jackson and the anti-Federalists lost power in the 1840 election, they struck a critical blow against central banking be — ore leaving o —
ice. Their policy changes impacted how the nation recovered — rom the Panic o —
- While Jackson’s — inancial policy — ailed miserably, his political policy o — decentralizing banking power had succeeded. Jackson — irst crippled the Bank o — the United States, then he killed it. Meanwhile, public opinion o — banks and bankers was at an all-time low. This opened the door to a new era o —
ree banking that would last until the Civil War.
the --- ree banking era
The period --- rom 1837 to 1863 has come to be known as the “ --- ree banking era” in the
history o --- American banking, although the era began its end with the Panic o --- 1857.
This era is probably the most notable period in terms o --- currency in the United
States. Two attempts at establishing a central bank --- or the country had --- ailed. Prior to
the Panic o --- 1837, incorporation or chartering a new bank required an act o --- state
congress. This not only limited the number o --- new banks that could be --- ormed, but
also ensured that lucrative banking privileges would only go to well-connected
people who could in --- luence state legislatures. The Panic engendered public skepti-
cism o --- this crony capitalism.
States responded to bank --- ailures and the credit crunch by passing new laws that
allowed banks to be automatically chartered. Michigan was the --- irst state to allow
ree bank incorporation. Michigan’s Act to Organize and Regulate Banking o — 1837 allowed state banks to operate with very little oversight. New York and Georgia passed — ree banking statutes in 1838. Alabama passed a similar statute in 1849, and New Jersey did the same in 1850. Illinois, Massachusetts, Ohio, and Vermont
ollowed suit in 1851, as did Connecticut, Indiana, Tennessee, and Wisconsin in 1852. Some states imposed reserve requirements, interest rate limits, maximum debt to equity ratios, and other requirements, but this period was primarily characterized
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igure 1.1 A private banknote issued by Allentown Business College Bank in 1874. Such banknotes are a type o — private currency – similar to cryptocurrencies like Bitcoin today. Public domain work.
by loose regulations and little oversight. These banks re --- lected the Wild West
character o --- this --- irst era o --- corporate --- inance in America.
Article I, Section 8 o --- the Constitution reserves the right to coin money to the
ederal government. States cannot mint their own coin and other “hard currency.” But private entities such as banks can e —
ectively create “so — t money” by issuing banknotes. Banknotes were probably the earliest — orm o — paper money. In the eleventh century, the Song Dynasty o — China issued paper notes called “jiaozi” which promised that the bearer could reem the banknote at a later time in exchange
or valuable coins. During the private banking era, American banks and even private corporations such as the Delaware Bridge Company issued banknotes, which the bearer could later exchange — or government-issued currency. Private banks issued their own banknotes against their deposits o — gold and silver. Even drugstores, railroads, and insurance companies issued their own currency. As a result, various private currencies circulated during the — ree banking era. Some notes were not worth the paper on they were printed on. So-called “wildcat banks” were virtually — ree — rom — ederal regulation and only subject to control on the state level. But this does not mean banks were completely autonomous. Economic rules o — supply and demand, social rules regarding reputational e —
ects, and legal rules prohibiting — raud still applied. Although about hal — o — the banks chartered during this period — ailed, the national economy prospered — or much o — this era. This shows that deregulation and decentralization can have a positive impact on the economy.
return to national banking
The prosperity o --- the --- ree banking era ended in 1857 as a series o --- un --- ortunate events
un --- olded. The Ohio Li --- e Insurance and Trust Company, one o --- the country’s largest
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inancial institutions, — ailed. That institution had invested heavily in agriculture by lending money to — armers. This was a good investment while the Crimean War raged in Europe — rom 1853 to 1856. Europeans purchased — ood — rom America while its population was — ighting instead o —
arming. But when that war ended, and the soldiers returned home to their — arms, European — ood production resumed as well. Global — ood prices — ell. Many — arms became unpro — itable and unable to repay their loans. With so many bad loans on its books, Ohio Li — e was not receiving enough income — rom loan payments to pay its other obligations. This bank went bust, and suddenly its promises to pay others became worthless. Five million dollars in private banknotes issued by Ohio Li — e lost their entire value. Worried investors ran to other banks and attempted to redeem paper bank- notes — or gold and silver “specie” currency. Then, the SS Central America sank while carrying $1.5 million in gold bullion. The Bank o — Pennsylvania, unable to access hard money, suspended redemption o — its notes. Other banks — ollowed suit. Businesses were unable to redeem banknotes — or hard cash and so had no way to pay employees but with more worthless banknotes. The end o — the Crimean War, which allowed European nations to access Russia’s bounti — ul grain harvest, a —
ected not just Ohio Li — e’s investments but the entire American economy. The worldwide price o — grain plummeted, which especially impacted — armers in the American west. As — arms — ailed, railroads su —
ered — or want o —
goods to ship back east. The --- low o --- goods --- rom east to west slowed, impacting
regions --- rom New England to Georgia. The lesson here is that the economy is
intertwined in sometimes surprising ways. The --- orces that caused Ohio Li --- e to --- ail
also caused other banks to --- ail. The --- ailure o --- these banks caused other --- irms to --- ail.
Those --- ailures caused even more --- ailures to occur in industries that were not
obviously connected to American agriculture.
It is hard to say whether this --- inancial crisis, which magni --- ied disparities between
the agrarian south and the more industrialized north, was a --- actor leading to the
Civil War. But --- inancial crises do not generally help resolve social problems. And
social tensions between north and south were rapidly escalating. The Con --- ederate
States o --- America, whose economy was signi --- icantly based on slavery, organized and
voted to secede --- rom the Union on December 20, 1860. Although the --- ree banking
era technically ended with the passage o --- the National Banking Act o --- 1863, which
established a system o ---
ederal banks, the — ree banking era had uno —
icially ended already as the nation prepared — or civil war. The — ederal government desperately needed a way to — und the war and a universal currency by which to do it. In 1861, the — ederal government issued its
irst currency through the United States Department o — the Treasury. The Legal Tender Act o — 1862 permitted the government to issue “greenbacks,” aptly named
or their color, and distributed them directly into circulation among the American people allowing them to be used — or public and private debts. The National Bank Act o — 1863, also known as the National Currency Act, established a plan — or
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a --- ederal currency. The National Bank Act o --- 1864 established the new category o ---
banks known as --- ederally chartered national banks. It --- orbade the practice o --- printing
private money and essentially ended wildcat banking in all but the most remote
locations. By the time that Con --- ederate General Robert E. Lee surrendered the last
Con --- ederate army to Union General Ulysses S. Grant at the Appomattox Courthouse
on April 9, 1865, the American banking system was essentially a national system.
The trials and tribulations that the nation --- aced during the Civil War gave weight
to the Federalist’s argument that the --- ederal government should govern the nation in
its entirety, including the currency by which the nation paid its debts. But it would
take several more decades be --- ore the --- ederal government had power to domesticate
the --- inancial Wild West.
The government in the --- irst era struggled with regulating the awesome economic
power o --- the corporate --- orm. Corporations are legal entities, --- ormed under state law,
which exist perpetually and grant limited liability to their investors. These --- eatures
make corporations much more power --- ul economic entities than human beings can
be; a --- ter all, humans cannot live --- orever. Corporations are a compelling reason why
America quickly grew --- rom a war-ravaged huddle o --- colonies to a world power.
However, corporations – and the nature o --- investment into them – are also why
the Panic o --- 1837 a ---
ected not only bankers but also merchants, — armers, and ordinary people. There — ore, lawmakers must be care — ul when implementing
inancial policies, especially ones that encourage loose lending practices.
bibliography
Atack, Jeremy & Peter L. Rousseau, Business Activity and the Boston Stock Market, 1835–1869,
36 EXPLORATIONS IN ECON. HISTORY 144 (1999).
BOARDMAN, FON WYMAN, AMERICA AND THE JACKSONIAN ERA, 1825–1850 (H. Z. Walck eds.,
1975).
CASKEY, JOHN P., THE EVOLUTION OF THE PHILADELPHIA STOCK EXCHANGE (2004).
CHAUDHURI, RANAJOY RAY, THE CHANGING FACE OF AMERICAN BANKING: DEREGULATION,
REREGULATION, AND THE GLOBAL FINANCIAL SYSTEM (2014).
Desai, Mihir A., A Better Way to Tax U.S. Businesses, HARV. BUS. REV., July–August 2012.
Dwyer Jr., Gerald P., Wildcat Banking, Banking Panics, and Free Banking in the United
States, 81 ECON. REV. – FEDERAL RESERVE BANK OF ATLANTA (1996).
FEDERAL RESERVE BANK OF PHILADELPHIA, THE FIRST AND SECOND BANKS OF THE UNITED STATES:
THE HISTORICAL BASIS FOR A DECENTRALIZED FED (2009).
Hannah, Les, Corporations in the US and Europe 1790–1860, 56 BUS. HISTORY 865 (2014).
Khwaja, Asim Ijaz & Ati --- Mian, Rent Seeking and Corruption in Financial Markets, 3 ANN.
REV. ECONS. 579 (2011).
Klapper, Leora et al., Entry Regulation as a Barrier to Entrepreneurship, 82 J. FIN. ECON. 591
(2006).
LANDES, WILLIAM M. & RICHARD A. POSNER, THE ECONOMIC STRUCTURE OF INTELLECTUAL
PROPERTY LAW (2003).
LONG, KATHRYN THE REVIVAL OF 1857–58: INTERPRETING AN AMERICAN RELIGIOUS AWAKENING
(1998).
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Majaski, Christina, Rent Seeking, INVESTOPEDIA (August 28, 2019), https://perma.cc/7SBQ-
BBGR.
Rowley, Charles K., The Intellectual Legacy o --- Gordon Tullock, 152 PUB. CHOICE 29 (2011).
Simeon, E. Baldwin, American Business Corporations be --- ore 1789, 8 AM. HIST. REV. 448 (1903).
SMITH, ADAM, AN INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS (1776).
Sylla, Richard & Robert E. Wright, Corporation Formation in the Antebellum United States in
Comparative Context, 55 BUS. HIST. 650 (2013).
Tollison, Robert D., The Economic Theory o --- Rent Seeking, 152 PUB. CHOICE 73 (2011).
Tullock, Gordon, The Wel --- are Costs o --- Tari ---
s, Monopolies, and The — t, 5 GORDON W. ECON. J. 224 (1967). Willis, Hugh Evander, Capitalism, The United States Constitution and the Supreme Court, 22 KENTUCKY L. J. 343 (1933). Wright, Robert E., US Corporate Development 1790–1860, MEAD (2015).
https://doi.org/10.1017/9781316597736.002 Published online by Cambridge University Press 2
The Golden Spike
As American --- inancial markets grew, so too grew the power and in --- luence o --- the wealthy.
In particular, the Great American Railroad turned millionaires into dynasties. In 1869,
Leland Stan --- ord (the namesake o --- Stan --- ord University) placed a golden railroad spike to
connect the Union Paci --- ic and Central Paci --- ic lines at Promontory Summit, in the Utah
Territory, creating the --- irst transcontinental railroad. This story is legend, but lesser told is
the story o --- how this great in --- rastructure project was --- inanced. The story o --- the railroads is
also a story about an important --- inancial innovation: pre --- erred stock. Chapter two
explores the political problems with this --- inancial solution, which preludes challenges
to come.
The production o --- wealth is the result o --- agreement between labor and capital, between
employer and employed. Its distribution, there --- ore, will --- ollow the law o --- its creation, or
great injustice will be done.
– Leland Stan --- ord
Despite the Depression o --- 1837 to 1843 that --- ollowed the Panic o --- 1837, the nation’s
economy continued to chug along, thanks at least in part to a new technology. The
railroad connected people, products, and in --- ormation across the country. The
railroad is so signi --- icant to the development o --- America that historians have re --- erred
to the mid-1800s as “The Railroad Era.”
While rail cars o --- one sort or another had existed since ancient Greeks drove
wheeled vehicles along grooves in limestone streets, modern railways were not
possible until iron replaced wood, and steam engines replaced horsepower.
Richard Trevithick built the --- irst steam-powered locomotive in 1804 in Wales, but
it was Colonel John Stevens who brought this technology to the United States in
1826. In 1857, George Pullman invented the Pullman Sleeping Car, which made
long-haul passenger travel much more convenient.
But a rail car is useless without a rail line on which it can travel. It is not rail cars,
but rail lines that are the subject o --- this chapter because rail lines turn out to be the
vastly more expensive part o --- the transportation equation. The greatest railway
project o --- that era was the Transcontinental Railroad, which at the time cost over
24 https://doi.org/10.1017/9781316597736.003 Published online by Cambridge University Press
The Golden Spike 25
igure 2.1 Replica o — the Golden Spike. Credit Lucas Hugie, Park Ranger, Golden Spike National Historic Park.
$100 million.1 To put that --- igure in perspective, that amount o --- money in 1865 would
be worth about $1.5 billion today. In contrast, a new boxcar today costs about
$135,000, which amounts to less than $10,000 in 1865 dollars. In --- act, the
Transcontinental Railroad may have been one o --- the most ambitious --- inancial
projects o --- that era.
The entire project was so expensive that its consummation was celebrated by
driving the last railroad spike, a spike made o --- solid 17.6 karat gold, into the ground.2
1
Congressman Oakes Ames (R-MA 1863–73) testi --- ied that the Union Paci --- ic line, which stretched --- rom
Council Blu ---
s, Iowa to Promontory Summit, Utah, cost $60 million. Estimates o — the cost o — the Central Paci — ic Line, which ran — rom the San Francisco Bay to meet the Union Paci — ic at Promontory Summit, range — rom $36 to $51.5 million. These conjoined lines were called the Transcontinental Railroad, despite the — act that the eastern terminus was over 1,300 miles — rom New York City and the East Coast. 2 The Golden Spike symbolized the completion o — the transcontinental railroad. Leland Stan — ord, chie —
inancier o — the transcontinental railroad and — ounder o — Stan — ord University, ceremoniously placed this spike into the — inal railroad tie on May 10, 1869. The golden spike now resides at the Cantor Arts Center at Stan — ord. According to that museum, the spike was never “hammered . . . into anything,” rather it was “gently nudged into a pre-drilled hole[.]” Further, it was immediately removed and put on
https://doi.org/10.1017/9781316597736.003 Published online by Cambridge University Press 26 The Golden Spike
But even shorter rail line construction projects required massive investments. To
pay the great expense o --- rail line construction, a new sort o ---
inancing needed to be developed. In — act, a theme recurring throughout the eras o — corporate — inance is that technological innovation o — ten requires — inancial innovation. This is especially true with large in — rastructure projects. Here, we see how the barons o — the railroad industry invented a new type o — security – pre — erred stock – to incentivize investment in the great railway projects o — the 1800s.
inancing the railroads In 1834, the Baltimore and Ohio Railroad (B&O) ran — rom Baltimore, Maryland, to Harper’s Ferry, West Virginia. The next year, B&O extended its line — rom Baltimore to Washington, DC, and began lobbying the Maryland legislature — or — unds to complete an additional line to Pittsburgh, Pennsylvania. Meanwhile, the Chesapeake & Ohio Canal Company (C&O), which was then unpro — itable (per- haps due to its lack o — access to Pennsylvania’s rich coal — ields), the Eastern Shore Railroad Co., the Maryland Canal Co., and the Annapolis and Potomac Canal Co. also asked Maryland — or capital-improvement — unds. The Maryland Assembly heard a bill on March 9, 1836, which proposed to use public — unds to purchase $8,000,000 o — capital stocks o — the — ive private railroad and canal companies. This is the equivalent o — approximately $208 million today. The Maryland Assembly rejected the bill, but the — inanciers were undeterred. They just needed to — ind a way to make this stock subscription more enticing to the legislature. This called — or a little imagination and resulted in a critical — inancial innovation: pre — erred stock.
pre --- erred stock
The --- inanciers introduced a second bill, which called --- or a stock subscription to
B&O provided that the company guarantee a 6 percent annual dividend to the state.
This was a --- inancial innovation. By combining --- inancial --- eatures o --- equity and debt
securities into a new instrument, the railroad promoters created the --- irst “pre --- erred
stock.” This --- inancial product might seem obvious today, but at the time, this
combination was novel.
We can see this in how the de --- inition o --- “dividend” has evolved. In Webster’s
Dictionary o --- 1828, a “dividend” was de --- ined as “the share o --- the interest or pro --- it o ---
stock.” In other words, the 1828 de --- inition o --- dividend was purely an equity concept.
Now, however, we understand “dividend” to mean a sum o --- money that a corporation
display at the museum at Stan --- ord University (now the Cantor Arts Center). Interestingly, the spike is
only 73 percent gold. A replicate o --- the Golden Spike was taken into space on a Space Shuttle mission
in 1990 and now resides in the Golden Spike National Park, http://cantorcollections.stan --- ord.edu
/objects-1/in --- o/3852; www.roadsideamerica.com/story/64772.
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pays regularly to its stockholders. To put it another way, the de --- inition o --- “dividend”
shi --- ted --- rom a portion o --- the pro --- its to a set percentage like the interest o --- a debt.
The --- act that the common understanding o --- “dividend” now means a set manda-
tory percentage o --- investment as opposed to a pro rata share o --- pro --- its is a direct result
o --- the --- inancial innovation o --- pre --- erred stock. To understand pre --- erred stock – which
is today described as a debt-like type o --- stock – it is help --- ul to --- irst understand debt
and common stock.
Recall --- rom Chapter 1 that corporations can --- inance their operations by issuing
stock to investors or issuing debt to lenders. Lenders who hold debt are entitled to
regular interest payments --- or a set period o --- time, then a return o --- the principal at the
end o --- the term. For example, C&O could have --- inanced its operations by issuing
a 6 percent ten-year bond, which is a type o --- debt. I --- you purchased such a bond --- or
$1000, what would you be entitled to receive?
Assuming simple annual interest (although there are more complex interest
terms), you would receive 6 percent o --- $1000, or $60, each year --- or ten years. At
the conclusion o --- the ten-year term, you would then receive your initial $1000
deposit back. All in, you would earn $600 on this loan. This is calculable in advance
because debt earnings are --- ixed. You will not earn more than $600 on a 6 percent
ten-year $1000 loan under any circumstances.
However, what happens i --- C&O goes bankrupt be --- ore you are --- ully repaid?
Then, you become a creditor. C&O will have a liquidation sale – where C&O sells
its boxcars, steel rail lines, intellectual property, and other assets – to pay its
creditors in their order o --- priority. Un --- ortunately --- or creditors, things like steel
rail lines are worth much less when take --- rom the ground and smelted down than it
cost to install them as railroad lines. In other words, the liquidation value o --- the
assets o --- C&O paled in comparison to its operational value. Thus, a debt investor
runs the risk o --- losing its principal and some o --- the interest payments i --- the debtor
goes belly up. A smart lender will account --- or this by adjusting the interest rate (and
other terms) depending on the risk o --- nonrepayment. The lender’s decision
whether to issue the loan requires in part a calculation o --- C&O’s bankruptcy risk.
Stock earnings, on the other hand, are unlimited, but even more uncertain.
Stockholders own a piece o --- the company, so they are entitled to their share o --- the
pro --- its (i --- any are distributed) and a portion o --- the residual i --- the company is sold.
There is no concept o --- “interest” with regard to common stock. As a common
stockholder, you do not expect to get paid regularly.
In --- act, many common stockholders are never paid at all. For example, Berkshire
Hathaway is an investment company --- ounded in 1929 in Omaha – only miles --- rom
the eastern terminus o --- the Transcontinental Railroad – whose common stock now
costs almost $300,000 per share. But Berkshire Hathaway has never paid its stock-
holders a penny! In --- act, there are many corporations that have never issued
a dividend. Shareholders are not entitled to demand dividends. The board o ---
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directors o --- the corporation decides whether to issue dividends to common stock-
holders, and some choose never to do so.
Why would anyone pay $300,000 --- or a share o --- stock that will never issue
a dividend? Because common stock has --- undamental rights to the value o --- the entire
corporation as a going concern. In --- act, the price o --- all the stock is the same as the
operational value o --- the business. I --- the corporation is sold, the stockholders receive
the residual payment. I --- Warren Bu ---
ett – who is the chairman and CEO o —
Berkshire Hathaway and by --- ar its largest stockholder – decides to sell Berkshire
Hathaway, each stockholder will receive the same price per share as Mr. Bu ---
ett. There are 750 million shares outstanding, so i — someone else values the entire company at $75 billion, each share will be paid $1,000. For the same reason, another investor might be willing to pay you $300 — or your share today, in the hopes it will be worth $1,000 someday. The value o — common stock is tied directly to the value o — the company as a going concern, although the stock has little value i — the company — ails and goes bankrupt. Each common stock share is there — ore worth its percentage share o — the entire business value, called the “residual.” People buy common stock because they estimate that its value will go up, usually because the company as a whole improves. For these reasons, stock is a good investment vehicle — or compan- ies whose operating value exceeds their liquidation value. Pre — erred stock is thus a mix o — both debt and common stock. The proposed B&O “pre — erred” stock subscription o —
ered Maryland its percentage share o — the entire company value, plus a guaranteed amount annually. This is like getting the residual plus interest. In other words, pre — erred stock has all the bene — its o — common stock plus some o — the bene — its o — debt. Debt, however, has bene — its that pre — erred stock does not: debt is paid be — ore stock in a bankruptcy, and the corporation must pay its debtholder their principal back at the end o — the term be — ore paying any stock- holders. This particular combination o —
inancial terms had not existed be — ore. There — ore, pre — erred stock was a — inancial innovation.3
inancial pre — erences B&O’s pre — erred stock proposal initially — ailed in the legislature, but the idea began to take hold in the popular consciousness. Local newspapers reported that the bill “giving a pre — erence to the state in the Baltimore and Ohio Rail Company, was lost.” Constituents began to demand that the Maryland Assembly obtain this 3 The Corporation o — Georgetown, a substantial common stockholder o — B&O, published an editorial in the Baltimore American & Commercial Daily Advertiser that demonstrates how novel and unusual this proposed pre — erence was: “It is to the unreasonable and anomalous character o — the loan that Georgetown objects. Upon what principle o — justice does Maryland claim to receive a certain stipulated dividend, or interest, i — you please, to the exclusion o — all other stockholders, and at the same time to have equal rights with those excluded stockholders in controlling by her vote, the interests and work o — the company?” Note that Georgetown considered the dividend equivalent to an interest payment. BALTIMORE AMERICAN & COMMERCIAL DAILY ADVERTISER, June 2, 1836.
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“pre --- erence,” and the Maryland Assembly demanded additional rights --- rom B&O.
For instance, Maryland negotiated --- or the right to appoint one director --- or every
5,000 shares o --- stock it might hold, a provision designed to give Maryland control
over one third o --- the B&O board o --- directors. When B&O conceded, the bill passed,
and pre --- erred stock was born.
Today, pre --- erred stock has a number o --- other “pre --- erences,” which are discussed
more thoroughly in Chapter 8. Financiers are constantly innovating their o ---
erings to make them more appealing to investors, and concepts such as “dividends,” “participation,” “multiples,” and more have been introduced as needed to make the — inances o — pre — erred stock attractive to venture capitalists. The key lesson — rom the Golden Spike is that — inancial innovation is necessary to advance technological innovation. Novel inventions and di —
erent circumstances present new challenges and opportunities — or — undraising and investment. It is critical that our — inancial regulations permit the right amount o —
inancial innovation.
the gold standard
While the private markets created innovations in corporate --- inance, the --- ederal
government continued to evolve its approach to currency markets. As discussed in
Chapter 1, political thinkers and politicians in the early United States had di ---
erent views about the role o — the — ederal government. The Federalists supported a stronger central government, while the anti-Federalists would cede more power to state and local governments. The Federalists originally had the upper hand regarding — inan- cial policy, but anti-Federalist President Andrew Jackson quashed the National Bank o — the United States in 1836 and ushered in the — ree banking era. Then, the Civil War (1861–1865) necessitated a return to a central — inancial structure. Although there was some — iscal decentralization during Reconstruction (1863–1877), — inancial policy generally continued to trend toward a strong central government. The Constitution gives the — ederal government the exclusive right to mint coins, and it had been doing so pursuant to the Mint Act o — 1792 and its successor, the Mint Act o —
-
Both statutes permitted minting o
gold and silver, but they were replaced again by the Mint Act o — 1873, which permitted minting only o — gold bullion. The Gold Standard Act o — 1900 con — irmed the United States’ commitment to the so-called “gold standard,” which — ixes the international value o — currency to the market price o — gold. The Act e —
ectively assigned value to the — ederal paper money (“greenbacks”) — irst created in 1861, with a guarantee to the public that a certain amount o — paper money was worth, and could be redeemed at will, — or a certain amount o — gold. The problem with this standard was that it handcu —
ed the government in terms o —
in --- luencing monetary policy. Gold is a scarce resource. Gold is --- inite. I --- a certain
amount o --- money is to equal a certain amount o --- gold, then the amount o --- paper
currency the government can issue must be directly correlated to the government’s
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deposits o --- gold. Ergo, paper currency was also --- inite when it was backed by gold.
A --- ter an additional economic downturn and two world wars, the monetary system in
the second era needed an overhaul, in the United States and globally, which
prompted a departure --- rom the gold standard. Perhaps ironically, in the third era,
a nongovernmental cryptocurrency would take the world by storm precisely because
it mimicked the limitation o --- the supply o --- gold. But, --- or now, government money
was as good as gold.
bibliography
Dornbusch et. al., Rudiger, The Gold Standard: Historical Facts and Future Prospects, 1
BROOKINGS PAPERS ON ECON. ACTIVITY 1 (1982).
Evans, Jr., G. H., Early Industrial Pre --- erred Stocks in the United States, 40 J. POL. ECON. (1932).
Evans, Jr., George Heberton, The Early History o --- Pre --- erred Stock in the United States, 19 AM.
ECON. REV. (1929).
Hansmann, Henry and Mariana Pargendler, The Evolution o --- Shareholder Voting Rights:
Separation o --- Ownership and Consumption, 123 YALE L. J. 948 (2014).
Hoch --- elder, David, “Where the Common People Could Speculate”: The Ticker, Bucket Shops,
and the Origins o --- Popular Participation in Financial Markets, 1880–1920, 93 J. AM. HIST.
(2006).
Kiby et. al., Doug, The Golden Spike (In Transition), https://perma.cc/Z82E-UNME.
Stan --- ord University, The Last Spike, https://perma.cc/7XPK-4H9Z.
VELETSIANOS, GEORGE, LEARNING ONLINE: THE STUDENT EXPERIENCE (2020).
White, Richard, For Tech Giants, a Cautionary Tale --- rom 19th Century Railroads on the Limits
o --- Competition, THE CONVERSATION, available at https://perma.cc/SJ9E-BT3M.
https://doi.org/10.1017/9781316597736.003 Published online by Cambridge University Press 3
Roar and Crash
A zeitgeist o --- rugged individualism, --- reedom, and excess characterized the early Roaring
Twenties. America largely avoided the destruction o --- World War I, which decimated Europe
and especially Germany. But these United States were not immune to the turmoil. As the
old nation-states o --- Europe decayed into history, new ideas about government –
Communism and Socialism – enticed those disen --- ranchised by Capitalism. On
September 16, 1920, at 12:01 pm, a group o --- anarchists detonated a bomb in Manhattan’s
Financial District that killed 38, injured 143, and troubled many more. The Wall Street
Bombing was not the last time that an anarchist group would strike against a central locus
o --- capitalism. Meanwhile, Capitalism went to war with itsel --- . On October 29, 1929, the
Great Crash began. On this Black Tuesday, the Dow Jones Industrial Average (DJIA) lost
13 percent o --- its value. The Great Crash ushered in the Great Depression – and a new --- ound
political appetite --- or economic statism, a political system where the government exercises
signi --- icant control over corporate --- inance.
The Sultan asked Solomon --- or a Signet motto, that should hold good --- or Adversity or
Prosperity. Solomon gave him, “this too shall pass away.”
– Edward Fitzgerald, Polonius: A Collection o --- Wise Saws and Modern
Instances (1862)
Just as railroad technology bound America together through its network o --- steel, another
technology emerged that --- orever changed how America shares in --- ormation, in particular,
inancial in — ormation. The modern telegraph was developed in 1832 and subsequently commercialized by Samuel Morse. Morse – the namesake o — Morse code – invented a communications device that conveyed electrical signals via a wire, and it recorded what it received via dots and dashes on a moving paper tape. This paper tape would eventually become the eponymous “ticker” that captured America’s hearts – and wallets.
the ticker
The New York and Mississippi Valley Printing Telegraph Company – known today
as Western Union – incorporated in 1851. Their business model was to demonite the
31 https://doi.org/10.1017/9781316597736.004 Published online by Cambridge University Press
32 Roar and Crash
igure 3.1 Western Union Ticker Model 3-A. WU — irst introduced its popular stock ticker in 1866. The Universal Model 3-A ticker was designed by Thomas A. Edison in 1873 and sold through about 1900. Credit Don DeBold, licensed under CC0-1.0.
new market --- or communication o --- in --- ormation. Through an aggressive policy o ---
acquiring smaller competitors, Western Union quickly came to dominate the market
or telegraph lines. In 1861, Western Union built the — irst transcontinental telegraph. Such rapid expansion was expensive. Western Union — inanced its growth through many rounds o — stock issuances. By 1876, America’s centennial, Western Union had sold $41 million in stock, which equates to a market capitalization o — almost $1 billion today. Western Union also developed innovative telegraph technology that would change — inance — orever. In 1866, Western Union introduced the world’s — irst wide- spread stock ticker. The Hughes Telegraph was the — irst machine capable o — printing text (not just dots and dashes) on the ticker tape. The machine printed a series o —
ticker symbols (e.g., “GE” --- or General Electric Corporation) along with in --- ormation
such as the current price at which corporate stock was being bought and sold.
Thanks to the technological innovation o --- the stock ticker, people across America
could now gain timely and reliable access to in --- ormation that was previously only
available to stockbrokers located inside the New York Stock Exchange (NYSE). The
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ects 33
ticker’s tangible embodiment and widespread availability o --- otherwise esoteric
inancial in — ormation had a huge impact on the democratization o —
inance. Indeed, the stock ticker seemed to capture the public’s popular imagination, as an entire generation learned to “watch the ticker.” Ticker technology also encouraged the centralization o — stock exchanges. While it became easier to “watch the ticker” — rom almost anywhere in America, it became correspondingly harder to watch multiple tickers. Western Union sold access to ticker in — ormation on a per-exchange basis, so it cost double to get access to two exchanges instead o — one. Watching two tickers takes twice as much time as watching one. I — the incremen- tal bene — its o — that second ticker are not worth its costs, people will only watch one ticker. I — one stock exchange is better than another, people will tend to — ocus their e —
orts on the better one. As more people — ocus on a single exchange, that exchange becomes even better because it has input — rom more people. This — eature o — stock exchanges is called a “network e —
ect,” and industries that have strong network e —
ects tend to see consolidation toward one network.
network e ---
ects As people begin to — ocus e —
orts on one ticker and thereby one exchange, the trading volume on that exchange increases. This creates a vicious cycle, where the increased trading volume makes that exchange more valuable, and thus continues to drive people to watch that exchange’s ticker to the exclusion o — others. There — ore, the innovation o — the telegraph and ticker tape technology simultan- eously drove the democratization o — access to stock exchange in — ormation and the centralization and consolidation o — stock trading onto one exchange, the NYSE. To put this another way, ticker technology gave a much broader range o —
Americans access to stock market in --- ormation, but it had the opposite impact
on stock markets themselves.
Ticker technology, however, did not completely obviate the demand --- or alterative
stock exchanges. One reason --- or this is historical. Prior to the telegraph, stock
markets were regional, sheltered --- rom national competition. Buying and selling
stock was limited to people within a geographic region around the market, so each
region required its own stock market.
The Philadelphia Stock Exchange (PHLX) was --- ounded in 1790 as the Board o ---
Brokers, making it the oldest stock exchange in America. In 1834, this success --- ul
group moved trading out o --- co ---
ee shops and into the Merchants Exchange building at 3rd and Dock Streets. That same year, thirteen people — ormed the Broker’s Board in Boston, which would become the Boston Stock Exchange (BSE), the third oldest stock market in America. Underscoring the regional character o — these pre-telegraph exchanges, corporations listed on the BSE were primarily incorporated in Massachusetts.
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Moreover, this localization did not seem to hurt the exchanges. Over the period 1835
to 1869, scholars --- ound that the BSE outper --- ormed the NYSE. As prominent
economic pro --- essor John P. Casey observed, “relatively high communication costs
enabled the regional exchanges to compete in the --- irst hal --- o --- the [nineteenth]
century.” During this pre-telegraph period, multiple regional stock exchanges devel-
oped, and such large entities tend to persist.
However, the telegraph and the ticker greatly reduced communication costs, so
stock exchanges could compete nationally. By the 1860s, New York was clearly the
center o --- America’s economic activity. In 1865, the NYSE relocated to its present
location at 11 Wall Street, which anchored the NYSE on Wall Street as the premier
stock exchange o --- choice --- or brokers, investors, and corporations alike. However, the
Philadelphia and Boston exchanges did not simply disappear overnight. Moreover,
other exchanges have since been established. Why would there be multiple stock
markets when interconnected technology makes it possible --- or there to be only one?
sel --- -regulatory organizations
One reason alternative stock exchanges remained viable is because o --- sel --- -
regulation. Sel --- -regulation is where an industry creates, monitors, and en --- orces its
own adherence to standards. The NYSE, --- or instance, had rules regarding which
companies could list on the exchange and which people could trade on it. Even
today, the NYSE is listed as a “sel --- -regulatory organization” (or “SRO”) in the
Federal Register. NYSE sel --- -regulations pertain to admission o --- members, listing
and delisting o --- companies, o ---
-hours trading, arbitration o — disputes, broker con- duct, and disciplinary rules. Not all — irms or brokers were able to meet the NYSE’s stringent rules. Many o —
those --- irms and brokers elected to trade on the PHLX or BSE – exchanges with less
demanding rules – instead. Even today there are “alternative” stock exchanges, such
as the Canadian Securities Exchange (CSE), which compete by o ---
ering simpli — ied reporting requirements and reduced listing requirements. Moreover, thanks to ticker technology, an entire industry emerged purportedly to serve the “Main Street” investor who could not a —
ord a “Wall Street” stockbroker. The rise and — all o — these so called “Bucket Shops” thus illustrates the unintended consequence o — overregulation.
bucket shops
The proli --- eration o --- the ticker through American society raised public awareness
about investing and stock markets. To some extent, this drove more Americans to
invest in corporations, which is generally help --- ul --- or economic development.
Moreover, as more people participate in stock markets, the in --- ormation they pro-
duce about price and value o --- corporations becomes more accurate. But the ticker
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igure 3.2 Cover o — Fame and Fortune Weekly, May 6, 1921, titled “A — ter a Golden State or Breaking a ‘Bucket Shop’ Combine.” Credit Northern Illinois University Nickels and Dimes Collection.
also --- acilitated a certain type o --- gambling that proved quite problematic. This
gambling on stock markets occurred in bucket shops that popped up across
America in the latter hal --- o --- the nineteenth century, causing problems --- or “investors”
and broader problems --- or society in general.
A bucket shop is a physical location, typically in an o ---
ice building, designed to look like a high-end brokerage — irm. These shops existed — ar beyond Manhattan;
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indeed, bucket shops promised to give a typical Main Street investor access to Wall
Street investment opportunities. There would typically be a board, on which current
stock prices were written, and, o --- course, a ticker machine, the source o --- this data.
But, while this gave the look and --- eel o --- authentic stock brokerage operations, there
are clear di ---
erences between genuine stockbrokers and bucket shop operators. First and — oremost, a bucket shop does not actually buy or sell stock, so the bucket shop customer never becomes a shareholder. Bucket shop operators are not licensed stockbrokers, so they cannot themselves trade stock. Indeed, neither the bucket shop operator nor the client has any expectation o — actually receiving the stock. Instead, the client simply expects to be paid out i — the stock price goes up, or to lose the “investment” i — the stock price goes down. Since no stock purchase or sale actually takes place in a bucket shop, no trade based on this in — ormation ever occurs. There — ore, the “investment” does not actually go to — inance corporations, and the in — ormation about value does not directly impact the prices on the stock market. This creates two direct problems. First, the in — ormation is wasted in the sense that that client’s decision to “buy” or “sell” a stock does not enter the exchange and become re — lected in the overall stock price. There — ore, the price o — a stock does not really re — lect how people truly — eel about its value. Second, and more problematic- ally, this divorces the operator’s interest — rom the client’s interests. Since no stock is ever bought or sold, any payment to a client comes at the expense o — the operator. For reasons that may quickly become obvious, this divergent interest in how a stock will move creates motivation — or mayhem. A traditional stockbroker is a person who buys or sells a stock on the client’s behal — . Such a stockbroker is generally paid in two ways: a — ee to execute a trade, and a percentage o — pro — its — rom that trade. While this payment structure creates a con — lict o — interest with regard to “churning,” which is the incentive — or a stockbroker to make a lot o — trades in order to generate trading — ees, it aligns the stockbroker’s interest with the client regarding the value o — stock. Both stockbroker and client want the stock value to go up because both o — them pro — it in that case. In a bucket shop, on the other hand, the operator’s interests are completely opposite — rom the client’s interests. I — the client makes a bet that the stock price will go up, the bucket shop only earns money i — the stock price goes down. In economic terms, when the interests o — the client and the operators are so sharply opposite, the client bears a substantial “agency cost.” To put it another way, the bucket shop’s interests are directly adverse to the interest o — its “client.” This misalignment o — incentives means that clients need to be wary o — bucket shops, who would like to take advantage o — them, and who are well equipped to take advantage by manipulating in — ormation about stock prices or even attempting to manipulate the stock price itsel — . Thus, the second problem with bucket shops is that — raud was rampant. Some bucket shop — rauds could be passed o —
as mere negligence, like — ailing to keep
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enough cash on hand to pay patrons --- or their winning bets. Other --- rauds were petty,
like writing numbers on the board that did not accurately re --- lect the ticker. Some
rauds, however, had a much wider and more insidious impact on the entire market. Large bucket shops could employ a technique called a “wash sale” to manipulate actual stock prices, cheating the bucket shop client and harming the legitimate market as a whole. While petty — rauds that harm individual “investors” are bad enough, these wash sales had a negative impact on society in general. Some contemporary commentators tried to draw attention to the vice o — bucket shops, which were illustrated as crooked institutions to be broken up in early twentieth- century nickel and dime publications such as Fame and Fortune Weekly.
wash sales
To understand how a wash sale works, --- irst you need to understand how stock market
prices go up and down. In simple terms, stock price goes up when more people want
to buy it, and it goes down when more people want to sell it. Think about a classic
supply-and-demand graph. The demand curve slopes downward, signi --- ying that
ewer people will buy something the more that it costs. The supply curve slopes upward, signi — ying that more people will sell something the more it costs. The market price is where the supply and demand curves meet. I — the demand — or something increases, the demand curve shi — ts to the right, so supply and demand now meet at a higher price. I — the supply o — something increases, the supply curve shi — ts to the right, and the curves now meet at a lower price. Stock works the same way. I — more people want to buy a stock, that increase in demand relative to supply causes the price goes up. I — more people want to sell, that increases supply, and the price goes down. In a wash sale, a bucket shop will notice that a lot o — its clients are betting that a particular stock will go up. To prevent their clients — rom winning this bet, the operator will o —
er to sell a lot o — shares o — that stock. The sudden increase in supply o —
that stock causes its price to go down. Once its price --- alls --- ar enough --- or the clients to
lose their bets, the bucket shop operator repurchases the stock while it is o ---
ered at an arti — icially low price. This increased demand — or buying generally brings the stock back to its market price (although the rapid and unexpected change can also cause unexpected events, known as second-order e —
ects, to — ollow the initial action as a sort o — ripple e —
ect).
investment --- ever
Given this bucket shop’s clients are subject to --- raud and not entitled to shareholder
protections, why would anyone patronize a bucket shop? The answer to this question
is more complicated because it implicates human psychology as well as economic
rationality. The short answer is that NYSE regulations prevented ordinary people
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rom truly investing in stock exchanges. With only about 1000 seats available on the NYSE until the 1900s, authentic brokers paid dearly — or such seats. For example, in 1869, a seat on the NYSE cost about $5000, equivalent to about $90,000 today.1 With so — ew brokers, demand — or broker’s time was high. Since brokers’ pay was based on volume o — trades executed, brokers (who could be choosy with their client) naturally pre — erred to work with larger investors who instead o — smaller ones. Few brokers made time — or small deals. Brokers o — that era typically required a $1000 minimum investment — rom their client, equating to almost $18,000 today. Ordinary people simply could not pay such high minimum investments. Moreover, NYSE rules required margins o — at least 10 percent and trades o — at least 100 shares. As a prominent — inancial historian Brendan Sapien pointed out, “These — inancial requirements e —
ectively prevented the common citizen — rom playing a part in the stock market, allowing only the wealthy to partake in the business o — investing and speculating.” Thus, authentic brokers were out o — reach — or most working-class Americans in this period. The appeal o — becoming an overnight millionaire was not lost on the members o — the working class. Cut o —
rom authentic stock trading, but wishing to pro — it — rom corporate success, an ordinary American would be lured into the bucket shop, where a minimum “trade” could be $15 or less. As Sapien put it in his article Financial Weapons o — Mass Destruction: From Bucket Shots to Credit De — ault Swaps, “to overcome this — inancial barrier, an illegitimate
inancial institution began to emerge, which o —
ered average citizens an a —
ord- able opportunity to seemingly play the market as any wealthy investors would.” For investors, the tale o — bucket shops is a reminder that “i — it seems too good to be true, then it probably is.” Many bucket shop clients were duped and bamboozled because they did not understand the economics behind a get-rich-quick scheme. Unsurprisingly, investors make similar mistakes today. Indeed, some o — the new invest- ment opportunities today make investors prone to the same problems — aced by bucket shop clients o — yesteryear. As we will explore in Chapter 9, many startups now o —
er crypto-currency trading plat — orms. On these plat — orms, people can buy and sell Bitcoin, Ethereum, Litecoin, and other novel — inancial products. But, lately, the crypto-currency trading plat — orms have been accused o — manipulating prices, just as bucket shops did via wash sales. The bucket shop illustrates America’s investment craze at the beginning o —
the twentieth century. People were so eager to pro --- it --- rom stock markets that
they mistook investing --- or gambling – although, as the next chapter points out,
the distinction between gambling, speculating, and investing has never been
clear.
1
Purchasing a seat on the NYSE was itsel --- an investment. Seat prices --- luctuated wildly, but generally
increased over time. In 2006, the NYSE sold its last seat --- or $3.575 million.
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bibliography
BANNER,STUART, SPECULATION: A HISTORY OF THE FINE LINE BETWEEN GAMBLING AND INVESTING
(2017).
Caskey, John P., The Evolution o --- the Philadelphia Stock Exchange, FED. RSRV. BANK
PHILADELPHIA BUS. REV. (2004).
Hannah, Leslie, A Global Corporate Census: Publicly Traded and Close Companies in 1910, 68
ECON. HIST. REV. 548 (2015).
Neal, Larry & Eugene White Lance E. Davis, The Highest Price Ever: The Great NYSE Seat
Sale o --- 1928–1929 and Capacity Constraints, 67 J. ECON. HIST. 705.
O’Reilly v. Morse, 56 U.S. 62.
Sapien, Brendan, Financial Weapons o --- Mass Destruction: From Bucket Shops to Credit
De --- ault Swaps, 19 S. CALIFORNIA INTERDISC. L. J. 411 (2010).
https://doi.org/10.1017/9781316597736.004 Published online by Cambridge University Press https://doi.org/10.1017/9781316597736.004 Published online by Cambridge University Press The Second Era
Electric Light
Published online by Cambridge University Press Published online by Cambridge University Press 4
A New Deal
President Franklin Delano Roosevelt (FDR) championed the theory, rhetoric, and
politics known as the New Deal. The New Deal included new regulation o --- American
business. Under FDR, the U.S. Congress passed the 1933 Securities Act (requiring the
registration o --- sales o --- securities), the 1934 Securities Exchange Act (imposing --- raud
liability on securities o ---
erings), the 1935 National Labor Relations Acts (allowing the
ederal government to regulate workers’ hours and wages), the 1940 Investment Company Act (regulating mutual — unds), and the 1940 Investment Advisers Act (regu- lating anyone who gives advice about trading securities). FDR thereby created the
ederal government’s new — inancial police — orce, the Securities and Exchange Commission (SEC). Federal securities regulation is based on Brandeisian thinking, popularized in the Supreme Court Justice Louis Brandeis’s book, Other People’s Money and How the Bankers Use It. Sunlight is the best disin — ectant; electric light the most e —
icient policeman. – Justice Louis Brandeis
The national economy was riding high during the period a --- ter the First World War
known as the Roaring Twenties. In February 1929, the New York Stock Exchange
(NYSE) increased its membership, known as seats, --- or the --- irst time since 1879. Even
though the NYSE increased the number o --- seats by 25 percent, the resale price o ---
these seats reached their highest price ever (in terms o --- in --- lation adjusted real value)
in 1929. But be --- ore that year ended, the prosperity created by stock markets would
suddenly come to a crashing end.
A cacophonous scene erupted on the trading --- loor o --- the NYSE on October 24,
1929 as the Dows Jones Industrial Average (DIJA) lost 11 percent o --- its value. There
was a brie --- rally on the Friday as a consortium o --- investment bankers led by Richard
Whitney purchased large blocks o --- shares at above-market prices. But this only
halted the slide be --- ore the weekend. When the markets reopened on October 28,
many investors were trading on margin – meaning they were using borrowed money
to buy stock. These margin investors owed interest payments --- or every day that they
held shares bought on margin, making it costly to keep those shares, especially as the
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44 A New Deal
market value o --- those shares declined. Some margin traders who could not a ---
ord these interest payments decided to sell their shares, which drove the market price down — urther, and which in turn — orced other margin traders to sell. This drove the price down — urther, and even investors who owned their stock outright began to panic and to sell. This pushed stock prices down — urther still. The DJIA closed on “Black Monday” at a record loss o — 13 percent and an additional 12 percent loss on “Black Tuesday.” The market lost a staggering $30 billion dollars in just two days. The Great Depression began on so-called Black Tuesday, October 29, 1929, a day that shall live in — inancial in — amy.
a --- termath o --- the crash
The Wall Street Crash o --- 1929 played a major role in ushering in the worldwide
Great Depression that would last --- or years, and its impact was --- elt --- or decades. The
magnitude o --- this --- inancial disaster was unprecedented. All in all, the DJIA --- ell --- rom
a high o --- 5,557 in August 1929 to a low o --- 796.22 in 1932. Indeed, it would not be until
May 1959 that the market would --- ully recover --- rom this loss, when the market --- inally
hit 5,611.27.
One might argue that the stock market crash led in some ways to World War II
and, ultimately, to the Pearl Harbor bombing on December 7, 1941, the day that shall
truly live in in --- amy. The political economy o --- Germany was in serious trouble as the
Great Depression spread worldwide. There, Adolph Hitler rose to power by promis-
ing to make Germany great again. The causes o --- World War II are beyond the scope
o --- this book. But it is worth re --- lecting brie --- ly on why Germany was in such trouble, as
we should learn --- rom the past to consider how to avoid a similar disaster in the
uture. In addition to a worldwide crisis, Germany was repaying reparations — rom World War I. I — you lost a war in that era, you paid reparations. Germany’s territory was carved up, they were under the thumb o — these reparations, and then the entire global economy crashed. This led to the meltdown o — German society and thus to World War II. Even in America, able young men could not — ind work. They were standing in bread lines instead o — assembly lines. The mobster Al Capone opened a soup kitchen, and people were so desperate — or — ood that they ate out o — Al Capone’s hands. When the mobsters are society’s sa — ety net, the world is truly upside down. The impact o — the crash was not merely economic but political and legal as well. American citizens were unemployed and angry. Incumbent President Herbert Hoover, who presided during the Crash, lost the 1932 presidential election in a landslide victory — or Franklin Delano Roosevelt (FDR). FDR, — or his part, won that 1932 election a — ter a campaign promising traditional economic policies includ- ing a balanced budget. A sweeping change in American politics was about to take place. By FDR’s 1936 reelection campaign, he had completely changed his tune
https://doi.org/10.1017/9781316597736.005 Published online by Cambridge University Press Keynesian Economic Theory 45
igure 4.1 Unemployed men queued outside a depression soup kitchen opened in Chicago by Al Capone. Credit National Archives, photo no. 306-NT-165319 c.
about balancing the budget and --- iscal responsibility and instead adopted (his version
o --- ) Keynesian economic theory and Brandeisian regulatory theory.
keynesian economic theory
Keynesian economics – the brainchild o --- John Maynard Keynes, who published
The General Theory o --- Employment, Interest, and Money in 1936 – essentially
posits that, in the short run, governments can lessen the severity o --- recessions and
depressions by spending. In simpli --- ied Keynesian terms, recessions are periods
when aggregate demand is low. Government investment in in --- rastructure and
similar government expenditures can increase demand by injecting cash directly
into the economy, which can create jobs and increase output. Sometimes, a small
investment by the government can create a large economic improvement, and
when this occurs, it is called a multiplier --- actor. This stimulation can lessen, or
even reverse, the harsh e ---
ects o — unemployment and decreased demand during a period o — economic downturn. Keynes also advocated — or the Federal Reserve to
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reduce interest rates to promote private borrowing and spending and to discourage
excessive saving. It is critical to note that Keynesian economics puts the --- ederal
government in a much more active role vis-à-vis the economy as compared with
classical economic theory (which generally prescribed a laissez- --- aire role o ---
government).
Keynes met FDR on May 28, 1934 and explained his theories to the President in
considerable technical detail. A --- ter their meeting, Keynes met with the Secretary o ---
Labor, Frances Perkins, and clari --- ied the multiplier e ---
ect in oversimpli — ied terms. He explained that a dollar spent by the government on a public work’s project is like a dollar given to a grocer, who in turn spends that dollar on supplies — rom the wholesaler, who in turn spends that dollar on supplies — rom the — armer, essentially creating — our dollars’ worth o — output — rom a one-dollar investment. Perkins later noted that Keynes may have overestimated FDR’s understanding o — the underlying mathematical principles behind his ideas and that the meeting may have been more productive i — Keynes had explained his theories in layman’s terms, as he had done with Perkins. Although their initial meeting was brie — , Keynes made a pro — ound impact on the president, who was then a vocal opponent o — the classical laissez- — aire role o — the government. Inspired by Keynes’s theories, FDR’s New Deal set about an unprece- dented expansion o — the — ederal government that FDR enacted between 1933 and 1938. It included the creation o — the Civilian Conservation Corps, the Public Works Administration, the Works Progress Administration, the Resettlement Administration, the Rural Electri — ication Administration, the Civil Works Administration, the Farm Security Administration, the Federal Crop Insurance Corporation, the Social Security Administration, and other government agencies and programs.
brandeisian regulatory theory
On the regulatory --- ront, FDR was inspired by another leading thinker o --- the day,
Justice Louis Dembitz Brandeis. Brandeis was an American Jew born to immigrant
parents --- rom Bohemia who raised him in a secular home. Despite these humble
beginnings, Brandeis graduated Harvard Law School at age twenty and --- ounded
a law --- irm in Boston. Perhaps because o --- his background, Brandeis became well
recognized as the “People’s Lawyer” through his leadership --- or progressive social
causes.
Brandeis was notably anti-corporate. He denounced “cutthroat competition” and,
ironically, also denounced the evils o --- monopoly:
We learned long ago that liberty could be preserved only by limiting in some way
the --- reedom o --- action o --- individuals; that otherwise liberty would necessarily yield
to absolutism; and in the same way we have learned that unless there is regulation o ---
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competition, [capitalism’s] excesses will lead to the destruction o --- competition, and
monopoly will take its place.
In 1914, Brandeis published the book Other People’s Money and How the Bankers
Use It, which attacked investment --- unds and called --- or a breakup o --- the so-called
Money Trust – the cabal o --- investment bankers who had abused the public trust and
taken control o --- numerous industries. He also coined a phrase which would become
the watchwords o --- the New Deal regulatory regime: “Publicity is justly commended
as a remedy --- or social and industrial diseases. Sunlight is said to be the best o ---
disin --- ectants; electric light the most e ---
icient policeman.” In 1916, President Woodrow Wilson nominated Brandeis to the Supreme Court, to which he was con — irmed on June 1 o — that year. During his subsequent twenty- three years o — service on the bench, Brandeis became one o — the most in — luential members o — that high court. Jacket Library Publishers reprinted Brandeis’s polemic essays in 1933, resurrecting the attack on investment — unds re — lected in popular opinion at the time. American sentiment — avored expansive New Deal regulations. Other People’s Money supported the breakup o — the Money Trust. Its more — amous passages are o — ten quoted in support o — New Deal-era securities regulations.
the new deal securities regulations
Amid this zeitgeist, the government was galvanized to prevent another market crash
with --- ederal securities regulations. The New Deal included --- our major pieces o ---
ederal securities regulations, which created the Securities and Exchange Commission and established a — ederal governance over investments.
Securities Act o --- 1933
The Securities Act o --- 1933 regulates the sale and initial o ---
ering o — “securities.” Securities is de — ined broadly to include sales o — stock and other “investment con- tracts,” which are the “investment o — money in a common enterprise with pro — its to come solely — rom the e —
orts o — others.” The Securities Act requires investments to be registered with the Securities and Exchange Commission, unless they are exempt. There — ore, stock should always be analyzed with the Securities Act registration requirements (and exemptions to these requirements) in mind.
Securities Exchange Act o --- 1934
In addition to requiring initial registration, the Securities Exchange Act o --- 1934
created a continuing obligation to provide --- inancial in --- ormation. The “periodic
reporting” required registered companies to regularly disseminate --- inancial in --- or-
mation that ostensibly allowed investors to check in and evaluate whether to hold or
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sell their investments, stretching accountability over the duration o --- the investment.
These re --- orms mandated more in --- ormation about the investments themselves.
Un --- ortunately, despite these re --- orms, many still considered the marketplace to be
a bacchanal o ---
iduciary abuse. There was still a lack o — transparency surrounding the companies who supervised — inancial investments and a lack o — legal assurances that companies were doing so responsibly. Congress reached this conclusion a — ter a multiyear investigation that examined the industry in “ — astidious and convincing detail,” involving working papers, court documents, and other technical memoranda.
Investment Advisers Act and Investment Company Act o --- 1940
The Investment Advisers Act o --- 1940 allowed the SEC to keep track o --- who invest-
ment advisers were. Its companion Act, The Investment Company Act o --- 1940 did
the same thing, only with investment companies. The Investment Advisers Act o ---
1940 required the registration o --- all investment advisers. The Act draws a distinction
between investment pro --- essionals and other pro --- essionals who give --- inancial advice
incidentally, such as “lawyers and accountants.”
Sunlight Is the Best Disin --- ectant
The primary motivation behind the Securities Regulations was to compel disclos-
ure. Investors were presented with standardized in --- ormation, and then --- rom there
could make an in --- ormed decision about whether to entrust their wealth to an adviser
or a speci --- ic investment. Companies now had to provide a baseline level o --- in --- orma-
tion, but the client still had the burden o --- evaluating their adviser or their investment
opportunity. Initially, the Investment Advisers Act “lacked en --- orcement power.” In
act, the SEC was not even authorized to conduct inspections until 1960. Over time, the Courts — illed in the blanks in this legislation, emphasizing the importance o — the duty to disclose and ruling that the need to divulge con — licts o —
interest could never be waived. The Courts imputed a --- iduciary duty on the part o ---
investment managers and companies, even though it was unwritten in the legislation
itsel --- .
The anti- --- raud provisions were litigated heavily. Section 10(b) o --- The Securities
Exchange Act o --- 1934 is the provision which guards against --- raud Rule 10(b)
disallows “the use o --- any device, scheme, or arti --- ice to de --- raud.”1
1
“Fraud” is de --- ined as “deliberately deceiving someone else with the intent o --- causing damage.” The
Courts have held that 10(b) creates a private cause o --- action against market participants, and have
commonly applied a 6-part test to prove an allegation o ---
raud: (1) An omission or misrepresentation that is material; (2) committed with scienter (ill intention); (3) a connection with the purchase or sale o —
a security; (4) reliance (5) economic loss; and (6) loss causation.
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The primary remedies --- or --- raud are rescission (return o --- ill-gotten money) and
damages (payments --- or harm caused), depending on whether the Plainti ---
possesses the security when the — raud complaint is — iled. I — the Plainti —
still owns the security, rescission entitles the Plainti —
to a re — und o — the security purchase price (plus interest), and in return the Plainti —
returns the security to the De — endant. I — the Plainti —
does not own the security anymore, the Plainti —
may recover damages. The lie or the omission must have been reasonably clear to the De — endant. I — the reduction in the security’s value was caused by a — act other than the material omission or representation, damages may be adjusted accordingly. On other topics, the securities laws are open ended, so guidance can be “scat- tered” and standards “unclear.” Furthermore, securities laws regulate a diverse set o —
inancial instruments – — rom high-risk hedge — unds to temperate — ixed-income securities. The general rule is: disclose everything. Such disclosure rules made have been good policy in the 1930s, but, over time, this resulted in an in — ormation overload. It quickly became impossible — or any human being to keep — ully in — ormed about market indicators and to act quickly upon that in — ormation. As the next chapter discusses, computer technology provided a solution to this in — ormation problem – but not everyone gained equal access to computing power, creating an asymmetry in access to computational power resulted in asymmetries in — inancial power, too.
bibliography
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BRANDEIS, LOUIS D., OTHER PEOPLE’S MONEY AND HOW THE BANKERS USE IT (1914).
BRANDEIS, LOUIS D., THE REGULATION OF COMPETITION VERSUS THE REGULATION OF MONOPOLY,
(1912), https://perma.cc/B3VZ-PYPF.
Brown v. Bullock, 194 F. Supp. 217 (S.D.N.Y. 1961).
Carlson, David, Fraud, CORNELL U. (May 2020), available at https://perma.cc/G7GD-YHZM.
Carney, Caelainn, Robo-Advisers and the Suitability Requirement: How They Fit in The
Regulatory Framework, 2018 COLUM. BUS. L. REV. 586 (2018).
Dura Pharms., Inc. v. Broudo, 544 U.S. 336 (2005).
Ernst & Ernst v. Hoch --- elder, 425 U.S. 185 (1976).
Fed. Hous. Fin. Agency v. Nomura Holding Am., Inc., 873 F.3d 85 (2017).
Glass, Andrew, Wilson Nominates Brandeis to Supreme Court, Jan. 28, 1916, POLITICO
(January 28, 2019 12:00 AM), https://perma.cc/B2Z7-BJQ5.
Herman, Edward S., Lobell on the Wharton School Study o --- Mutual Funds: A Rebuttal, VA.
L. REV. 938 (1963).
History.com Editors, Civilian Conservation Corps, A&E Television Networks (May 11, 2010
(updated October 17, 2018)), https://perma.cc/LUZ8-G6QM.
Ji, Megan, Are Robots Good Fiduciaries? Regulating Robo-Advisors under the Investment
Advisers Act o --- 1940, 117 COLUM. L. REV. 1543 (2017).
Kardon v. Nat’l Gypsum Co., 69 F. Supp. 512 (E.D. Pa. 1946).
Kohn v. Am. Metal Climax, 458 F.2d 255 (1972).
Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2005).
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Lin, Tom C. W., Reasonable Investor(s), 95 B.U.L. REV. 461 (2015).
Lindsay v. Morgan Stanley, 592 F.3d 347 (2010).
Novak, Matt. Yes, Adol --- Hitler Really Said He Would ‘Make Germany Great Again.’
Gizmodo (Nov. 22, 2016) [https://perma.cc/45UN-ZGH7] (citing Green Bay Press-
Gazette, January 4, 1934 (“Adol --- Hitler. . .told people that he would make Germany
‘great’ again.”); St. Louis Star and Times, Feb. 24, 1940 (“Nationalism and
Socialism. . .would make Germany great again.”)
SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963).
Securities Act o --- 1933, amend. 15 USCS § 77a
Sharp v. Coopers & Lybrand, 649 F.2d 175 (1981).
Strategic Diversity, Inc. v. Alchemix Corp., 666 F.3d 1197 (2012).
The Investment Advisers Act o --- 1940, amend. 15 U.S.C. § 80b-1 §§ §§ 80b-1–80b–21.
The Investment Company Act o --- 1940, amend. 15 U.S.C. § 80a-1 §§ §§ 80a-1–80a–64.
Timeline: The Evolution o --- the CCC, WGBH https://perma.cc/XNR2-R2GB.
https://doi.org/10.1017/9781316597736.005 Published online by Cambridge University Press 5
Computational Asymmetry
A --- ter World War II abated, American economic prosperity emerged in its wake.
Technologies developed --- or war – including plastics, synthetic rubber and oil, and penicil-
lin – trickled into consumer products. Nylons, radial tires, and the polio vaccine gave
Americans a new con --- idence in Capitalism. The newly minted Middle Class hoped to
become wealthy through investments, and, thanks to massive advances in computer power,
a stock market innovation --- or the Everyman was invented. The Index Fund made pro --- iting
rom Dow Jones returns easy. Computers managed and balanced — unds in a way that only Investment Advisers could previously do. But computer power is not created equal, and some bene — itted — rom computational — inancial innovations more than others did. This “compu- tational asymmetry” bene — its investment — unds with T-1 lines and MIT programmers running custom — ormulas. As “trickle-down economics” began to — ail, public opinion against corporations began to turn sour. Greed, — or lack o — a better word, is good. – Gordon Gekko, Wall Street (Directed by Oliver Stone, 1987)
A --- ter the Great Depression and the implementation o ---
ederal securities regula- tions, two distinctly di —
erent — inancial ecosystems began to develop separately in the East and in the West. In the East, which is the subject o — this chapter, trading centralized in lower Manhattan in New York City, where the New York Stock Exchange was located. This ecosystem — ocused on publicly traded stocks which were registered under and regulated strictly by — ederal securities regulations. This chapter explains how this eastern terminus o — American — inance implemented computer technology to innovate and create new — inancial products through the twentieth century. Meanwhile, out West, a di —
erent market was growing — ar — rom the watch — ul eye o —
ederal regulators. The next chapter tells the story o — Silicon Valley, the western terminus o — American — inance, where technology startups grew — rom humble begin- nings to corporations o — immense size and power. Since these two di —
erent stories occurred at the same time, this book takes a necessary detour — rom its chronological narrative by — irst looking at what happened in the East, and then exploring events out
51 https://doi.org/10.1017/9781316597736.006 Published online by Cambridge University Press
52 Computational Asymmetry
West over the same period. These parallel tracks converge again at the turn o --- the
millennium, when the Western startups listed on the Eastern stock exchanges in
a --- renzy o ---
inancial activity that we now know as the Dot-Com Bubble and which is the subject o — Chapter 7.
pre-regulation investment advice
At the beginning o --- the twentieth century, investing was closer to an art than it was to
a science. The criteria --- or evaluating wealth management were simpler – and more
subjective. While good wealth managers may have intuitively understood market
undamentals, they were more prized — or staying levelheaded through periods o —
market turbulence than --- or being good at math. Investing was known as “specula-
tion,” and investors were o --- ten --- orced to do just that: speculate. Standardized
accounting statements were o --- ten unavailable. Even i ---
inancial snapshots were
urnished to investors, many would lack the wherewithal to interpret them because the academic discipline o — economics had not developed the core o — methodologies
or systematically evaluating and comparing securities. As a result, many people took investment advice at — ace value. The opacity o — investment advice in general made schemes and — rauds easier to perpetrate. The — ederal government sought to solve these problems with a set o — new laws called securities regulations. As discussed in the previous chapter, the — ederal government instituted the Securities Regulations in the 1930s in an e —
ort to make investing less speculative and to make investment advising more objective. The primary mechanism — or accomplishing this was disclosure regimes, whereby companies would have to regularly reveal their — inancial data in return — or the privilege o — seeking investments
rom the general public and listing on public stock exchanges. While the Securities Act o — 1933 was primarily responsible — or requiring disclosures about the securities themselves, the Investment Advisers Act o — 1940 and the Investment Company Act o —
1940 created a new disclosure regime --- or investment advisors.
the investment company and investment company act o --- 1940
On August 22, 1940, just as the --- irst German bombs --- ell within the London Civil
De --- ense Region, the U.S. Congress passed the Investment Company and
Investment Advisors Act into law. In its original --- orm, Public Law 76–768 contained
both the Investment Company Act (ICA) as its Title I and the Investment Advisers
Act (IAA) as its Title II. Those laws are now codi --- ied in separate portions o --- the
U.S. code, as they regulate di ---
erent aspects o — investing: the ICA primarily regulates what — inancial products may be o —
ered, while the IAA regulates who can recom- mend — inancial products to clients. In this period, two new — inancial products emerged that have remained highly relevant — or — inancial markets. The — irst was the mutual — und, which — irst emerged in
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the Roaring Twenties and gained prominence a --- ter the Great Depression. These
early mutual --- unds required substantial human involvement, but they paved the way
or — urther — inancial innovations that automated investment in ways that were impossible in earlier times. Once computer technology developed to the point that computers could exceed human capacity — or computation and mathematical analysis, a new — inancial instrument – the index — und – became possible. This development in turn paved the way — or a new era o — algorithmic trading. But let’s not get ahead o — ourselves. To explain how we got to our present regulation situation, — irst, this Chapter will start with a discussion o — the original mutual — unds that the ICA sought to regulate. Notably, the original mutual — unds were “actively” managed, meaning that human beings made decisions about when to buy and when to sell stocks in the — und. Second, this Chapter will describe the technological development o — computers and the rapid increase in computing power created the new possibility o — “passively” managed index — unds, which were traded based on algorithms and not on human analysis and instinct.
mutual --- unds
The original mutual --- und was established in 1924 by Massachusetts Investors Trust in
Boston. This actively managed --- und survived the Great Depression and can still be
purchased today under the stock symbol MITTX. The --- act that a mutual --- und may
have a stock symbol just as a publicly traded corporation does is an important clue in
understanding the purpose and --- unction o --- a mutual --- und.
Mutual --- unds were a sort o --- platypus o --- the --- inancial world in that they are hard to
classi --- y, as they have a novel combination o --- two --- eatures. On the one hand, shares in
mutual --- unds can be bought and sold just like individual shares in corporate stock.
On the other hand, mutual --- unds are not individual shares but rather a collection o ---
a large number o --- shares o --- stock. The purchasers o --- a “share” in a mutual --- und
actually purchases a small percentage interest in a large number o --- other stocks.
Mutual --- unds are there --- ore a sort o --- synthetic instrument in that they are an arti --- icial
bundle or construction o --- other instruments. They should have no independent
value apart --- rom the combined value o --- their constituent parts – although, as we will
see, sometimes the whole has a greater value than the sum o --- its parts.
While a mutual --- und can be bought and sold like corporate stock, a mutual --- und is
undamentally di —
erent in that the — und itsel — is a collection o — various corporate stocks. O — ten re — erred to as “investment pools,” investors who purchase a share o —
a mutual --- und are actually buying a collection o --- stock called a “stock port --- olio.”
Mutual --- und shareholders may not actually own stocks in the port --- olio, but rather
are simply entitled to gain or loss depending on whether the stock in the port --- olio
gains or loses value. This makes mutual --- unds somewhat similar to bucket shops: in
both instances, the “investor” does not make an investment in and gain ownership o ---
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a corporation; rather, the “investor” makes a bet on whether the value o --- corporate
stock (or a port --- olio o --- stocks, in the case o --- a mutual --- und) will go up or down.
However, mutual --- unds o ---
er three great advantages — or ordinary investors that bucket shops did not. First, mutual — unds automatically diversi — y investments, thus lowering certain risks. Second, mutual — unds are pro — essionally managed, thus lowering in — ormation costs. Third, publicly traded mutual — unds are highly liquid and convenient to buy and sell, thus lowering transaction costs. These three advan- tages make mutual — unds a compelling value — or investors.
diversi --- ication
I --- you have ever been admonished not to put all your eggs in one basket, then you
have some intuitive understanding about the importance o --- diversi --- ication.
Diversi --- ication is quite simply allocating investments, opportunities, bets, or any
other event subject to chance among multiple possibilities. Betting provides a rather
straight --- orward illustration. I --- you go to Las Vegas and play roulette, you can make
a bet on a game called roulette (French --- or “little wheel”) that a little ball dropped
onto a spinning wheel will land on one o --- thirty-eight spaces (numbered 1–36 plus 0
and 00). Your chance o --- winning this game is 1/38. (Note that the payout --- or winning
straight-up roulette in Vegas is 35 times, making this by de --- inition a bad investment
as you are statistically guaranteed to lose money over time.) What i --- , instead o ---
putting, say $100 on number 18, you put $50 on both 18 and 36? This will double your
chance o --- winning $50 x 35, although it guarantees you will lose at least $50 on this
spin (since the ball cannot --- all into two slots on one spin).
Fortunately, the stock market is not exactly like Vegas, and investing in corporations
is not exactly like dropping little white balls onto numbered spinning wheels. In
Vegas, the casinos design the games so that statistically gamblers lose money over time.
But it is possible to make money in the stock market through long-term investing.
Additionally, more than one stock can increase in value during a given time, whereas
there will never be two winning numbers in one game o --- roulette. The challenge with
picking stocks is picking the right ones. For example, even when the stock market
crashed in 1929, some stocks remained valuable. In --- act, the Electric Boat Company
survived the Great Depression and then returned 55,000 percent --- rom 1932 to 1952.
The Dow Jones Industrial Average (DJIA), which tracks the per --- ormance o --- the top
stocks on the NYSE, only increased about 380 percent over that same period.
Meanwhile, over 20,000 other companies went bankrupt in the wake o --- the Great
Depression. While earning almost 150 times more than the DJIA returned seems like
a great victory, there was little reason in 1929 to pick the Electric Boat Company
instead o --- any one o --- the many companies that went bankrupt. While some people
picked the right stock, doing so was little better than random chance.
Each company is unique and so it has unique risks that are technically known as
idiosyncratic risks. Idiosyncratic or individual risk represents the chance that any one
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company will have a de --- ect or be unlucky. For example, the CEO who led the
company to success could suddenly die o --- a heart attack. A major supplier could --- ail
to deliver a critical good. The novel technology that the company is developing
might not pan out, or might be preempted by something newer. A regulatory agency
might not permit production and sales to go --- orward. Someone might sue the --- irm
and embroil it in years o --- expensive litigation. Fashions may change such that the
company’s products are not seasonable. The list o --- problems that can occur is almost
limitless.
But as you invest in more and more companies, the risk o --- that un --- ortunate event
happening to all o --- them goes down and down. While a single CEO might suddenly
die o --- a heart attack, it is rather unlikely that ten CEOs would all suddenly die
around the same time. Although a novel technology might not pan out, one o ---
a dozen new technologies is likely to succeed. Even though --- ashions change, people
still need to purchase products, so some o --- the --- irms in the clothing industry will
prove --- ashionable in any given year.
Thus, diversi --- ication reduces (and may even eliminate) idiosyncratic risk. An
investor who holds a well-diversi --- ied port --- olio will not lose everything because
a CEO happens to get sick, a technology happens to --- ail, a regulation happens to
be imposed, or a --- ashion --- ails to develop. In --- act, one company’s struggles may be
another company’s opportunity. Picture two gas stations across the street --- rom each
other at a busy intersection in an otherwise remote location. I --- one station loses
power and cannot make any more sales that day, many o --- its potential customers will
divert to the other station, increasing its sales. This is an example o --- a zero-sum
game, where one competitor’s gain is always o ---
set by the other’s loss. Here, there is a certain amount o — gas sales to be made at a given intersection on a given day, and one or the other competitor will capture those sales. While an investor who only has shares in the closed gas station will be upset at his unexpected loss, an investor who only has shares in the open station will be pleased at his surprise wind — all. An investor who has shares in both gas stations will be indi —
erent as to which gets the larger share o — the daily sales because he has diversi — ied away the idiosyncratic risk that one or the other will close. Although the investor in both gas stations has diversi — ied away some idiosyncratic risk, he has not gotten rid o — all o — it. I — people in that region switch — rom gas to electric cars, — or example, or i — people relocate away — rom that region or stop using that route would result in lost sales to both gas station. To diversi — y away the risk that drivers will switch — rom gas to electric cars, the gas station stockholder would also need to purchase stock in companies that supply electricity — or vehicles. To diversi — y away the risk that people will leave the region, the investor will have to purchase stock in stations outside the region. Even diversi — ication by investing in several startups or even several industries and in various regions will not protect the investor i — , say, a pandemic occurs and governments respond by issuing stay at home orders such that people drastically
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reduce their driving overall. To reduce this risk, the investor should buy stock in
unrelated industries such as so --- tware and lumber. By investing in a wide range o ---
industries and a number o --- companies within each o --- those industries, our investor
may be able to diversi --- y away almost all o --- the idiosyncratic risk he had when he just
owned stock in one gas station.
in --- ormation costs
Diversi --- ication is a power --- ul way to minimize investment risk, but it takes time,
e ---
orts, and money to diversi — y holding. A smart investor researches each company be — ore investing in it, so the amount o — time spent on researching investments increases as the investor diversi — ies. The investor will also need to keep track o — all his investments, which represents an ongoing time commitment that also increases with diversi — ication.
transaction costs
To return to the basket analogy, one reason why putting all your eggs in one basket is
a bad idea is because any single basket can break, and then everything will be lost.
But i --- you use multiple baskets, it’s less likely that all those baskets are de --- ective,
misplaced, or unlucky. The beauty o --- the stock market is that an investor can put
eggs in multiple baskets, so to speak, at just a little additional cost. It is not totally --- ree
to diversi --- y because an investor is wise to research any investment opportunity be --- ore
investing, and this time spent on research is not --- ree. Stockbrokers, who execute
these trades, may charge --- or each transaction, so they can add transaction costs as
well.
What i --- there was a way to get the bene --- its o --- diversi --- ication, which reduce or
eliminate idiosyncratic risk, --- or little or no additional costs? Mutual --- unds, which are
themselves baskets o --- multiple stocks, and the answer to the question o --- how to
diversi --- y cheaply and easily. By making one easy-to-track purchase, an investor in
a mutual --- und ends up with a diversi --- ied stock port --- olio. To obtain the same level o ---
diversi --- ication without using a mutual --- und, that investor would have to research,
purchase, track, and sell dozens or even hundreds o --- individual corporate securities.
Mutual --- unds, however, create some new costs o --- their own.
agency costs and misaligned interests
Despite the advantages o --- mutual --- unds to create cheap and easy diversi --- ication,
mutual --- unds also present unique economic problems. Namely, there may be
problems o --- misaligned interests among the entities involved in the --- und.
A mutual --- und is usually organized such that investors put money into the --- und
but have no control over where the --- und’s money is allocated. The --- und managers
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make the allocation decisions. In legal terms, the investors are the principals, and the
und manager is the agent. It is well known that such arrangements can go badly where the principal and the agent have di —
erent interests. In the case o — a mutual — und, the investors and the managers have di —
erent incentives. The investors want to maximize a — ter-tax returns on investment. The
und managers want to maximize current assets under management, a pre-tax number that determines their compensation. When the goals o — increasing money under management and maximizing returns per dollar invested con — lict, the man- ager-agents have perverse incentives to take advantage o — their investor-principals. In a nutshell, Congress designed the ICA and IAA to deal with what is now known as the “agency cost” problem. An agent is a person who acts on behal — o — another person called the principal. For a variety o — reasons, agents may not always act — or the principal’s best interest, especially when the interests o — the agent are in con — lict with the interest o — the principal. Consider an employee who is paid by the hour. While an employer would like the employee to work as much as possible — or that wage, the employee would like to work as little as possible. The employee might pre — er, — or example, to take smoke breaks and chat with the other workers on the job, while the employer might pre — er the employee to work diligently without rest or distraction. When employees work less diligently, this is called shirking. Worse than shirking, an agent could use its position to steal — rom the principal. In a simple example, an employee could take cash — rom the register, pocket money
rom customers, or take company property and sell it on the side. Financial agents can likewise de — raud clients. History is replete with examples such as Ponzi schemes, where the investment advisor pays one client with investments — rom another in order to make it look like advisor is making lucrative investment; pump-and-dump schemes, where the investment advisor buys low-priced stock — or himsel — and then drives the price o — that stock up by recommending it to clients be — ore selling his own stock at an in — lated price; advance- — ee schemes, where the investment advisor recommends that the client put up a small, up — ront payment to receive a large sum o — money later; and many other schemes, scams, — rauds, and deceptions. Principals and agents may work to reduce agency costs in many ways as well. The agent may have to undergo a bonding process, where she completes a di —
icult task, such as getting a college degree in order to prove that she will work diligently in the
uture. The principal may monitor the agent to ensure he does not shirk or steal. The principal can incentivize the agent to work in the principal’s interest by giving the agent a share o — pro — its such that the interests o — principal and agent are more closely aligned. Reputational e —
ects may also be a power — ul — orce to limit agency problems, as agents who get a reputation as bad actors are unlikely to be hired again while agents who do right by their principals may have increased opportunities — or — uture employment. These techniques to reduce agency cost are not — ree. Whether the cost is borne by the principal or the agent, someone has to pay — or bonding, monitoring,
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incentivizing, and developing reputation. One might think o --- agency cost as a kind
o --- “ --- riction” in the mechanics o --- a mutual --- und. Just as --- riction makes a machine
ine ---
icient by producing wasted heat energy, actively managed mutual — unds tend to lose some e —
iciency as a result o — agency costs. Although the modern parlance o — agency and transaction costs was not yet well established, lawmakers in the 1930s understood that — und managers could easily take advantage o — clients and investors in myriad ways that range — rom relatively benign to
orthrightly sinister. A relatively benign agency cost occurs when the — und manager spends time raising more — unds instead o — managing existing ones. This may result in lost opportunities — or additional pro — its in existing — unds, thus harming investors, while the manager increases the overall amount under management and thus increases the management — ee. This is similar to when an elected o —
icial spends time campaigning — or the next election instead o — spending that time working on current legislation. Law has established its own solution to the problem o — agency cost – and these solutions are likewise not — ree either. It is costly to become an investment advisor, and this bonding process does not end with accreditation. Registered investment advisors need to keep up with continuing education and to produce regular disclos- ures. Clients pay at least part o — these costs in the — orm o — higher — ees and commissions. Aside — rom intentional wrongdoing, investors also lose money when — und man- agers make human errors in good — aith. Investors generally cannot sue managers — or good- — aith errors in — und allocations. But — und managers, being human, are subject to the same cognitive challenges that all humans have. For example, — inance scholars explained how “bounded rationality” (limited in — ormation limits rational decision making) results in — und-level decreasing returns to scale. In other words, as the — und gets bigger (remember that — und managers earn more by managing bigger
unds, so managers try to maximize — und size), the — und manager is less able to remember, understand, and analyze all the — und’s investment opportunities. As a result, all else being equal, the larger — und tends to earn a smaller return on investment. The emerging — ield o — behavior — inance continues to — ind new “behav- ioral costs” in which — und members’ limited cognitive abilities make actively managed mutual — unds ine —
icient. As this section explained, mutual — unds o —
er many bene — its — or investors. However, there are also signi — icant agency costs that arise whenever one person actively makes decisions about another person’s money. Even i — a — und manager acts in good — aith, the manager’s latent biases and cognitive limitations result in hidden costs — or investors. Basically, the ICA and IAA attempt to reduce agency costs through a disclosure regime – although disclosure has its own costs – while doing very little to reduce behavioral costs. Based on the continued popularity o — mutual — unds, it appears that many investors believe the bene — its o — mutual — unds outweigh their costs.
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But what i --- there was a way to automate decisions about --- und allocations? I ---
unds were not actively managed by human intervention, then the human problem o —
agency cost may not arise. Although the mutual --- und --- irst emerged be --- ore passive
management was technologically possible, computing power quickly grew to the
point where computers could make investment decisions more e ---
iciently than humans. Moreover, computers have no sel — -interest, so there is no problem o —
misalignment o --- interests between human principals and computer agents. The
next section describes how the rise o --- computer power enabled passively managed
unds and algorithmic trading.
computer power
The --- irst “computers” were people, not machines. Organizations such as Langley
Memorial Aeronautical Laboratory began hiring women to work as “computers,”
calculating mathematical equations by hand. From 1935 to 1970, hundreds o ---
women, many o --- whom with degrees in mathematics, applied their computational
skills to solve problems in statistical research, ballistics testing, and even aerospace
engineering.
igure 5.1 A — emale “computer” at Langley. Credit NASA, image no. L-74768.
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Meanwhile, the World War II war e ---
ort led to government investment in the development o — computer technology. Calculating reliable ballistic — iring tables – which would tell soldiers in the — ield how to correct — or wind, elevation, temperature, and other variables when — iring long-distance projectiles at enemy combatants – required a great deal o — computing power while demanding top secret treatment. These needs prompted the U.S. government to look — or new technologies that could process vast quantities o — data at all hours and without the need — or security clearance. This led to the top-secret ENIAC Project. Like the Manhattan Project – a secret research and development e —
ort to produce atomic weapons that enlisted many o — the world’s top scientists including Robert Oppenheimer – the ENIAC Project was — unded by the U.S. government. Building the ENIAC (Electronic Numerical Integrator and Computer) machine enlisted the top physicists and engineers at the University o — Pennsylvania Moore School o —
Electrical Engineering. Work began in early 1943, and the ENIAC machine went
online in 1945. Its --- irst task connected directly to the Manhattan Project. Beginning
on December 10, 1945, ENIAC spent six weeks computing thermonuclear calcula-
tions --- or the --- irst hydrogen bomb. Notably, this calculation was rendered a --- ter
Germany and Japan had surrendered and World War II had ended.
The University o --- Pennsylvania announced ENIAC to the world on February 15,
1946. At its unveiling, ENIAC could calculate a ballistic trajectory in thirty seconds.
That same calculation required twenty human-computer hours to calculate.
Moreover, ENIAC was designed in a modular --- ormat. Adding vacuum tubes, diodes,
relays, resistors, and capacitors increased ENIAC’s power and speed. But these
vacuum tubes were volatile and ine ---
icient, and ENIAC was non — unctional — or approximately hal — o — its service li — etime. When ENIAC was retired in 1955, Jack St. Clair Kilby – an engineer at Texas Instruments who would go on to win the Nobel Prize in Physics in 2000 – was developing a new technology that would revolutionize computing. Kilby produced the world’s — irst — unctional integrated circuit in 1958, and he — iled a patent — or this “Miniaturized Electronic Circuits” technology on February 6, 1959.1 Integrated circuits, or “ICs,” are essentially a collection o — tiny transistors connected together on a single chip. ICs proved — ar more reliable than vacuum tubes. Moreover, ICs are much smaller than vacuum tubes. Electronics move at a consistent speed (the speed o — light), so the smaller distance they have to travel, the — aster the computer will be. There — ore, the smaller ICs per — ormed calculations — aster than the larger vacuum tubes did. Computer technology manu — acturers raced to create smaller and smaller transistors, leading to ICs with more and more transistors per square inch. On April 19, 1965, Gordon Moore – the co — ounder o — Fairchild Semiconductor and CEO and co- — ounder 1 Kilby’s integrated circuit was awarded U.S. Patent No. 3,138,743. A copy o — the patent, along with a description o — its impact, is available here: https://inst.eecs.berkeley.edu/~ee40/su04/publications/ 3138743.pd — .
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igure 5.2 Logarithmic increase in processing power, according with Moore’s law.
o --- Intel – published an article in Electronic Magazine in which he posited that the
density o --- ICs will double approximately every year. In 1975, he revised this estimate
and predicted a doubling o --- ICs and there --- ore o --- computer power every two years. His
revised prediction proved remarkably prescient.2
By the mid-1970s, computer power was mature enough to enable technological
innovation in --- inancial markets. When the index --- und was --- irst revealed on
December 31, 1975, however, it was not heralded with trumpets or revered --- or
democratizing access to investment markets. Even though the --- inancial industry’s
irst index — und was designed as a low-cost way — or individual investors to gain diversi — ied exposure to the U.S. equity market, it was derived as a decidedly “un- American” invention. That — irst — und is known as the Vanguard 500 Index Fund (VFINX), which holds over $600 billion in securities today. 2 Computing power (as measured by transistor density on ICs) has essentially doubled every year since then 1975. In 1976, RCA managed to squeeze 5,000 transistors on its 27 mm2 “1802’chip. In 2019, AMD unveiled its “Ryzen 7 3700X” chip, which — eatured 9,890,000,000 transistors on a 273 mm2 chip. From 1976 to 2019, transistor density increased — rom about 185 per mm2 to over 36,227,106 per mm2, representing an almost 200,000 times increase in computing power over these decades. For more on Moore’s law, see Ilkka Tuomi, The Lives and Death o — Moore’s Law, 7 FIRST MONDAY (2002), available at https://doi.org/10.5210/ — m.v7i11.1000. Moore’s Law is currently thought to be at or near its theoretical limit; that is, it may not be physically possible to make transistors any smaller than they are today. The lower bound o — transistor size is not only limited by the width o — an atom but also by a quantum- mechanics issue called “electron tunneling,” whereby an electron moves probabilistically and not linearly at tiny sizes. It is possible the quantum computers, which harness the probabilistic nature o —
electrons, will enable an entirely new kind o --- computing technology, which may in turn lead to
hereto --- ore unimagined --- inancial innovations.
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the index --- und
An index --- und is a passively managed port --- olio o --- investments that are bought and
sold based on a static algorithm. To the extent they are pooled investments, index
unds are a type o — mutual — und. But passive management makes mutual — unds
undamentally di —
erent — rom actively managed mutual — unds, at least — rom the perspective o — the economic costs and bene — its. I — a — und is actively managed, as opposed to passively managed, then the — und manager closely monitors the — und and usually intends to “beat the market” or provide a higher return than the overall market. This requires a great deal o — human analysis and gut instinct, which are susceptive to cognitive biases, behavioral costs, and agency costs. An index — und, on the other hand, requires no human input, once deployed, to buy and sell securities. The index — und is a “ — ire and — orget” — inancial weapon. This sharply reduces or even eliminates the costs described above. However, computer programs are only as good as their code, which today is still written by humans. Moreover, algorithms can hide deeply rooted biases and propagate errors at alarming rates.
agency costs in index --- unds
As described above, --- riction between mutual --- und investors and mutual --- und
managers may reduce overall e ---
iciency o — actively managed — unds. It may seem that removing the human element, the investment advisor, — rom the — und would also reduce agency costs to zero. While it is true that index — unds do not employ humans to make day-to-day decisions, and there — ore does not experience human agency cost on a day-to-day basis, index — unds do not totally eliminate these costs. It is possible to render bad advice, even in the context o — passive investing. First, an index — und is only as diverse as it is programmed to be. There are broad-based index
unds which are designed to track entire stock markets or even national economies, and there are narrow-based index — unds which are designed to track speci — ic indus- tries or industry subsectors. Whenever a human advisor directs a client to a particular
und, there is a risk that human — und managers can direct investors to unsuitable index — unds. For example, a — und agent could (improperly) recommend that a retiree invest 50 percent o — savings in a volatile commodity index – such as an index — und — or small-cap oil stocks, where that investor cannot a —
ord to lose the amount o — principal that is at risk is such a volatile narrow-based — und. On the other hand, a risk-averse advisor might recommend that a twenty-year-old millionaire invest only in broad-based — unds that track the DJIA, but this would not give that millionaire enough exposure to high-risk, high-reward investment opportunities. To put it another way, index — unds expose investors to a variety o — benchmarks that vary in risk to suit a variety o — risk-appetites. The human element o — discretionary trading is largely removed — rom these investments, but that does not guarantee the suitability o — an index — und — or any given client.
https://doi.org/10.1017/9781316597736.006 Published online by Cambridge University Press Regulation o — Index Funds 63
As mentioned above, the law tries to reduce or eliminate agency costs through
de --- ault and mandatory rules and regulations, which come with some costs in return
or o —
ering some protections. The landmark case o — Brown v. Bullock held that — und managers must consider whether a product is — easible — or a client. Additionally, investment advisers must disclose con — licts o — interest that could bias their recom- mendations. Although regulations do not incentivize — und managers to unlock the hidden potential o —
und stewardship, where — und managers are encouraged to make intelligent decisions that maximize the value o — the — und, the hazards o — index — unds to investors appear managed within the SEC’s current regulatory — ramework.
mistakes have been made
Just because a decision is made by a computer does not mean that decision is sound.
Computer decisions are only as good as their base level programming. Sometimes
a programmer does not consider a --- uture situation that --- lummoxes the algorithm,
sometimes with disastrous results.
On May 6, 2010, --- rom 2:32 pm to 3:08 pm EDT, stock markets lost one trillion
dollars. Why, on such a balmy day in Spring, did investors suddenly sell assets at the
incredible rate o --- a hal --- -billion dollars per second? The --- ault lies in part with trading
algorithms and technical glitches. Although a British --- inancial trader named
Navinder Singh Sarao probably prompted the initial sell-o ---
by using a “spoo — ing” algorithm (where buy orders are placed and then cancelled rapidly and automatic- ally in order to manipulate stock process), other algorithms quickly — ollowed suit. The initial spoo — triggered a cascading sell-o —
. Without human intervention, com- puters ran amok, selling stock at incredible rates until humans physically shut them down. An SEC report on the Flash Crash — ound “a market so — ragmented and — ragile that a single large trade could send stocks into a sudden spiral.”
regulation o --- index --- unds
It seems that every crash, panic, downturn, crisis, and market --- ailure leads to more
regulations. The Flash Crash was no exception. As mentioned above, the ICA and
IAA were designed to resolve agency problems that resulted --- rom active human
management o --- mutual --- unds. These statutes were not designed to handle the
problems caused by passively managed index --- unds. In --- act, these securities regula-
tions are particularly inept at dealing with solo traders who are not managing anyone
else’s money. But it was precisely this sort o --- solo trader who crashed the entire stock
market on May 6, 2010. Sarao was just a guy in an apartment with a personal
computer who was able to create and deploy algorithms that would spoo --- the market
so he might gain a --- inancial advantage.
The SEC responded by promulgating Regulation NMS, which prohibits spoo --- ing
and other ne --- arious stock market activities such as “banging the close” and “layering.”
https://doi.org/10.1017/9781316597736.006 Published online by Cambridge University Press 64 Computational Asymmetry
Without getting into too much technical detail, these are e ---
ectively new types o —
scams that have been enabled by computerized trading. For example, a trader can
quickly place and cancel orders that he never intends to --- ul --- ill by using a computer
program to place and then quickly cancel trades. This --- ake order is called a “spoo --- .” By
placing a spoo --- bid to buy stock, --- or example, the trader arti --- icially increases the price
o --- the next trade on that stock by indicating there is more demand --- or it. This is easier
to do when the market --- or that stock is thin, meaning, that stock is not --- requently
traded. While the price is arti --- icially elevated, that same trader places a real bid to sell
at the higher price. The trader then cancels the buy order, thus obtaining the stock at
a lower-than-market price. Layering is a more complex and higher speed variant o --- this
scam where the trader places multiple buy o ---
ers to drive the price even higher be — ore
ul — illing multiple sell orders and then — inally cancelling the buy orders. Spoo — ing, layering, and similar algorithmic schemes have been outlawed. But regulators have a hard time keeping ahead o — the technology. As technology con- tinues to increase the speed at which trading operates and the complexity o — trading algorithms, — raudulent conduct becomes harder to detect. Moreover, the line between harm — ul high- — requency — raud and bene — icial activities that quickly resolve price anomalies can be blurry. Regulating these technology-driven trading schemes and strategies is like playing a game o — Whack-a-Mole at an accelerating pace. As Moore’s Law predicted, computer speed has roughly doubled every two years, and algorithmic traders double their speed too as the processors get — aster. In addition, innovations in communications technology like — iber optic internet access and 5G high-speed wireless networks allow traders to take quantum leaps — orward. The result is a system where regulations are always behind, and regulators make constant e —
orts just to keep up. This marks the beginning o — the end o — the Second-Era model o —
regulation.
conclusions on computational investing
The Flash Crash represents a turning point in the history o --- securities regulation.
Regulations created at the beginning o --- the Second Era were primarily designed to
prevent large institutions --- rom taking advantage o --- ordinary investors. This goal was
to be accomplished primarily by requiring disclosures --- rom large --- irms on the one
hand and prohibiting ordinary investors --- rom participating in risky markets on the
other. At least in the early and middle parts o --- the twentieth century, these regula-
tions appeared to work reasonably well. Investment in mutual --- unds increased, and
the stock market slowly climbed --- rom the pits o --- the Great Depression to all-time
highs in the 1980s.
Meanwhile, computational technology and computing power increased at an
exponential rate. By the 1970s, technology had developed to the point where index
unds became possible. These index — unds can act like computer programs that trade based on their code and not on — urther human instructions. This reduces agency
https://doi.org/10.1017/9781316597736.006 Published online by Cambridge University Press Conclusions on Computational Investing 65
costs and human error, but such algorithmic trading also opened the market up to
a new sort o --- risk. As computational power grew to the point where virtually anyone
could implement a trading algorithm, computers created a new risk that did not exist
be --- ore. High- --- requency trading, enabled by massive computing power, enabled new
ways to spoo --- , bang, layer, --- ront-run and otherwise de --- raud and cheat the market at
large. Meanwhile, individual human decision makers --- ailed to keep pace with the
rate o --- algorithmic trading.
As the twentieth century drew to a close, widespread --- ear about computers taking
over impacted the American mindset. From movies like The Terminator – where an
algorithmic system gains sel --- -awareness and attempts to destroy humanity – to the
Y2K problem – where people --- eared that society would collapse on January 1, 2000,
because computers were not programed to handle --- our-digit dates – popular anxiety
about the rise o --- the machines grew. While the 1950s promised that computers
would handle the tedious tasks so humans could engage in more leisure time, the
1990s were laden with --- ear that humanity would become subverted by the almighty
algorithm.
But history took a di ---
erent turn. In the early part o — the twenty- — irst century, web technology matured such that “Web 2.0” technologies emerged. The Internet shi — ted — rom a situs o — in — ormation to a locus where people would connect with each other. Power — ul new ways o — using technology to tap into human decision- making, such as crowdsourcing, advanced — inance, and the sciences. Technology became much more personal. Laptops, smartphones, Wi-Fi, and broadband access connected society. As the new millennium dawned, a new source o — data and decision-making appeared: society itsel — . This ushered in the Third Era o — corporate
inance.
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https://doi.org/10.1017/9781316597736.006 Published online by Cambridge University Press 6
Silicon Valley
The Internet evolved --- rom a Department o --- De --- ense project into the center o --- the new
economy. Companies rushed to develop e-commerce, and investors bought almost any stock
that pertained to the internet. There was a --- lurry o --- initial public o ---
erings (IPOs), as companies rushed to sell registered stock on public exchanges to capitalize on the sudden interest in everything digital. But the bubble burst. Scandal dogged public markets, and
ederal legislators once again were galvanized to pass statist and protectionist laws. The sub-prime mortgage crisis — urther — ueled the drive to regulate securities. In particular, the Sarbanes-Oxley Act o — 2002 and the Dodd-Frank Act o — 2010 parallel the New Deal securities regulation in that both limited and conditioned the public sale o — stock. As a result, being a public company became much more expensive and less bene — icial, so — ewer companies went public. So — tware is eating the world. – Marc Andreessen, Founder o — Netscape, Opsware and the Andreessen Horowitz Venture Capital Firm
Stan --- ord University ( --- ounded by Leland Stan --- ord, the same man who hammered the
Golden Spike that completed the transcontinental railroad in 1869) has attracted
pioneers in science and technology to its campus in Northern Cali --- ornia --- or over
a century. The computer technologies developed there were used to power the index
unds and algorithmic trading discussed in the previous chapter. But the companies who developed such technology are interesting in their own right, especially — or our story, because these Western pioneers also developed a di —
erent — inancial ecosystem that evolved to become distinct — rom the stock markets back East. To understand this parallel track in the evolution o —
inancial markets, we must go back in time and to another place, where one could reasonably argue that the modern computer era began – and where the venture capital — inance industry started up. The story o — computers could well begin with the invention o — the abacus, a machine that used beads on wires to calculate math problems even be — ore Arabic numerals were invented. But we will begin our discussion o — the brie — history o — computers as relevant to the evolution o —
inancial markets in 1913, when electrical
67 https://doi.org/10.1017/9781316597736.007 Published online by Cambridge University Press
68 Silicon Valley
engineer Harris Ryan installed a high-voltage laboratory on Stan --- ord’s campus. His
work accelerated in the Roaring Twenties, when it expanded its capacity to handle
two million volts in 1926. Frederick Terman joined the Stan --- ord --- aculty a --- ter
receiving his ScD in electrical engineering --- rom MIT in 1924. His work on vacuum
tubes paved the way --- or the --- irst computers, which were initially used in the giant
machines that calculated nuclear missile payloads and trajectories.
the start o --- startups
Terman’s legacy exceeded electrical engineering. Terman also institutionalized
a sense o --- entrepreneurship and innovation into the Stan --- ord University culture
that helped generate a new business model that we now know as the startup model.
Throughout the 1930s, Terman encouraged his graduate students, including
William Hewlett and David Packard, to create new businesses based on their
research. These businesses had unique qualities o --- being very risky and rather
expensive, but their success had the potential to change the world – and make
a lot o --- money in the process. The term “venture” – meaning an undertaking
involving uncertainty, risk, speculation, and the hope o --- pro --- it – was applied to
these nascent technology --- irms.
Terman even invested money in these projects. In this sense, Terman was what we
today call an angel investor, which is someone who invests their own money in
startups. Investing in risky business projects at early stages in their development can
generate huge returns, but more o --- ten than not the investment could be a total loss.
This type o --- high-risk, high-reward investing is not --- or the --- aint o --- heart, but, with an
appropriate level o --- diversi --- ication, it can be an incredibly lucrative pursuit.
Although Terman provided capital --- or his students’ ventures, he was not really
a venture capitalist as that term is used today. The distinction between an angel
investor like Terman and a modern venture capitalist is that venture capitalists invest
other people’s money, whereas angel investors invest their own money.
With Terman’s --- inancial support, William and David --- ounded Hewlett-Packard
in 1939. William and David started work in a one-car garage in Palo Alto, but went on
to create a tech empire that developed personal computers, inkjet printers, handheld
touchscreen devices, optical character recognition so --- tware, digital cameras and
photo services, medical devices, rewritable DVDs, enterprise security so --- tware,
cloud computing solutions, and more. The HP Garage at 367 Addison Avenue is
now designated at the “Birthplace o --- Silicon Valley” by the Cali --- ornia Historical
Association.
HP --- ormally incorporated on August 18, 1947 and went public on November 6,
1957. Perhaps unintentionally, Hewlett and Packard thereby established a paradigm
that would resonate throughout the second era o --- startup history. HP’s success set up
a paradigm that ventures continue to emulate today: generating a business plan
based on inventing power but unproven technologies, developing prototypes o --- that
https://doi.org/10.1017/9781316597736.007 Published online by Cambridge University Press Early Origins o — Venture Capital 69
igure 6.1 The garage in Palo Alto, Cali — ornia where the Hewlett-Packard (HP) corporation began – and where some say Silicon Valley was born. Credit raneko (Flickr), licensed under CC BY-ND 2.0.
technology on a shoestring budget, attracting local venture capital to turn prototypes
into products and to scale up production, and then going public by registering with
the SEC and selling stock on the NYSE when it came time to broadly expand
production. But this approach – which is now known as the startup model – would
not really come into its own until the SEC made it easier --- or entrepreneurs to
navigate the complex set o --- security regulations that were established to protect
society --- rom another Great Depression.
early origins o --- venture capital
Today, venture capital is a multibillion-dollar industry. But in the early days o ---
Silicon Valley, raising money --- or technology projects like HP was not yet institu-
tionalized. Entrepreneurs like Hewlett and Packard raised money in --- ormally --- rom
people they knew well, like Terman. In --- act, the --- irst organization to describe itsel --- as
a “venture capital --- irm” was the American Research & Development Corporation
(ARDC), --- ounded in 1946 by Harvard Business School pro --- essor Georges Doriot and
others.
ARDC created opportunities --- or soldiers returning --- rom World War II to invest in
the emerging de --- ense industry, which included many veteran-owned businesses. It
was a unique type o --- investment company because it sought --- unds --- rom sources
https://doi.org/10.1017/9781316597736.007 Published online by Cambridge University Press 70 Silicon Valley
other than wealthy --- amilies. Prior to ARDC, only wealthy --- amilies – such as
Rocke --- eller, Whitney, Payson & Trask – --- ormed --- unds to invest in startup ventures.
ARDC was also novel --- or an investment company because it registered its --- und
with the SEC and listed its stock on the New York Stock Exchange. ARDC’s
decision to list stock publicly was a direct response to the New Deal securities
regulations that made it di ---
icult — or ordinary investors to invest in private compan- ies. As a public company that invested in private companies, ARDC made it possible
or ordinary investors, including many World War II veterans, to pro — it — rom risky startups. This blurred the lines between public and private investing. Moreover, ARDC blurred the de — inition o — a mutual — und. Most mutual — unds at that time simply bundled together publicly traded stocks, which could be purchased separately by ordinary investors via the NYSE. But ARDC’s port — olio o — investments included stock in private companies that ordinary investors could not have separ- ately purchased. ARDC closed in 1971, however, when Doriot retired and several other — ounding members went on to create private venture capital — irms in Silicon Valley, including Greylock Ventures, one o — today’s most prominent venture capital
irms. This marked the beginning o — the end o — the early venture capital era. But each — inancial era’s end is a new beginning. In this case, this was more than passing the baton — rom ARDC to Greylock. It was the beginning o — the modern venture capital (VC) era.
evolution o --- venture capital
In the more than seventy- --- ive years between ARDC’s advent o --- VC --- und, the VC
industry has evolved --- rom an oddball stock to a major --- orce in the global economy.
VC investments has resulted in technologies and innovations that themselves
changed the relationship between investors and regulators. Later chapters will
discuss how venture-backed startups changed public markets --- orever due to the so-
called Dot-Com Bubble, and how the rise o ---
inancial technology (FinTech), much o — which was supported by VC dollars, has propelled America into the Third Era o —
inancial evolution, where traditional — inancial regulation is no longer possible. Other books provide a more detailed historical record o — all the key people and companies in Silicon Valley and elsewhere that are part o — the rich story o — venture capital’s evolution. This book will — ocus on the details that matter — rom the perspec- tive o — the impact o — regulation and that shed light on what to expect in the — uture. There — ore, we — ast — orward — rom 1945 to the 1970s, when venture capital became known as its own type o — investment or “asset class.” It is no mere coincidence that this period in the 1970s coincides precisely with the development o — transistor-based computers and their steady growth since then. The VC industry out West (described in this chapter) and the computers that powered stock market transactions back East (described in the prior chapter) were running on two parallel but symbiotic tracks
https://doi.org/10.1017/9781316597736.007 Published online by Cambridge University Press Evolution o — Venture Capital 71
that would collide at the term o --- the millennium in what is now known as the Dot-
Com Bubble (described in the next chapter).
Two o --- the most historically important VC --- irms were established in 1972: Kleiner
Perkins Cau --- ield & Byers and Sequoia Capital. Over the next decade, Kleiner
Perkins raised --- unds that invested heavily in semiconductors, databases, and com-
puters. Startups in their port --- olio include Compaq Computers (personal com-
puters), Electronic Arts (video games), Sun Microsystems (computer chips and
programming so --- tware), Quantum Corporation (data disk storage), Qume (com-
puter printers), Tandem Computers (industrial computers), Applied Materials
(semiconductors), and other business that have since trans --- ormed the technology
and computing industry. Kleiner’s investments into these companies proved incred-
ibly pro --- itable.
Sequoia Capital is equally impressive in its --- oresight and investment strategy. Two
o --- its early investments turned into world-changing technology --- irms: Apple (per-
sonal computers) and Oracle (database so --- tware and server hardware). A --- ter Apple’s
success --- ul initial public o ---
ering, an initial public o —
ering being a type o — liquidity event that returns cash to investors and will be discussed in detail in the next chapter, Sequoia deployed the cash proceeds — rom that event to invest in the next generation o — technology startups including Cisco Systems (networking hardware), Webvan (online groceries), and Google (internet search). Sequoia was also one o — the — irst VC — irms to expand operations to Israel, a country which has since earned the moniker “Startup Nation.” Kleiner Perkins and Sequoia established a staged investment model that is still generally — ollowed today.
Early- or Seed-Stage Financing
VC --- irms develop relationships with startup --- ounders at the --- irst, “early” stage, when
the company may not even have a product or any revenue. This “seed” --- inancing is
used --- or product development and market research. Other “startup” --- inancing may be
used in initial product commercialization and marketing e ---
orts, which may help the company develop its — irst revenue streams and hope — ully get to the point where the company is earning revenue that meet or exceeds its expenses. In other words, the early-stage — unding, o — ten termed “Series Seed” or “Series AA,” helps a startup go — rom having a marketing idea to commercializing that idea and, ideally, breaking even with its revenues versus expenses. “Seed — unding” is the beginning o — the startup — inancing cycle. Startups need money to create products and services be — ore they ever earn their — irst dollar. They use seed — unding to research, assess, and develop an initial concept. Who would invest in a completely nascent unproven concept? Friends, — amily, and — ools (FFF) –
ools re — erring to the high risk associated with investment in nascent startups – provide seed — unding to local entrepreneurs, while angel investors provide the
https://doi.org/10.1017/9781316597736.007 Published online by Cambridge University Press 72 Silicon Valley
seed --- unding capital to high-growth startups. In 2019, angels invested about
$8.8 billion in seed-stage startups, which accounted --- or 37 percent o --- all the angel
capital invested that year.
VC --- irms are less likely to --- ocus on such early-stage startups. Although the VC
industry invested a total o --- $9.6 billion in seed-stage startups in 2019, that
represents just over 7 percent o --- the total amount that VC --- irms invested
that year. And while VC --- unds invested slightly more total dollars into seed-
stage startups than angels did that year, those VC --- unds invested all that money in
just 4,760 startups, while the angels spread a comparable amount in approxi-
mately 23,580 startups.
Moreover, 2019 was somewhat anomalous --- or the VC industry, which usually
invests in --- ar --- ewer seed-stage startups. In 2006, --- or example, angels invested in about
23,460 seed-stage startups, while VC --- unds only invested in 460 seed-stage deals. This
trend is consistent over time. There --- ore, angels are the leading source o --- capital --- or
most seed-stage companies.
Once a startup receives seed --- unding, the company begins operations and enters the
“seed valley o --- death,” where companies require signi --- icant capital in --- lows but have
little or no revenue. Startups begin to leave the perilous seed valley o --- death when their
revenue increases enough to cover all monthly --- ixed and variable costs. This is called the
“breakeven.” Startups who survive until breakeven can continue to grow organically, or
they can expand more rapidly through an in --- usion o --- expansion stage --- inancing.
Expansion Stage Financing
The second stage is designed --- or expansion. Startups are distinguishable --- rom other
small businesses in that startups generally have ambition to grow rapidly so that
success --- ul ones can return substantial capital back to investors, whereas small
business owners may be quite content with just doing a bit better than breaking
even a --- ter salaries (including their own) are paid. In other words, small businesses
generally do not have an emphasis on this expansion phase, i --- they have an expan-
sion phase at all, whereas the expansion phase is a critical aspect o --- high-growth
startups.
Startups decidedly exit the seed valley o --- death when a venture capital --- irm makes
its --- irst early-stage investment, called “Series A.” A --- ter this point, VCs --- requently
reinvest in the startup in Series B, C, D, and so on, so the startup can a ---
ord to invest in growth even i — doing so causes net pro — its to become negative again. Small venture capital — irms may only make early-stage investments. Large VCs make “later stage” investments all the way up to the end o — the startup — inancing cycle, when a startup ceases to be a startup. Fortunate high-growth startups move quickly through the breakeven to the “early stage,” where VC managers become substantially more interested in investing in startup. VC managers pre — er to invest in companies in the expansion phase because
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that provides an ideal mix o --- risk (which is lower than at the early stage because the
product has been developed and is proven to work and be sellable to some market)
and reward (because the company still has incredible potential --- or growth). But
startups entering this phase requiring capital may --- irst turn to their early-stage
investors --- or additional --- inancial support. This is why VC managers develop an
investment relationship with promising startups during the early stage, so they are
more likely to get the --- irst opportunity to --- und that startup in the lucrative expansion
phase. Investments in the expansion phase are usually characterized by names like
“Series A” and “Series B.”
Later Stage Financing
Some VC --- irms continue to make new investment in companies who have com-
pleted the phase o --- rapid expansion and are now in the third, “later stage” --- inancing.
Companies in this later stage typically have a positive cash --- low, meaning they take
in more cash each month than they put out. This means that later stage companies
no longer need VC investment to survive – but they may desire it to grow even --- aster.
Liquidity Events
The goal o --- most startups is to eventually return cash to investors in what is called
a liquidity event. The traditional gold standard --- or a startup liquidity event historic-
ally was an initial public o ---
ering (IPO), which is discussed in the next chapter. A — ter the IPO, the company is public. It will be listed on a stock exchange and — unction much like the companies described in the prior chapter. An alternative liquid- ity event that is growing in popularity is the sale o — the startup to a larger — irm in what is called a merger and acquisition (M&A) event. The cycle ends badly when the startup goes broke and liquidates or sells the — ledgling operations at a discount. The entire VC industry has evolved substantially since this second wave o —
investments into startup companies in the late 1980s. In 1987, there were only 361
VC --- irms and 687 VC --- unds in existence, who raised $4.4 billion that year. By 2007,
the VC industry nearly doubled to 946 --- irms and 1,586 --- unds. Meanwhile, the
amount o --- capital raised per year increase eight --- old to $35.1 billion in 2007 –
which also means that the average size o --- a VC --- und grew tremendously. In 2019,
there were 1,328 --- irms with 2,211 --- unds who raised a total o --- $50.5 billion that year.
As the VC industry matured and VC --- irms and --- unds grew, the Kleiner-Sequoia
model o --- staged investment has changed. As VC --- irms and their --- unds get larger,
which is usually the result o --- being success --- ul in past investments, these larger --- irms
ind it harder to invest in smaller startups at earlier stages in the startup — inancing cycle. The result o — the growth o — VC — unds size is that VC — irms make larger investment in later stage startups. In 1980, over hal — o — VC — unds were deployed as
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igure 6.2 The traditional startup — inancing timeline.
investment into seed- and early-stage companies. By 2007, that trend had reversed,
with almost 4/5ths o --- VC --- unds deployed into expansion- and later-stage companies.
Through 2019, VC --- irms’ pre --- erences --- or investing into later-stage companies
remained, with only 7 percent o --- total VC dollars invested that year into seed-stage
companies.
A new group o --- investors called “angels” has picked up the slack in seed-stage
inancing. Angels, who are people who are not usually pro — essional investors but rather are wealthy — rom other means and who invest their own money in startups, are discussed below. More recently, super angels, a term coined in the 2010s to describe wealthy people, who, like VC managers, and pro — essional investors — or whom investing is their — ull-time occupation, and who, like angels, invest their own money in startups. Additionally, startups have begun to stay private — or longer. The reasons why are discussed in the next chapter, but the e —
ect is that it has become more common — or additional investment rounds titled Series C, D, E, and even F to occur more
requently today than they did in the past. This stretches out the expansion phase o — the startup — inancing cycle and thereby changes the nature o — startups who — it in this model. In the 1980s, companies used to be valued in the tens o — millions o —
dollars when receiving expansion phase --- inancing. But a new concept has evolved o ---
a “unicorn” company, which is a company that is valued at more than $1 billion in
a private venture capital stock --- inancing. In 1987, there were no unicorns. Today,
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almost 500 companies meet the de --- inition o --- a “unicorn” by being very large private
companies that still rely on VC investment even though they are valued at over
$1 billion. In --- act, new terms such as a “decacorn” (a venture-backed company worth
$10 billion or more) and “hectocorn” (worth more than $100 billion) have been
coined to describe these once-rare entities that now seem to be growing more and
more common.
modern venture capital
The modern VC industry is distinguishable --- rom the ARDC’s model in that it tends
not to admit ordinary investors into its investment --- unds. Rather, venture capital today
is predominately --- unded by extraordinarily wealthy intuitions and a --- ew very wealthy
people. The reason --- or this has to do with securities regulations, in particular the
prohibitions against general solicitations and the limitations on sales to nonaccredited
investors, which will be discussed in the next section. This section will convey the
orm and structure that is paradigmatic o — the modern venture capital industry so you will more easily see how regulations caused this — orm to take its present share. Venture capitalists create — unds in which large institutional investors (such as pension — unds and university endowments) invest. Typical investors in VC — unds are pension — unds, — inancial — irms, insurance company, university endowments, and other large — unds that want to allocate a small portion o — their vast port — olios into high-risk, high-reward investment. VC managers then “deploy” that capital primarily by purchasing stock in startup companies. The nature o — venture capital — irms is quite di —
erent — rom the nature o —
angel investors like Terman because VCs manage other people’s money, whereas
angels invest their own money. VC --- irms raise sums o --- money in --- unds that is --- ar in
excess o --- most angels’ personal net wealth, and VCs have to deploy this money very
quickly because the --- unds typically have eight to twelve-year li --- espans. This limited
li --- espan o --- a VC --- und is necessary --- or investors into that --- und to receive their return
on investment within a speci --- ied period. When the --- und’s li --- e is over, the capital
must be returned to investors. This create pressure on companies --- unded by VC
unds to have a so-called liquidity event – where the startup’s stock can be exchanged
or cash – within the — und’s li — espan. As pro — essional, institutional money managers, VC — irms typically employ dozens o — managers and hundreds o — analysts and other support sta —
to help with sourcing deals, crunching numbers, dra — ting contracts and other transactional documents, and supporting startups a — ter — unding them. This is a small industry that has an outsized in — luence. Only a hand — ul o — top — irms consistently raise the largest — unds and have the greatest in — luence on the industry, on the startup market, and indeed on the entire American economy. Most o — the signi — icant VC — irms are located in Cali — ornia. In 2019, — irms located in Cali — ornia raised 65 percent o — the total amount o — money raised by VC — unds across
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all o --- America. Massachusetts was a distant second at 16 percent, and New York came
in third at 10 percent. No other state received more than 2 percent o --- the total
amount o --- VC --- unds. This --- urther demonstrates that this industry is not as diverse as
the simple number o ---
irms might make it seem. In — act, the greatest concentration o —
VC --- irms anywhere in the world is on just one road a --- ew miles --- rom Stan --- ord
University: Sand Hill Road in Menlo Park, Cali --- ornia.
Although popular culture and TV shows like Shark Tank make it seem that VC
managers invest in very early-stage startups, the truth is that the modern VC industry
typically invests at the later, growth stage o --- startup projects. It is axiomatic that
earlier stage projects are riskier. But where there is risk there is also the opportunity
or rewards. VC managers maximize their — und’s risk-versus-reward calculation while optimizing their return on their time spent managing investments by investing an average o — about $16.1 million dollars per company into companies that are valued at around $23 million; however, the average investment amount is a bit misleading because there have been a — ew so-called mega rounds, where VC invested more than $100 million into several early-stage biotech startups. Instead o — considering the average Series A round size, the median Series A round size, which is $6.7 million per investment, is probably a better characterization o — what most VC — irms’ initial investment into a company looks like. VC managers do also invest smaller amounts into seed-stage startups that may have little more than a business plan or a prototype. They do this despite the incredible risks in order to — orm a relationship with that company that is calculated to lead to larger investment opportunities when and i — that startup succeeds in its initial product development and marketing strategy. Usually, this happens where the
ounder o — the startup is well-known — or his prior successes in entrepreneurship. The VC manager may be betting that the — ounder will succeed again, regardless o — the product. Similar to the real estate saying that one should invest in location, location, location, it seems that VC investors likewise invest in management, management, management. It is a misperception that VC managers are risk-seeking. While it is true that VC
unds invest millions o — dollars into unproven startups, even thought that investment may be entirely lost, But VC managers have ways to mitigate the risks o — investing in startups such that they can earn returns that outstrip the risks. In particular, VC managers diversi — y the investments o — each — und. Funders Club Education Center reports that an average — und contains $135 million and invests in thirty to eighty companies. In addition, success — ul VC — irms have multiple — unds with di —
erent — und managers, which — urther diversi — ies the — irm itsel — . Complete diversi — ication, however, is not plausible or desirable in the VC model. While VC — unds diversi — y against the risk that any one company’s technology or management team — ails, VC — unds are generally exposed to market risk — or the tech industry and o — ten exposed to additional risk in a speci — ic subsector. VCs cannot completely avoid systemic risk because their — und managers tend to be specialists in
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a certain tech industry subsector. Such managers generally invest in their --- ields o ---
expertise, where they can better evaluate technologies. Specializing in a tech area
also helps VC managers become keenly aware o --- promising developments and
pit --- alls in that subsector. While this encouraged VC managers to invest more heavily
in speci --- ic subsectors, the risk o --- port --- olio imbalance is somewhat outweighed by the
value add and synergies --- rom --- ocusing on a --- ew types o --- companies.
VC managers also avoid some risk o ---
ailure by supporting the companies they
und. This support makes VC managers “more than money,” meaning they provide bene — its to startups beyond merely investing in them. Good VC managers are seen as partners with, or at least valuable advisors to, startups and their entrepreneurs. VC managers o — ten sit on the board o — directors o — the corporations in which they invest. Today, larger VC — irms like Andreessen Horowitz o —
er in-house logistics, marketing, sales, and strategy consultants to port — olio companies. But mega VC — irms like Andreessen Horowitz did not take o —
into the — inancial scene until the SEC cleared a runway through the snarl o — securities regulation. SEC Regulation D Rule 506(c), a —
ectionately known as “Reg D” by those in the VC industry, is now the regulatory sa — e harbor through which trillions o — dollars — low each year.
reg. d: private --- inancing’s sa --- e harbor
Prior to Reg D, the VC industry relied on Section 4(a)(2) o --- the Securities Act o --- 1933
to purchase startup stock without registering with the SEC. The Securities Act
requires all securities (including private corporation stock sold to VCs) to be regis-
tered with the SEC – unless an exemption applied. Section 4(a)(2) provides the
exemption VCs needed: the Securities Act’s registration requirements “shall not
apply to . . . transactions by an issuer not with or through an underwriter and not
involving any public o ---
ering.” This could include VC transactions, which do not typically require an under- writer. What, then, is a “public o —
ering”? This term is nebulous and unde — ined in the Securities Act. The SEC — irst attempted to answer this question on January 24, 1935, when it published an opinion letter outlining — our — actors that would be considered in determining whether a public o —
ering is involved in a given transaction: 1. The number o — o —
erees and their relationship to each other and to the issuer 2. The number o — units o —
ered 3. The size o — the o —
ering 4. The manner o — the o —
ering A — our- — actor test is relatively unhelp — ul at the beginning. This test is typical o —
a regulatory “standard.” Standards are deliberately vague so that courts can consider
each case on its own merits. This is great --- or achieving justice in each early case, but
it makes it virtually impossible to evaluate what transactions will or will not be ruled
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invalid or illegal by a court. Early VCs and startups simply took the risk that the
ederal agencies in Washington might prosecute them — or securities violations. Under our common law system, however, standards develop contours over time. As courts make decisions in speci — ic cases as to whether securities violations occurred or not, case law, or “precedent,” de — ines what is and is not a securities violation. Over vast periods o — time, common law systems regarding traditional doctrinal areas such as property and contracts develop into relatively clear rules. But this process takes time, perhaps centuries, to per — ect. Meanwhile, the budding VC industry was impatient — or clarity. That clarity — inally came in 1982, when the SEC promulgated Regulation D. The regulation is relatively complex, comprising six separate rules (501–506) in the Code o — Federal Regulations. But the point is simple enough. Regulation D Rule 506(b) allows VCs to invest an unlimited amount o — money in startups so long as there is no “general solicitation” (advertising the sale o — stock to the general public) o — the investment opportunity. VC — irms – specialists in private stock — inancing – were per — ectly poised to count on this easy-to-use sa — e harbor. The consequence, however, is that ordinary investors were generally not invited to participate in VC — unds. As a technical matter, Regulation D has other exemptions that allow startups to
undraise — rom ordinary investors, including — riends and — amily, but in reality, these other exemptions are not o — ten used. Over 99.9 percent o — Regulation D — inancings
all under the Rule 506(b) exemption, which is only available to “accredited invest- ors” as de — ined below.
accredited investors and quali --- ied purchases
Until very recently, only “accredited investors” (AIs) could make unlimited invest-
ments in private startup corporations. Prior to August 2020, the only way to be
classi --- ied as an AI, and thereby to gain access to invest in VC --- unds, was to
demonstrate a su ---
icient amount o — net wealth. The exact standards have changed over time, but, until recently, Regulation D Rule 501 deemed a natural person (human beings, not corporations or other legal entities) to be an AI i — one has an annual income o — at least $200,000 ($300,000 — or joint income) or at least $1 million in net wealth (not including one’s primary residence). A business entity is con- sidered an AI i — it has over $5 million in assets. Then, on August 26, 2020, the SEC issued a press release stating that the agency will update the Rule 501(a) to permit natural persons (human beings) to quali — y as accredited investors based on certain pro — essional certi — ications, designations or credentials or other credentials issued by an accredited educational institution. This change could create entirely new classes o — VC investors. It is too early to determine the impact o — this change, which went into e —
ect on December 8, 2020. It will be very interesting to see how this change in rules impacts the VC industry and
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especially how it impacts the number and nature o --- startups that receive money --- rom
VC --- unds.
But while the SEC has broadened the de --- inition o --- who can invest directly in
startups, there is another, higher standard required to invest in many VC --- unds.
The general rule under the Investment Company Act (ICA) is that --- und man-
agers need to register as investment companies unless there is an exception --- rom
this registration requirement. Since registration is costly, time consuming, and
risk generating, VC --- irms strongly pre --- er to avoid registration by --- inding an
exception. There are two main exceptions that can be used --- or this purpose.
First, under Section 3(c)(1) o --- the ICA, a VC --- irm is not an investment company
i --- (1) it has not more than 100 investors, (2) the investors are all accredited
investors, and (3) the --- und did not “generally solicit” investors. General solicita-
tion is a topic in its own right, but, in simple terms, the ban on general
solicitation generally prohibits any public advertising o --- or notice about the
und that seeks the 3(c)(1) exception. The problem with using the 3(c)(1) exemption, aside — rom the prohibition against general solicitation, is that it can be hard to count the number o — investors. Many o —
these investors are themselves --- unds, corporations, trusts, and other entities. The VC
irm is supposed to “look through” some o — these entities to determine the number o —
ultimate bene --- icial owners (UBOs). This look through can be di ---
icult to do, especially where some — unds have signed con — identiality agreements with their clients, or where the — und views its client list as business con — idential and proprietary in — ormation. In addition, the number o — UBOs can change. For example, imagine that Adam is an accredited investor who — orms an investment entity called Genesis Investments Limited. Genesis then becomes an investor in Sequoia Fund X. The ICA requires Sequoia to look through Genesis and count its owners; thus, Genesis counts as one UBO — or Sequoia Fund X. Then Adam dies, and his children Abel, Cain, and Seth inherit Genesis Investments Limited. Now Sequoia Fund X has three UBOs through Genesis. I — Sequoia Fund X had 99 investors be — ore Adam died, it has 102 now, and it no longer quali — ies — or the exception. Disquali — ying — or the exception in this way can be incredibly costly and thus VC — irms tend to avoid getting into this problem in the — irst place. Fortunately — or VC — irms, there is another exception: ICA § 3(c)(7). Under the 3(c)(7) exception, more than 100 investors can participate in a private — und i — all o —
them are “quali --- ied purchasers” (“QP”). The wealth requirement o --- a QP is --- ive
times (5x) that o --- an AI; that is, a QP is a natural person with not less than
$5 million in investment, or a business entity with not less than $25 million in
investments.
As the landscape appears today, AIs have di ---
erentiated into two general types: angels and VCs. In the 2010s, a new investor class, termed super angels, emerged. The rise o — super angels is described in the upcoming chapter on Social Media Investing.
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Angels
Angels are pro --- essionals who invest their own money in startups. Traditionally,
angels were hard to --- ind. Throughout the late 1980s, these wealthy individuals
connected with startups through in --- ormal and even secretive channels. In the
early 1990s, angels began to --- orm groups and publicize their activities. The --- irst
prominent angel investment group --- ormed in 1994. Silicon Valley’s “Band o ---
Angels” began with twelve members and grew to 110 members by 1998. From then
on, angel groups sprouted up throughout the United States. The number o --- regis-
tered angel groups has tripled since 1999. The Angel Capital Association estimates
that there are between 10,000 and 15,000 angel groups operating in the United States
today, with about 40 members per group. Many o --- these angel groups now have
a prominent website that contains a contract --- orm, public membership list, and even
a list o --- port --- olio companies.
Not all angels invest in groups. Some o --- the most popular angels continue to invest
in the traditional, solitary, and secretive way. Many o --- these traditional angels – like
Peter Thiel (one o --- the --- irst investors in Facebook) and Naval Ravikant (who --- unded
Twitter and Uber) – are --- amous --- or building groundbreaking startups or investing
early in hugely success --- ul ventures.
Not everyone can be an angel. Legally, an angel must be an “accredited investor,”
someone with at least $1 million in net wealth or $200,000 in annual income. The
U.S. census counts household wealth, not individual wealth, so estimates --- or the
number o --- potential angels varies, but 9.63 million American households had a net
worth o --- $1 million or more in 2013, which is about 3 percent o --- the U.S. population.
The Angel Capital Association estimates that about --- our million potential angels
reside in the United States – although this number may be o ---
because accredited status is determined by investors’ sel — -reporting, and corporations o — ten do little to veri — y whether such investors are actually accredited or not beyond merely asking the investors to certi — y their status. Despite the large number o — potential angels, only around 300,000 to 350,000 Americans make an angel investment each year. This is partially because an angel should have a solid understanding o — business planning, corporate — inance, pre — erred stock investment, and market conditions, plus a risk-seeking constitution. Angel investment is not — or everyone.
Angel Groups
Angel investors have learned to --- lock together in groups called angel syndicates. In
a syndicate, angels share the responsibility --- or sourcing opportunities to invest in
startups, evaluating those opportunities, negotiating terms --- or --- inancing the startups,
and overseeing the startup’s progress. Syndicates solve an economic problem called
“rational apathy,” which occurs when the time and e ---
ort spent on pursuing
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a --- inancial opportunity exceeds how much pro --- it that opportunity is expected to
bring.
Investing in startups requires a lot o --- work and expense. First, the investors need to
promote themselves, so entrepreneurs know to come to them looking --- or money, or
investors need to attend events where entrepreneurs are seeking --- inancing. Such
events are also styled as “demo days,” during which a variety o --- startups present their
ideas and prototypes to a crowd o --- potential investors. Then the entrepreneurs and
the potential investors usually have a meeting or series o --- meetings known as
a “pitch,” where the entrepreneurs share their ideas and explain what those ideas
are likely to lead to lucrative businesses. No one cannot be an expert in all business
areas, so simply understanding whether the pitch is plausible can be challenging --- or
angels, especially when the idea regards new technology. The angels also need to
evaluate whether the entrepreneurs seem reliable and honest.
I --- the business plan and the businesspeople pass muster, the investors will usually
conduct a more thorough investigation in a process called “due diligence,” in which
con --- idential business documents are shared so the angels can evaluate more speci --- ic
things like con --- irming the technology does not in --- ringe on existing patents. The
angels will also make sure the entrepreneurs’ company was properly incorporated,
that corporate actions were duly authorized, and that the company owns valid rights
to essential technology. The angels will also need to review ancillary agreements like
lease agreements (to con --- irm the corporation can continuing doing business at its
location without great expense or disruption) and to make sure that no --- ormer
ounders or disgruntled employees will lay claims upon the company’s property. I — the company passes diligence, then the angels usually pay — or lawyers to negotiate the terms o — the — inancing and to document the deal. Negotiating, docu- menting, and closing an early-stage angel — inancing deal can easily cost $10,000 or more. Even a — ter the closing o — the — inancial deal, angels still spend more time and incur more costs because they generally want to attend board meetings and review regular reports about the company’s progress. Keep in mind that angels, like VC — unds, need to diversi — y their investment into at least thirty companies in order to minimize idiosyncratic risk. In 2019, 323,365 angels invested a collective $23.9 billion into 63,730 startups, which amounts to an average o — $73,810 invested per angel investor. Angels usually do not create their entire diversi — ied port — olio o — thirty-plus companies in just one year, but even i —
a typical angel invests in --- our startups per year, this is less than $20,000 per angel
per startup.
Given the relatively small amounts that most individual angels invest in each
startup, it does not make sense --- or them to spend tens o --- thousands o --- dollars in
transaction costs to identi --- y, negotiate, and supervise these investments. In economic
terms, angels should be rationally apathetic about doing so much work --- or
a relatively small potential payo ---
. Moreover, i — angels had to spend this much time, e —
ort, and money on each — inancing transaction, that would — urther limit
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angels’ ability to diversi --- y their investments and to protect themselves --- rom idiosyn-
cratic risk.
The solution is angel syndicates. By collaborating, angels can share the work and
the cost o ---
inancing startups, which makes smaller deals more pro — itable and allows angels to diversi — y enough to signi — icantly reduce their investment port — olio’s risk. In 2019, there was an average o — 5.1 angels per investments. Angel groups have grown larger as technology has made it easier — or them to organize. The rise o — angel syndicate web plat — orms like Angel List are an important — eature o — twenty- — irst- century startup — inancing that is discussed in detail in the next part o — this book on ‘Social Media Investing’.
Venture Capitalists
To recapitulate the key points detailed above, VC --- irms create VC --- unds that are
managed by VC managers. The VC industry is thus distinguishable --- rom angel
investing because angels invest their own money, whereas in the VC industry
pro --- essionals manage the investments o --- large institutions known as quali --- ied pur-
chasers. VC managers --- irst create VC --- unds, which are o --- ten structured as limited
partnerships. The VC manager o --- a VC --- und then solicits large institutional invest-
ors (such as pension --- unds and university endowments) to invest in these such --- unds.
Once the VC --- und is --- ormed and capitalized, VC managers “deploy” that capital
primarily by investment in startup companies. These investments are mainly in the
orm o — purchases o — pre — erred stock in those startups. Pre — erred stock is so called because it has various pre — erences that common stock does not have; — or example, pre — erred stock is paid — irst upon a liquidation event, and this is known as the pre — erred stock liquidation pre — erence. The nature o — VC investment is quite di —
erent — rom angel investment because, as mentioned above, VC managers manage other people’s money, whereas angels invest their own money. VC — unds raise sums o — money — ar in excess o — most angels’ personal net wealth, and VC managers have to deploy this money very quickly because the — unds typically have eight to twelve-year li — e spans. When the — und’s li — e is over, the capital must be returned to the — und’s investors. As a result, VC invest- ment has evolved to occur in stages (early/seed, expansion, and late), while angels might only be able to a —
ord investing in early-stage companies. By investing across multiple stages, VC managers mitigate some o — the risk that startup investing typically entails. The VC industry has grown tremendously over the last — orty years, which has necessitated some changes in how VC managers invest VC — unds. While the number o — VC — unds and the amount invested in those — unds has increased dramat- ically, the number o — VC — und managers has not. With a similar number o — people managing a — ar larger amount o — money, contemporary VC managers tend to make larger investments than VC managers made — orty years ago. The result is that a very
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ew companies get a lot o — money — rom VC — unds: in 2019, VC — unds raised $51 billion o — new money into just 272 — unds. In that same year, VC managers invested $133 billion into 10,430 companies. But 44 percent o — that entire amount was invested in just 237 “mega-deal” investments o — over $100 million. In other words, less than 3 percent o — venture-backed companies received almost hal — o — the entire amount invested by VC — unds that year. The VC industry tends to specialize in investing in speci — ic industries. This is partly because VC managers have expertise in just a — ew industrial sectors. Those VC managers have better abilities to determine which startups are good to invest in when they are looking in an industry in which they have great expertise. VC managers also add more value to the startup companies they invest into when those managers have relevant knowledge about the startup’s business. In 2019, a third o — all VC investment went into so — tware companies. More than 10 percent went into pharmaceuticals and biotechnology, and another 10 percent was invested in commercial services. This trend has been consistent over time. Thus, over hal — o — VC investment goes into just three industry sectors. The VC industry tends to be localized. About 60 percent o — all the U.S. venture capital invested into VC — unds in 2019 went into — unds located in Cali — ornia. Likewise, about hal — o — all the capital that U.S. VC — unds invested into startups went to startups located in Cali — ornia that year. All o — the top ten VC — unds are located in Cali — ornia, with many o — them located on the same road, Sand Hill Road, just miles — rom Stan — ord University. The startup — inancing li — ecycle is a description o — how VC — unds invest into startups in stages – usually named Series A, B, C, and so on – that are described as li — ecycle events. The average Series A — undraising round, which is typically de — ined as the — irst — inancing that a startup received — rom a VC — und, has grown larger over time. In 1980, the average — irst-round — inancing into a startup was just over $1 million. In 2019, the average — irst round grew to $4.14 million. As VC — irms succeed and grow larger, they tend to make larger investments, which has created a gap in the startup — inancing li — ecycle at the earliest stage. Angels and, more recently, super angels moved in to — ill that gap. While angels are individuals who invest their own money in startups, super angels are a new term to describe — ormer angels who now organize — unds. Super angel activities have been — acilitated by the websites like Angel List that are dedicated to organizing investors and connecting them to startups, which in turn have only recently been both technology possible and legal thanks to changes under Regulation D as described above. Super angels invested around $500,000 in startups, which helps many early-stage — irms cross the seed valley o — death and grow into companies that become attractive investments — or VC — unds. The modern startup li — ecycle thus has distinct stages and distinct investors who participate more heavily at each stage. Angels invest small amounts at the earliest stage, sometimes be — ore the startup even — orms as a company when its — irst prototype is just an idea in the promoter’s mind. Super angels have evolved to — ill in the
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ever-widening gap, known as the seed valley o --- death, between when angels
tend to invest and when VC managers tend to invest. VC --- unds invest in
startups over stages, and increasing at later stages. The li --- ecycle ends well when
the startup sells itsel --- to another company in a merger or acquisition and
returns a pro --- it to investors. The li --- ecycle ends poorly when the startup goes
broke and liquidates or sells the --- ledgling operations at a discount. The ultim-
ate conclusion to a startup is when the startup goes public and accesses the
public capital markets through an initial public o ---
ering. The startup — inancing li — ecycle has evolved since the modern VC business model was — irst developed by — irms like Sequoia and Kleiner Perkins in the 1980s. Now it is going through another stage in its evolution. The original model concluded most success — ully when a startup went public. The problem is that startups aren’t going public as o — ten anymore. Instead, they are becoming large private companies, a new beast in the wilds o — private — inance. The emergence and dominance o — these large private companies, which were once called “Unicorns” — or their rarity and now number over — ive hundred, seriously impacts not only the VC industry but also the public stock markets. The legal reasons why Unicorns became a destabilizing — actor in the evolution o —
inancial markets stems — rom reactions to a startup — inancing bubble, which we will discuss in the next chapter.
bibliography
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Green, Alisha & Blanca Torres, Not Venturing Far --- rom Home: Why VCs Won’t Leave Sand
Hill Road, SAN FRANCISCO BUS. TIMES (2017).
KARAHAN, FATIH ET AL., UNDERSTANDING THE 30-YEAR DECLINE IN THE STARTUP RATE: A GENERAL
EQUILIBRIUM APPROACH (2015).
Manjoo,Farhad, How “Super Angel” Investors Are Reinventing the Startup Economy, FAST
COMPANY (January 12, 2011).
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National Venture Capital Association, NVCA 2010 Yearbook, (2010).
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National Venture Capital Association, NVCA 2020 Yearbook, (2020).
National Venture Capital Association, NVCA Yearbook 2008, (2008).
Oranburg, Seth C., Bridge --- unding: Crowd --- unding and the Market --- or Entrepreneurial
Finance, 25 CORNELL J. L. PUB. POL’Y 397 (2015).
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Press Release, SEC, Release No.33–295 (1935).
Rowley, Jason D., There Are More VC Funds than Ever, but Capital Concentrates at the Top,
CRUNCHBASE NEWS (2019).
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Gompers, Paul A., The Rise and Fall o --- Venture Capital, 23 BUS. & ECON. HISTORY 1 (1994).
https://doi.org/10.1017/9781316597736.007 Published online by Cambridge University Press The Third Era
Social Media Investing
Published online by Cambridge University Press Published online by Cambridge University Press 7
The Dot-Com Bubble
The emergence o --- the internet created at least two new opportunities --- or investors. First,
many companies raced to dominate the new region o --- commercial cyberspace, and
these “dot-com” companies needed billions o --- dollars o ---
unds to do so, which they sought and received — rom the stock markets. Second, the internet created a new means o — investing directly, without brokers. Ordinary investors could learn about stocks and even purchase them using new online plat — orms like Yahoo! Finance and e*Trade. While this democratized access to the stock market, it also created new challenges. Ordinary investors are generally less — inancially sophisticated and invest smaller amounts that large brokerage — irms and institutional investors, making the ordinary investors less able and less willing to understand the risks involved with investing in “dot-com” companies. At some points it seemed that any company with “dot-com” in its name could raise millions or even billions o — dollars, regardless o — whether it actually made money. As investors piled into these technology stocks, a bubble — ormed, and when it burst, — ortunes were lost. Angry citizens called upon the government to intervene, especially where losses could be blamed on loose regulations. Legislators answered the call by instituting new regulations that were meant to protect investors. But these protections went too — ar. Companies abandoned the public markets and instead sought — unding — rom private sources, such as in Silicon Valley. Ordinary investors were le — t clambering — or new investment opportunities, which they — ound in the — orthcoming cryptocurrency marketplace, a marketplace that turned out to be — ar harder to regulate. I don’t know technology, and I don’t know — inance and accounting. – Bernard Ebbers, CEO o — WorldCom, during his trial — or accounting — raud
The emerging dominance o --- large private companies (LPCs) – corporations that are
not registered with the SEC yet are valued by shareholders at billions o --- dollars –
undermines a --- undamental assumption o --- securities regulation. Securities regula-
tions are based on a sharp dichotomy between public and private companies. The
public/private dichotomy is a hallmark o --- securities regulations. Securities regula-
tions categorize a company as private i --- it has not registered its stock with the SEC.
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88 The Dot-Com Bubble
Registration brings the obligation to make periodic disclosures to the public and the
opportunity to raise money by selling stock in public markets. Startups traditionally
sought to “go public” by registering and having an initial public o ---
ering within about seven years o —
ormation because the venture capital — unds that — inance startups are established with a ten-year term. The invested money needs to be returned to the — und investors when the term expires. The ideal way — or this money to be returned is when a startup has an IPO, which is regarded as the “gold standard” in venture capital success. The ten-year term limit on venture capital
unds, established by HP’s success — ul model, drove startups to go public within that time — rame. The IPO was the crowning event at the culmination o — a process known as the startup — inancing cycle. It was once very rare — or a privately — unded startup to be worth more than one billion dollars and rare — or a startup to stay private — or long a — ter being valued at more than one billion dollars. The startup worth more than one billion dollars was so rare it was called a “Unicorn.” Startups, however, are not going public in an IPO or liquidating in an M&A event. Increasingly, they are staying private. As o — December 31, 2021, there were over 1,000 so-called Unicorns, with a cumulative value o — over $3 trillion. The most valuable private U.S. companies – such as Ripple ($10.0 billion), Stripe ($95 billion), and JUUL Labs ($12.0 billion) – are so large they prompted the new coinage “Decacorn,” a private startup valued at over $10 billion. Now there are even two hectocorns: Bytedance, a venture-backed startup now valued at over $140 billion, and SpaceX, worth over $100 billion, which have still not gone public. To put this in context, consider how valuable an average publicly traded company is. Although it does not capture every public company in U.S., the Russell 3000 Index measure the per — ormance o — the largest 3,000 U.S. companies and represents about 98 percent o — the investable U.S. public stock market. The median market capitalization o — all the companies in the Russell 3000 Index, meaning the middle valuation o — all 3000 o — these companies, is just under $1.9 billion. In other words, about 1500 companies representing almost 50 percent o — all publicly traded U.S. companies are worth less than $1.9 billion. Meanwhile, there are 216 private companies, each worth more than $1.9 billion. By the time you read this book, those high numbers will probably be even larger. Large private companies are larger and thus more in — luential than many compan- ies on stock exchanges, but they are not nearly as regulated. I — companies can become so success — ul by deliberately avoiding public markets, that says a lot about how poorly markets are — unctioning — or startups and their investors. Startups staying private and growing extremely valuable is a new phenomenon that a —
ects all startup stakeholders, including investors, employees, and society at large. This trend is the unintended consequence o — the securities regulations and market — actors, the result o — which is a large and growing gap between large private
inancing rounds and initial public o —
erings. In other words, startups are now able to
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stay private, yet access plenty o --- capital. Staying private longer undermines many
assumptions about private securities.
Why have unicorns – and now decacorns and even hectocorns – come onto the
scene? Why aren’t private companies going public anymore? The answer can be
ound by analyzing the impact o — a set o —
ederal regulations that were intended to protect the ordinary investors — rom the perceived excesses o — the IPO markets. Those excesses are o — ten re — erred to as the Dot-Com Bubble, a boom-and-bust cycle that was directly connected to the emergence o — the public Internet.
nasdaq: the tech stock market
The Dot-Com Bubble, which burst in March 2000, might trace its origins all the way
back to 1971. In that year, the National Association o --- Securities Dealers (NASD)
ounded a new stock market o —
ering an innovation called “automated quotations” (AQ). Unlike the NYSE, which had a physically trading — loor, the NASDAQ was a — ully electronic system since its inception. A startup itsel — , the NASDAQ — ocused on o —
ering more volatile growth-oriented securities. Its electronic AQ system, lower bid-ask spreads, and smaller commissions attracted technology companies. As the NASDAQ grew in popularity, it added — eatures including — our-character stock symbols, whereas the NYSE was limited to three characters (e.g., MSFT versus CAT). The extra character multiplies the possibilities — or naming and marketing stocks. In 2008, NASDAQ got even more — lexible, allowing one-, two-, three-, or — our- character symbols. Zillow (Z) because the — irst public company to o —
er a one-letter trading symbol. Perhaps the most impact — ul was the — act that NASDAQ could execute trades — or as little as a penny per share. The NYSE, on the other hand, could not handle spreads below 1/8 o — a dollar. Electronic trading made it possible
or computers to execute thousands or even millions o — trades per second, so the di —
erence between $0.01 and $0.125 quickly added up to millions or even billions o —
dollars in savings on the spread. This paved the way --- or penny stock to enter the
public markets.
penny stocks
Although the classic NYSE systems could not execute trades --- or less than 1/8 o ---
a dollar, the NASDAQ’s electronic system allowed trading --- or just a penny, which
enabled the innovation electronically traded penny stocks. Prior to this --- inancial
innovation, penny stocks were mostly traded “over the counter” (OTC). OTC trades
are one-o ---
inancial transactions. There is no OTC market per se, at least not one that is centralized in any physical location. The absence o — a central market, plus the variety o — products sold, is what distinguishes an OTC market — rom a central marketplace. Without a market in which to sell, OTC companies originally got noticed by investors by being listed on
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a publication by the National Quotation Bureau (NQB), which changed its name to
Pink Sheets LLC in 2000 and then the Pink OTC Markets in 2010. The moniker
“pink sheets” comes --- rom the color o --- the paper this publication was originally
printed on. NQB would publish over 200 pages o --- daily quotations o --- bid and ask
prices --- or stock that were generally much cheaper than those traded on exchanges
like the NYSE. The only way to order one o --- these stocks was to telephone a broker –
or get a call --- rom one. The popular movies Wol --- o --- Wall Street and Boiler Room show
how brokers would aggressively sell these pink-sheet stocks, including stock in
companies that were already bankrupt and others that never existed at all, to
unsuspecting buyers. The promise o --- cheap stock and easy money have always
proved alluring to the naı̈ ve and hope --- ul masses, especially those who --- eel otherwise
deprived o --- the American Dream. In 1989, the LA Times reported that American
investors were de --- rauded out o --- at least $2 billion a year by schemes involving penny
stocks, and that many o --- these --- rauds were run by the ma --- ia.
A --- ter the story broke, the --- ederal government responded with the Penny Stock
Re --- orm Act o --- 1990, which imposed stricter regulators on OTC stocks sold --- or under
$5 per share. This created an incentive --- or legitimate companies to list cheap stocks
on an exchange. In economic terms, the pink sheets created a pooling equilibrium,
in which it was hard to distinguish between legitimate and --- raudulent OTC penny
stocks. A solution to the pooling equilibrium problem is --- or one group to expend
resources to send a signal that it is higher quality than the others in that pool.
Initially only the legitimate companies with the strongest --- inances spent the
considerable resources to register with the SEC and list on an exchange, creating
a semi-separating (or partial-pooling) equilibrium. But this made the pink sheet
stocks even less attractive. Legitimate companies thereby --- ound listing on the pink
sheets less and less help --- ul and more and more legitimate companies abandoned
the NQB.
The NASDAQ made registration and listing more attractive by presenting
a cheaper and easier pathway than the NYSE. Today, the situation is reversed: the
NASDAQ imposed the world’s highest initial listing standards in 2005. Firms must
have a market value o --- at least $45 million, and the minimum stock listing price is
$4 per share. But it was and is cheaper to list on NASDAQ in part because there are
three market tiers. At the lowest tier, listing on NASDAQ’s capital market will cost
about $80,000 --- or the initial listing and an additional $27,500 annually. In compari-
son, the NYSE initial listing --- ee would be about $300,000, with an additional
$69,750 in annual --- ees.
Meanwhile, the growing internet was making it easier to get in --- ormation about
listed companies. This made it easier --- or investors and analysts to research small-cap
companies. Moreover, investors could more easily share in --- ormation. As America
got connected to the internet, ordinary investors could trade --- rom home. NASDAQ’s
digital --- eatures meant that, at least in theory, a trader in a home o ---
ice in Cleveland had the same access to trades as a broker in New York. In the mid-1990s, the
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NASDAQ appeared to be an a ---
ordable and equitable stock market, powered by the latest technology, that promised to give ordinary investors access to incredible opportunities to own a piece o — the internet. In practice, however, a digital divide was emerging, where high-speed internet connections would power algorithmic trading “bots” (automated so — tware robots that execute stock trades) — or the well-connected and technologically sophisticated, while others continued to get increasingly outdated data — rom traditional analog means.
the dot-com bubble
The internet grew organically --- rom the need to connect the various computer
networks that had been developing across the world. The De --- ense Advanced
Research Projects Agency (DARPA) organization was especially interested in con-
necting military and research computer systems. DARPA awarded a contract to Bolt
Beranek & Newman to build an Advanced Research Projects Agency Network
(ARPANET) that connected UCLA and Stan --- ord University. Other networks
including PRNET and SATNET --- ollowed, but they all used di ---
erent protocols and programming languages. DARPA and other organizations developed a universal Transmission Control Protocol and Internet Protocol (TCP/IP) in 1973 and pub- lished their — indings in 1974. Their paper, known simply as FRC 675, contains the
irst use o — the word “internet,” as a shorthand — or internetwork. The early internet was slow and limited, but by the mid-1980s the National Science Foundation (NSF) had developed the hardware and so — tware to send relatively highspeed messages across the country. NSFNET connected MIT in Cambridge, MA to Stan — ord University in Palo Alto, CA. Its decommissioning in 1995 was not the death knell — or the internet but rather a harbinger o — a shi — t — rom the internet as a military-industrial tool to a commercial product. While NSFNET was wrapping up, thousands o — private internet service provider (ISP) companies were — ounded. Although ISPs allowed ordinary people to access the internet, there was not much to see there in the early 1990s. The internet as we know it today did not yet exist, until Tim Berners-Lee developed the — irst web server and web browser in 1989 and 1990. Marc Andreessen, who would go on to — ound the Andreessen Horowitz (A16Z) venture — irm, developed the Mosaic web browser in 1993, which he sold to Microso — t — or use in its Internet Explorer. Both were surpassed by Netscape Navigator, the most popular browser o — its time. What made web browsers special is their graphical inter — ace that everyone could use. The web employed a point-and-click inter — ace that was much easier — or non- technical people to use. Windows and Mac OS emerged around this time such that many computers could natively display color — ul text, images, hyperlinks, and advert- isements. Thus the modern internet was born as a user- — riendly inter — ace built on
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repurposed military technology that provided a user- --- riendly way to search --- or
in --- ormation and to shop online.
Internet shopping or e-commerce was one o --- the biggest trends o --- the 1990s. As
consumer interest in the internet increased, virtually any company with dot-com in
the name proved to be a hot investment, regardless o --- whether or not they were
pro --- itable. Pets.com became the poster child --- or this internet mania.
Pets.com launched their website in November 1998, incorporated in
February 1999, obtained $10.5 million in venture --- inancing in March 1999, went
public --- or $11 per share in February 2000, purchased their biggest competitor
Petscore.com in June 2000 --- or $10.6 million, and announced their --- ailure and
liquidation in November 2000. In its --- irst --- iscal year, Pets.com earned $619,000 in
revenue and spent $11.8 million in advertising.
You do not have to be a --- inancial analyst to understand that these numbers do not
add up. Obviously, a company cannot survive long while spending --- i --- ty times more
than it earns. But Pets.com represented a paradigm shi --- t in thinking about invest-
ments and value. During the Dot-Com Bubble, companies went public be --- ore they
made pro --- its and, in some cases, be --- ore they realized much revenue. Financial
analysis --- rom respected publishers including the Wall Street Journal and CNBC
suggested that investors should rethink --- undamental theories in corporate --- inancing.
Some even suggested that traditional strategies, such as using pro --- its-to-earnings
ratios to assess whether a stock was over- or under-valued, no longer applied to
internet stocks, whose price could seemingly go up --- orever even i --- the company
never made any pro --- its.
The Dot-Com Bubble did not last long. Dot-com spending may have reached
its zenith in January 2000, when --- ourteen o --- the sixty-one ads shown during Super
Bowl XXXIV were purchased by dot-com companies --- or about $2 million per
thirty second video. O --- these, only --- our o --- those companies remain in business
today. And only three dot-com companies bought ad spots in January 2001 Super
Bowl XXXV.
That year brought several disasters that probably contributed to the down --- all o ---
dot-com companies, including the September 11 attacks upon America’s --- inancial
centers in New York and the Enron scandal in October 2001 that eroded con --- idence
in public companies. But dot-com companies were already burning out. These
events only accelerated their immolation. The WorldCom scandal in June 2002
and the Adelphia Communication Corporation scandal in July 2002 threw yet more
uel on the — ire. Paper millionaires went up in smoke. When the — lames — inally burned themselves out, the stock market had lost $5 trillion. One might think that we have learned — rom this con — lagration. But the — ederal government responded the way it always seems to in the a — termath o — a crisis: by presenting legislation so that past crises will never happen again. Un — ortunately, this reactionary approach to legislation might have simply pushed investors headlong into an even more risky and unregulated market: cryptocurrencies. In any event, the
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regulatory response is correlated with a growing divide between a wealthy private
investor class and the rest o --- America.
the sarbanes-oxley act o --- 2002
The Sarbanes-Oxley Act o --- 2002, sometimes called “SOX,” is a rare thing by today’s
standards: it was a bipartisan --- inancial bill. It quickly passed Congress with a vote o ---
423 in --- avor, 3 opposed, and 8 abstaining in the House and 99 in --- avor and 1
abstaining in the Senate. President George W. Bush signed it into law saying,
“today I sign the most --- ar-reaching re --- orms o --- American business practices since
the time o --- Franklin Delano Roosevelt.” He meant this as a positive, but history
might prove otherwise.
The intentions o --- the law were quite clear and consistent with the original
securities regulations that FDR signed into law in the 1930s. They were --- ounded
on the belie --- that higher disclosure requirements would eliminate --- raud. The
problem with Enron, WorldCom, and the rest o --- those scammers was simply that
the requirements --- or audits were too easy to manipulate, investors were too naı̈ ve,
and management too inept.
Never mind that Pets.com, WebVan.com, and Beauty.com all disclosed that they
made almost zero revenue while spending millions, yet people purchased these
stocks anyway. The blame was squarely laid on immoral managers and lazy auditors.
“The auditors will be audited,” President Bush went on. “The accountants will be
held to account.” But who will audit the audits o --- the auditors? Who will account --- or
accounting --- or the accountants? And who will pay --- or all this?
Dr. Suess addressed this problem in his philosophical treatise, Did I Ever Tell You
How Lucky You Are? The young protagonist, Duckie, travels to the --- ictional land o ---
Hwatch-Hawtch, where there’s a Hwatch-Hwatcher Bee-Watcher whose job is to
watch the lazy town bee, who presumptively will work harder and produce more
honey i --- he is watched. But monitoring the bee in this way did not result in increased
honey output. The town blames the Bee-Watcher --- or being lazy and prescribes
another Hwatch-Hawtcher to be a Bee-Watcher-Watcher. The story un --- olds in an
endless chain o --- useless oversight:
The Bee-Watcher-Watcher watched the Bee-Watcher. He didn’t watch well. So
another Hawtch-Hawtcher had to come in as a Watch-Watcher-Watcher! And
today all the Hatchers who live in Hawtch-Hawtch are watching on Watch-
Watcher-Watching-Watch, Watch-Watching the Watcher who’s watching the
bee. You’re not a Hawtch-Hawtcher. You’re lucky, you see!
Instead o --- concentrating their e ---
orts ensuring that the worker bee was not shirking his responsibilities, perhaps the Hawtch-Hawtchers would have been better served by diversi — ying their investments: investing in other industries would make the town less dependent on its bee’s per — ormance. Alternatively, they could have incentivized
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the bee to work harder by creating a pro --- it-sharing or stock-option plan, where the
bee was incentivized to work harder by earning a share o --- the pro --- its --- rom its honey.
Instead, the Hawtch-Hawtchers imposed a costly strategy on their society. Likewise,
the SOX o ---
ers limited protection at a premium price. Conservative estimates provide that companies spend about $10 billion each year on SOX compliance. Financial Executives International surveyed 200 public companies in 2006, — our years a — ter the enactment o — SOX. At that time, only 22 percent o — respondents believe that SOX’s costs were worth its bene — its. SOX also has a hidden cost to society that its promotors might not have con- sidered. Because SOX make it relatively expensive to be a public company, it encourages companies to stay private, where SOX and a myriad o — other regulations do not apply. SOX — ocuses its regulatory e —
orts on public companies. In — act, one o —
its primary contributions was to create the Public Company Accounting Oversight
Board. As the name implies, this board only oversees public companies. Private
companies are spared the expensive, hassle, and potentially criminal liability --- or
corporate --- inancial o ---
icers. Berkeley Law Pro — essor Randy Bartlett researched the impact o — SOX on staying private. His 2009 paper — ound that not only did SOX have a signi — icant impact on — irms’ decision to stay private, but SOX actually drove going- private transactions. In 2007, $329.7 billion in take-private deals were announced. This take-private trend continues today. In August 2019, Bain Capital announced that the pendulum has swung in — avor o — private deals over public ones. It seems that going public is too expensive — or most — irms. The result is the government has even less oversight and control, and even — ewer disclosures are required, than be — ore SOX was passed. Although public companies might be sa — er thanks to SOX – and the jury is still out on that question – there are — ewer public companies and many more large private companies to worry about. This is not just bad — rom a — raud perspective. Private companies are out o — ordinary investors’ reach. The securities laws, by de — inition, prevent nonaccredited investors
rom these lucrative opportunities. As more companies stay private, their employees who are paid in stock options — ind these options less valuable, since they cannot sell their shares into an open market. While the intention may have been good, legisla- tors should have considered that, over time, companies would try to avoid these expenses. Instead o — realizing this basic economic reality, well-meaning regulators and lawmakers have actually made the world a more dangerous and less lucrative place — or the ordinary investor. Only the accredited investors, who can invest in private companies, stand to pro — it — rom this expensive legislation.
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(2020).
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Surprise You (2012).
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Sarbanes-Oxley Act o --- 2002, 28 J. CORP. L. 1 (2002).
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Sarbanes-Oxley Act o --- 2002, 107 P.L. 204.
https://doi.org/10.1017/9781316597736.008 Published online by Cambridge University Press 8
Social Media Activism
The decentralization o --- news and in --- ormation due to the use o --- social media has
changed the --- inancial landscape. Large corporations used to be able to control the
in --- ormation that shareholders receive. But Wikileaks and Twitter have democratized
shareholder in --- ormation by allowing them to communicate with each other. Large
public corporations are not well equipped to use social media to send in --- ormation to
shareholders, and Regulation Fair Disclosure (Reg FD) may preclude them --- rom
doing so. But a new breed o --- activist shareholders who use Twitter to mobilize their
co-shareholders have increasing in --- luence over corporate activity. This social media
shareholder activism is one reason why being public is not as appealing to companies
as it once was.
We currently have a large position in APPLE. We believe the company to be extremely
undervalued. Spoke to Tim Cook today. More to come.
– Carl Icahn via TWITTER, August 13, 2013
On Monday, July 27 2020, upwards o --- 1.6 million shares o --- Kodak (KODK), a near-
extinct remnant o --- the --- ilm-photography industry, suddenly shot --- rom $2.62 per
share to $33.20 per share – a 1167.18 percent increase in just two days. Kodak has
made no announcements about upcoming products, nor about changes in leader-
ship. Their previous investor call ranged --- rom sleepy to downbeat. What would
cause such as remarkably rapid spike in price?
Social media – websites that allow users to connect and share in --- ormation – was
the source o --- the Kodak buying --- renzy. A news station in Kodak’s hometown o ---
Rochester, N.Y., tweeted that Kodak was poised to receive a passive $765 million
government loan – be --- ore this in --- ormation was made public. Almost simultan-
eously, local news outlets also prematurely reported on the initiative. The repercus-
sions were swi --- t and momentous.
Although the leaked in --- ormation was swi --- tly removed --- rom news streams and
Twitter, you cannot really scrub in --- ormation --- rom the internet. Kodak’s shares
quickly soared 8 percent within the hour. Within the week, the company’s stock
96 https://doi.org/10.1017/9781316597736.009 Published online by Cambridge University Press
Social Media Activism 97
33.20
30.00
25.00
20.00
15.00
10.00
8.75
5.00
8.45M
Jun 14 Jul 14 7/29/2020 14 Sep 14 Oct
igure 8.1 The Kodak price spike. Credit Yahoo! Finance.
hit a high o --- $60. Although the price eventually settled to around $7.50, --- ortunes
were won and lost in a span o --- just six days.
While stock prices have risen and --- allen due to wild speculation based on tenuous
in --- ormation --- or the entire history o --- stock trading, this episode re --- lects something
new. The in --- ormation was not provided by credible news sources, inside in --- orma-
tion, or word o --- mouth. Rather, the in --- ormation was provided by random and o --- ten
anonymous people via the internet.
Thanks to Web 2.0 technology, virtually anyone can send a message to the entire
world. The internet has democratized in --- ormation, meaning, the internet makes it
much easier --- or people to send and receive in --- ormation directly, without some inter-
mediary like a newspaper or a television reporter. This includes --- inancial in --- ormation.
Social media thus democratized the --- inancial landscape: using social media
plat --- orms like Twitter, Facebook, and Reddit, virtually anyone could send and
receive opinions about which stocks to buy, hold, or sell.
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Then, companies designed complex algorithms and other computerized tech-
niques to analyze social media --- eeds, news streams, and other sources to trade stock
almost instantaneously based on the available in --- ormation. Now, a single tweet can
set the automated stock trading systems into a --- lurry o --- activity, even when that tweet
is merely a tale told by an idiot, --- ull o --- sound and --- ury, signi --- ying nothing.
This chapter explores how social media creates a new basic --- or shareholder
democracies – and how it creates new risks --- or corporate control. Corporations
can harness the power o --- Web 2.0 to make corporate decisions more transpar-
ent and democratic, or they can risk users creating backchannels in the gray
areas o --- the web where cult o --- personality and magical thinking o --- ten de --- eat
common sense.
direct democratization o --- corporate governance
A public corporation is similar to a republic in that both employ representative
democracy. Shareholders delegate broad decision-making powers to a board o ---
directors, just as voting citizens delegate lawmaking powers to legislators. A direct
democracy, on the other hand, allows citizens to directly participate in voting on
policy decisions by re --- erendum. The --- ramers o --- the American constitution dis-
avored direct democracy, as does corporate law. However, historic trans — ormations in the way we communicate could make corporate direct democracy – where shareholder voters play an integral role in a broad scope o — corporate decision-making – possible and even practical. This begs the question o — whether such a system is desirable. With just a — ew SEC- sponsored tweaks to the — ederal securities law and some modi — ications to key state statutes, American public companies could be run as direct democracies. Innovations like webcasting, Twitter, Internet Protocol Security, and blockchain make it — easible — or shareholders to gain immediate access to extensive managerial and operational in — ormation and securely vote in real-time on a wide array o —
corporate matters.
In light o --- the social-media organized mass movements like the Arab Spring and
Occupy Wall Street – and being mind --- ul o --- increasing public pressure --- or corpor-
ations to make social responsibility business decisions – would shareholder direct
democracy be a glorious conclusion to the capitalist era, or would it be a crippling
impediment to e ---
icient economic — unctioning? Some may have a bias toward one approach or the other. A middle road to this modern circumstance is to let the market determine which corporate political structure is best.
internet shareholder voting
One way to unlock new shareholder governance regimes is simply to allow Internet
voting on corporate matters. Presently, shareholders have essentially zero
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opportunities to --- ormally address corporate governance issues between annual
meetings. The shareholder annual meeting is an anachronism. It imposes great
expenses on shareholders, e ---
ectively excluding many would-be participants. The direct bene — iciaries o — the current system are the institutional investors. Small shareholders who cannot a —
ord to attend the meeting are excluded — rom the process, or at the very least le — t with limited access to in — ormation and diminished interaction with board members and management, just as small shareholders were not invited to attend the quarterly analyst calls and who were excluded — rom timely receiving material non-public in — ormation. Corporations may be able to modi — y their bylaws to allow virtual shareholder meetings and Internet voting. By opening up a new avenue — or shareholder engagement, the SEC can create an opportunity — or the market to decide what mixture o — shareholder corporate control it values most – even i — that control is democratized. Antiquated rules mandated that shareholders submit their questions and demand that those questions be put to a shareholder vote through an arduous process. Rule 14a governs shareholders’ rights to present proposals at the annual meeting. Through a series o — amendments to Rule 14a, the process by which shareholders can commu- nicate their opinions has become more democratized. Shareholder communication rules are now more liberal than they once were, but shareholder voting rules remain limited by SEC rules and securities laws. While the intricacies o — 14a are beyond the scope o — this chapter, it is important to note one crucial amendment to Rule 14a which allows shareholder communication in real-time through “the use o — elec- tronic shareholder — orums.” The problem is that no one really knows what an electronic shareholder — orum is. Is it a chat room? A social media website? An open source blog? The rule does not de — ine the term, nor does it prescribe any particular — ormat — or such a — orum. The nebulous nature o — Rule 14a creates a great deal o — uncertainty as to where shareholders may communicate, although subsequent cases have begun to provide a little clarity. The SEC has determined that Facebook apparently is not an “electronic shareholder — orum.” Social media — irst got CEOs into trouble on July 3, 2012, when Net — lix CEO Reed Hastings posted to his personal Facebook page, “Net — lix monthly viewing exceeded 1 billion hours — or the — irst time ever in June.” Net — lix stock price increased 10 percent that day, and the SEC investigated whether Hastings’ post violated Regulation Fair Disclosure.
regulation --- d and shareholder collective action
Social media has had a pro --- ound impact on collective action, enabling users to
mobilize and swi --- tly communicate in --- ormation with --- ollowers and other users.
While its impact on social activism is well documented, its impacts on --- inancial
markets and shareholder activism are less known but equally pro --- ound. Shareholder
activism, which has long been plagued by collective action problems including
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rational apathy and --- ree riding,1 has been rejuvenated by emerging social media
tools like Twitter. Tweets, and other social media --- eeds, are a cheap and easy way --- or
shareholders to engage with each other and build consensus and support --- or
collective action.
As previously noted, the --- inancial revolution will not be televised. That one-way
communications channel o --- TV broadcasts has been predominately substituted --- or
two-way internet communications channels. Unlike TV, which is a passive medium
controlled by a --- ew major networks, social media in an active medium where users
participate in both consuming and producing in --- ormation. Social media has pro-
vided users, shareholders, and investors with a plat --- orm to express their opinions and
dissent with corporate dealings.
For example, Carl Icahn, the --- amous activist investor, grabbed Wall Street and
the tech world’s attention when he tweeted caustically, “All would be swell at Dell i ---
Michael and the board bid --- arewell.” These types o --- communications can have
monumental impacts on corporate decisions and valuations. However, the SEC-
mandated disclosure that is supposed to be included on all public securities-related
communications is not among them. A major problem with using Twitter to
disseminate securities in --- ormation is that it might violate Regulation Fair
Disclosure, or Reg FD --- or short, which requires public companies to disclose
material in --- ormation to all shareholders at the same time.
Reg FD is a relatively new rule promulgated in August 2000. At that time, only
reporters and large investors were invited to the quarterly analyst con --- erence calls,
where results o --- the past quarter were --- irst disclosed. Small investors who traded over
the Internet wanted equal access. Reg FD granted them equal access to material
nonpublic in --- ormation.
Shareholders can use social media in ways management cannot. Reg FD applies
unequally to Reed Hastings, CEO o --- Net --- lix, and Carl Icahn, stockholder o --- Apple.
Activists can now access virtually all shareholders and in --- luence public opinion
through social networks, relatively unencumbered by reporting requirements under
SEC rules. But management cannot simply tweet back to the critiques o --- activists.
Despite the --- act that Hastings was --- ound not to have violated Reg FD with his
Facebook post, it is not clear that management can simply respond to activist banter
without risking a disclosure violation. Management has to --- ight proxy battles in the
1
Rational apathy or rational ignorance occurs where the cost o --- educating onesel --- exceeds the expected
value --- rom that knowledge. For example, i --- it takes --- our hours to read corporate reports, a reasonable
person who only owns $50 worth o --- stock in that corporation would probably not bother to make that
e ---
ort, even i — it leads to a better investment decision, because the cost o — the e —
ort is worth than the value o — the investment. Free riding is a related concept. Where there is public in — ormation about a corporation – such as its stock price – people reasonably may rely on that in — ormation instead o —
educating themselves. When a stock price starts going down, people tend to sell because the price tells
them that the stock is not worth its current price, even though most o --- these people have not analyzed
the corporation’s --- undamental --- inances and prospects --- or themselves. Many o --- these investors assume
that a stock prices re --- lects someone else’s analysis o --- that stock’s real value, but this assumption is
increasing unsupportable in a social media investing world.
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social network arena with one hand tied behind its keyboard while activists use the
ull power o — social media to their advantage. Management does have one advantage: the power o — the purse. Management can pay — or its own reelection campaign with corporate money. In such a “proxy contest,” management might spend tens o — millions o — dollars o — corporate money to stay in power. However, board access to the corporate co —
ers to — und reelection campaigns – an antidemocratic — eature o — corporate law – might become less signi — icant as shareholder engagement gets cheaper and more democratized. Social media could enable low-cost yet e —
ective shareholder campaigns against management. For example, — or — our consecutive years, shareholder have organized to press ExxonMobil and other oil and gas companies to disclose the dangers o — hydraulic
racking. Management vehemently opposed this corporate social responsibility initiative. It was not until the ExxonMobil shareholders got enough votes to pass a precatory proposal — or — racking risk disclosure that management capitulated and stopped — racking. Nowadays, however, shareholder and even non-shareholders can pressure oil and gas companies simply by using social media. The battle over
racking has gone — rom the boardroom to the web where corporations that impact climate worldwide have signed on the Net Zero Carbon by 2040 Pledge. It has yet to be seen, however, whether these policies and promises are e —
ective substitutes — or shareholder votes and regime change — or corporate management. Unless social media pushes corporations to take legally binding actions, not just make policy statements, actualized commitments to these action statement are as ephemeral as the tweets they pu —
out. Some shareholder campaigns may be unsuccess — ul in moving management to change its policies, but they may yet be e —
ective in accomplishing goals o — awareness and corporate social responsibility. For example, grassroots activist shareholders – who originally organized on the Internet – descended on Sa — eway’s annual share- holder meeting to protest genetically modi — ied (GMO) — oods. Inside the meeting, shareholders voted on a proposal to remove GMO — oods — rom Sa — eway shelves that was proposed by the Sisters o — Notre Dame de Namur, a Roman Catholic order, who owned 8,800 shares o — Sa — eway stock, representing only about 0.00173 percent o — the outstanding shares at that time. Only 2 percent o — shareholders supported the proposal to remove GMO ingredi- ents — rom its products, and the proposal did not pass, but the demonstrations – which consisted o — shareholders in biohazard suits dumping Sa — eway produce in garbage bins in — ront o — the hotel where the annual meeting was held – attracted signi — icant media attention. Another grassroots movement, 99% Power, an o —
shoot — rom the Occupy Wall Street movement, organized protests at the shareholder meetings o — major banks during their annual meetings in Spring 2012. At least 500 protesters gathered at the Wells Fargo annual shareholders meeting, o — which about two dozen were arrested
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or chaining themselves together to block entry to the meeting at the bank’s head- quarters and — or entering the meeting and interrupting CEO John Stump — during his presentation. The protest, which included signs that read “Hells Fargo” and hand- outs o — dollar bills with an image o — a stagecoach (Wells Fargo’s corporate logo) pulled by human beings with the caption “Debt Slavery,” became so active that some shareholders were not allowed to enter the meeting. One such shareholder even used the protest’s Twitter hashtag to voice her — rustration that the protest prevented her — rom voting her shares. Just like the physical protests in the Arab Spring that were organized through social media plat — orms, grassroots shareholder activism can be organized and empowered by Twitter and Facebook. In — act, the Wells Fargo protest was planned, organized, and broadcast live using social media. The web site “Stop Wells Fargo” was established to — ocus attention on and raise support — or “major disruptions” at the Wells Fargo shareholder meeting. Visitors to that website were invited to “Follow the action on Twitter with #w — 24 #w — shareholders #not — eelingwells” and on Facebook.
A New Shareholder Activism
The “Hells Fargo” protests show a dramatic shi --- t away --- rom “classic” shareholder
activism. In the classic model, an activist would locate a company that it believed to
be undervalued. It would then purchase a large percentage o --- a corporation’s share
and use its shareholder voting rights to --- orce corporate management to make
changes designed to increase the corporation’s value. Classical activist means to
accomplish the ends o --- increasing corporate value include replacing management,
divesting unpro --- itable operations, downsizing ( --- iring employees), or even liquidat-
ing the company in merger or asset sale. Sometimes, the threat o --- these actions alone
would give activist leverage to --- orce management to make more modest changes.
Although classical activists’ tactics were largely success --- ul at increasing corporate
stock value, these actions were seen as ruthless and against the public interest. For
this reason, classical activists were o --- ten termed “corporate raiders,” and their actions
described as “asset stripping.”
An example o --- a classical activist who was o --- ten considered to be a corporate
raider is Phil Goldstein, --- ounder o --- Bulldog Investors. In an interview with --- inan-
cial writer Mark Gottlieb, Mr. Goldstein described himsel --- as a “transactional
activist,” but explained his standard playbook including buying enough shares to
threaten the board, then demanding cost-cutting measures. I --- management resists,
Bulldog will pursue a proxy --- ight, where it o ---
ers to buy shares — rom other investors until it has a controlling percent o — shares and the ability to replace management unilaterally. New social media might make traditional shareholder tactics unnecessary in many cases. Instead o — going through the costly process o — buying shares, social
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media activists seek to control the marketplace o --- ideas through likes, retweets,
ollowers, and subscriptions. I — trends continue, the — uture o — shareholder activism may start to look more like political activism and less like Bulldog Investors. Brayden King, Pro — essor at the Kellogg School o — Management has noted that activism through social media is inherently di —
erent — rom “classic” activism. It is not, “we are going to tout the party line, we are going to say what the NGOs are telling us to say.” Instead, King notes that it is, “we are going to personalize it. And this can catch activists by surprise. They may have gotten the ball rolling, but what actually occurs
alls out o — the control o — any hierarchical entity.” The most poignant distinction is that grassroots shareholder activism can quickly become unpredictable, because social media activists are not only motivated by corporate pro — its, and may in — act bene — it — rom the corporation’s economic — ailure.
corporate gad --- lies
Grassroots shareholder activism is not necessarily directed at increasing the overall
value o --- corporate stock, also known as unlocking shareholder value. There have
been numerous studies on whether shareholders’ ability to control or at least reign in
corporate activity increases share prices. This inquiry is particularly pertinent to the
shareholder social media activism. Many grassroots shareholder campaigns are
sponsored by shareholders with minimal holdings. The old name --- or these pesky
shareholders was “corporate gad --- lies.” Some gad --- lies are peskier than others: two-
thirds o --- all proposals submitted to Fortune 150 companies between January 1, 2008
and August 1, 2011 by individual investors came --- rom Evelyn Davis and members o ---
the Steiner, Chevedden, and Rossi --- amilies.
Nonpro --- its have --- ormed solely to purchase minimal amounts o --- securities
and leverage Rule 14a to make “precatory” proposals to major corporations,
which are statements --- rom shareholders expressing their wish --- or how manage-
ment might govern the company, but these statements are merely requests and
do not compel management to take action in accord with them. As You Sow,
a nonpro --- it --- ounded in 1992 to increase corporate accountability, launched its
shareholder activism program in 1997, whereby As You Sow would purchase
$2,000 in securities, hold them --- or one year, then make precatory proposals
related to various social issues. Corporate social responsibility activist As You
Sow is a per --- ect example o --- how a shareholder may purchase securities --- or
purposes other than value creation.
Whether shareholder democracy is good or bad is an immensely personal and
political question. Corporate law has not – and might never – settle on whether
corporations must maximize shareholder wealth or prioritize corporate social
responsibility. It is clear, however, that social media, in an age o --- already increasing
shareholder democracy and activism, is a power --- ul new tool --- or proponents o ---
corporate social responsibility.
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in --- luencers
Social media not only democratized access to communications. Social media also
made it possible --- or ordinary people to in --- luence market behavior. In --- act, social
media gave rise to a new kind o --- endorsers who are --- amous --- or being --- amous.
Individuals can create a brand identity based on their own identity, which they
use to target audiences and sell products via social media.
Sometimes called “micro-celebrities,” social media in --- luencers are ordinary
people who seek and achieve --- ame by creating a recognizable and marketable
internet identity. This concept is not entirely new – reality TV shows ranging --- rom
The Real World to Survivor have been broadcast since the early 1990s – but what
distinguishes social media micro-celebrities --- rom those who came be --- ore is that
social media allows people to make their own celebrity without any network,
publisher, or political support.
The quintessential in --- luencer is Kim Kardashian West, who is --- amous --- or being
amous. She has over seventy million — ollowers on Twitter, and many more on Instagram and other plat — orms. She can reach a lot o — people, and she commands a high price to do so. In her 2019 complaint against Missguided (a — ast- — ashion brand), she alleged that she commonly receives three to — ive hundred thousand dollars — or a single Instagram post. Recently she has posted advertisements — or a new cryptocurrency, Ethereummax, on her accounts. Experts report that Ethereummax is a risky new coin with — ew virtues and no documentation, but the coin’s advertising campaign appears to be drawing users. In the social media era, in — luencers are able to generate a great deal o — public interest to various opportunities, including investment opportunities, even though such in — luences would not have any credibility in a traditional marketplace o —
ideas. For example, in 2017, entrepreneur Billy McFarland and rapper Ja Rule
decided to create a new music --- estival on a remote island in the Bahamas. Despite
the --- act that neither had any experience in developing such events, and despite
the --- act that the location was totally unsuitable to host tens o --- thousands o --- people
over a several-day period, the event promotors were able to pay social media
in --- luencers to advertise the event. The resulting Fyre Festival turned out to be
a total disaster, o --- course, and McFarland pled guilty to wire --- raud to de --- raud
investors and ticket holders, which led to his six-year jail sentence. Nevertheless,
many investors and consumers lost millions o --- dollars in this --- raud. The in --- luen-
cers were not held accountable.2
In --- luencers can and do e ---
ect stock prices, too. For example, when Carl Icahn, the legendary investor, tweeted that he has a large position in Apple Corporation, the
2
In --- act, co-authors Pro --- essor Duncan Brown and historian Nick Hayes essentially predicted this
outcome in their 2008 book, INFLUENCER MARKETING: WHO REALLY INFLUENCES YOUR CUSTOMERS?,
which de --- ined an “in --- luences” as in --- luencer as a “third party who signi --- icantly shapes the customer’s
purchasing decision but may never be accountable --- or it.”
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stock price immediately rose and hit a six-month high. When Elon Musk, CEO o ---
Tesla Corporation, tweeted that he was selling 10 percent o --- his shares to pay taxes,
the stock price --- ell almost 5 percent. The SEC has investigated some o --- Musk’s
tweets because they could violate Regulation Fair Disclosure, which limits what
major public companies can say to a select audience. The SEC --- ined Musk --- or his
impropriety, but he continues to bend the rules to their limits.
More recently, however, Congress and --- ederal regulators are paying more atten-
tion to social media in --- luences’ impact on public markets. In particular, an episode
involving a relatively small public company, GameStock (GME), was targeted by
social media in --- luences in a potential pump-and-dump scheme that led to
a Congressional hearing.
The GameStop Episode
Even people who are not already --- amous can impact stock prices --- rom their
desktops. Keith Gill, who posts on the social media plat --- orm Reddit under the
username DeepFuckingValue, drove a --- renzied mob to purchase GameStop stock
in the major “meme” stock event o --- 2021. Gill claimed that GameStock was a good
value to purchase because too many investors held short positions. I --- enough people
purchase the stock, Gill reasoned, the price would go up. As the price goes up, it
becomes more expensive to maintain a short position. Eventually, the short-sellers
would have to give up their position or hedge by taking long positions too; either way,
that should --- urther increase the stock price.
GameStop (GME) was not a particularly interesting or compelling stock. For
most o --- 2020, its stock price hovered around $5 per share. Its price rose along with the
rest o --- the market in last 2020, but this was neither exceptional nor outstanding. Its
market capitalization (the total value o --- all its outstanding shares o --- stock) ranged
rom about a quarter-billion dollars in early 2020 to a little over a billion dollars by the end o — that year; thus, GME never accounted — or more than about 0.002 percent o — the New York Stock Exchange’s total market value o — about $50 trillion in 2020. There were no particularly compelling announcements, either. On an investor con — erence call in the third quarter o — 2020, GameStop announced that, like most retail companies amid the pandemic, sales and pro — itability were down, with a net loss o — $0.53 per share. The company tried to paint a rosy picture o — its so-called optimization journey, which was it plans to shutter over 1,000 stores and reduce inventory. This was hardly a cause célèbre; rather, it was seen by most investors as a generally dismal picture that was commonplace — or corporations in the doldrums o — the COVID-19 pandemic economy. But the story circulating on social media painted a vastly di —
erent picture. Amateur investors organized on the Reddit — orum “WallStreet Bets.” There, a pseudonymous user going by the name o — “delaneydi” shared his alternative thesis on why GameStop was undervalued. His, her, or its back-o — -the envelope math
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suggested the share price should be $18. This post led to users bantering and joking
that the social media investors on that Reddit --- orum should take over the company.
At some point, however, the joking grew serious. Sometime around November 29,
2020, the r/WallStreetBets conversation turned --- rom the merits o --- GameStop to the
act that major Wall Street investors were shorting the stock. A “short” position pro — its when stock values go down. In brie — , the short investor borrows the stock and sells the borrowed shares. I — the stock price goes down, the short seller can repur- chase shares at the lower market price and then return them to the investor — or a pro — it. Short sellers have been reviled throughout history. President Herbert Hoover blamed the stock market crash on in 1929 on short sellers. Short sellers were blamed again — or the 1987 “Black Monday” crash, and again — or the 2008 — inancial crisis, when short selling was brie — ly banned. A short seller even played the role o — a James Bond Villain – Le Chi —
re, The Cypher. The negative public impression o — short sellers and regulatory uncertainty around short selling limits some managers’ ability to interpret these actions and — or novice investors to use such instruments. In January 2021, a r/WallStreetBets moderator known as DeepFuckingValue prodded his community to go long on GameStop stock. In — luencer and YouTube micro-celebrity Roaring Kitty goaded them to — orce the short sellers into a “short squeeze” just to cost them billions.
The Short Squeeze
A short squeeze can occur when a stock that has been shorted has an unexpected rise
in value. When the price surprisingly goes up, short investors (who have bet that the
stock price will go down, and who pay o --- ten interest --- or every day they maintain that
position) will want to limit their losses. One way to limit these losses is to convert to
a long position, that is, to buy shares immediately, instead o --- waiting --- or the price to
climb even higher. Such a purchase stops interest payments, and, moreover, the
ormerly short investor now will instead make a pro — it i — the stock continues to go up. But i — many short investors cover in this way, the sudden demand to buy this stock sends its price even higher. A positive — eedback loop buoys the stock price higher and higher, wreaking havoc upon the short investors who continue to bet that the stock price would go down, while providing a wind — all to the long investors. Short sellers usually trade on margin (meaning they pay a daily interest rate to hold the short position), which creates an additional pit — all — or them. Margin is a term that simply means the money that is borrowed to purchase an investment. Investing using borrowed money is called buying on margin. When the investor borrows money — rom a stockbroker, the stockbroker opens a margin account, into which the margin investor must make an initial cash deposit to “cover” part o — the margin. The initial cash deposit varies, but most brokers require investor to deposit an amount equal to hal — o — the cost o — the stock to be purchased. In general, such
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50 percent coverage shall be maintained so long as the investor has an outstanding
short position.
Margin investors are also contractually obligated to deposit additional cash into
the margin account upon various events. When brokers require investors to deposit
additional cash into the margin account, that is called a margin call. For example, i ---
the investor used borrowed money to purchase a stock (taking the long position),
a decrease in the market value o --- that stock may trigger a margin call.
Investors can also obtain short positions on margin. In --- act, Federal Reserve
Regulation T requires short traders to maintain 50 percent o --- their loan amounts
in margin accounts. I --- the value o --- the equities in that account decreases, then the
investor must put more cash into the margin account so it totals 50 percent o --- the
loan value again. This is called a “Regulation T call,” and it mandates that short
seller put more cash into margin account as a matter o ---
ederal regulations. In addition to Regulation T calls, lenders who lend stock to short investors may become increasingly worried that the short investors will become unable to repay that loan as the short’s value decreases. Such worried lenders – who are o — ten the investor’s stockbroker, too – o — ten demand that the short investors make additional margin calls, lest the investor’s trading account be — rozen. Thus, short investors have to put more cash into margin accounts, which — unc- tions as collateral that the lenders can take i — the borrower de — aults on the loan, especially when the short drops precipitously in value. To get the cash necessary to true up the margin account, short investors might have to sell some o — their short positions immediately, even at a loss, or as a stop-loss strategy. As short investors sell o —
their short positions to raise cash — or margin calls, this increases the supply o —
short positions in the market, which puts downward price pressure on the value o ---
short positions. As the short positions lose value, more and more short investors need
to sell o ---
larger and larger positions to make margin calls, thus creating a — eedback loop that pushes the value o — short positions lower and lower while the value o — the long position climbs higher and higher. In theory, long investors could — orce short investors into a money-spewing short squeeze i — the long investors simply drove the price up enough. This is generally hard to do with the large-cap stocks that short investors tend to pre — er, but stranger things have happened. In — act, Porsche SE employed the short squeeze on investors. Volkswagen almost went bankrupt in the Financial Crisis o —
- Short investors bet heavily that the car company would not survive. But Porsche was secretly buying up shares in the beleaguered company. On October 26, 2008, Porsche announced that it held 74 percent o — Volkswagen stock. The stock price suddenly surged, and the nearly bankrupt Volkswagen brie — ly became one o — the world’s most valuable stocks, topping out at over $370 billion in total market capitalization. Short investors lost billions in what has been called the Mother o — all Squeezes and the In — inity Squeeze.
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The un --- ortunate economic --- act that short investors can be put into an unrecover-
able tailspin has thus been utilized by large institutional investors be --- ore, but not
until recently were short-squeeze tactics used by an online rabble o --- amateur
investors.
The GameStock Short Squeeze
In late January 27, 2021, tens o --- thousands o --- users on the --- ree stock trading app
RobinHood drove up GameStock. They were --- ueled by r/WallStreetBets and
YouTube in --- luencers who --- ocusing on and asked “Have you robbed your billionaire
today?” With the mantra “never sell, never surrender,” this social media consortium
drove the price up --- rom an average o --- just under $20 per share on January 11 to an
intraday high o --- $483 on January 28, 2021 – an incredible 2315 percent increase in less
than three weeks.
Short investors lost billions. Melvin Capital, who was explicitly targeted by r/
WallStreetBets users, lost 53 percent o --- its investment, requiring its --- inancier Citadel
LLC and Point72 Asset Management to invest another $2.75 billion just so Melvin
could meet its margin calls. Meanwhile, DeepFuckingValue apparently earned over
$11 million.
Damages to short investors and pro --- its to social media in --- luencers and others with
long positions were actually cut short. RobinHood, the --- ree trading plat --- orm on which
many o --- the social media users purchased long-call investments, ran out o --- money to
post collateral --- or its users and shut down. Within days, however, RobinHood raised at
least $3.4 billion so it could meet collateral calls and continue trading.
meme investing
Some pundits quickly concluded that the GameStop Episode may be the end o ---
short selling, but it’s too early to ring the death knell --- or this investment technique.
Short selling will always be pro --- itable in some instances, and many economists have
recognized how short selling helps markets --- unction more e ---
iciently. But the way in which investors take short positions may change. Short investors should now be about concerned about backlash and attacks on social media. Not only are short sellers unpopular — or pro — iting only when companies and economies are — ailing, but short sellers also make an easy target — or a mob with enough money. Unless short sellers — igure out how to avoid the short squeeze triggered by a social media rush into heavily shorted stocks, especially small-cap stock whose prices are more easily impacted, then short investors would be wise to keep their positions under wraps, lest their position comes into the crosshairs o — a r/ WallStreetBets social media in — luencer. The term “meme stock” entered the vernacular in February 2021 to describe a company whose stock price experienced a spike o — rapid growth not because o —
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any underlying improvement to its --- undamentals or economics but only because it
was targeted by a social media campaign. This is like the pump-and-dump schemes
o --- old, but this pump is “organized” by a loosely a ---
iliated online group o — outsiders and amateur investors, instead o — the corporate insiders and Wall Street pink sheet brokers that pumped stock be — ore. Such organization was not possible be — ore social media “democratized” access to in — ormation and investment. In this new era o — social media investing, stock manipulation schemes have been democratized, too. Now anyone with an internet connection can try to rally a crowd to purchase stock, seemingly without regard to that stock’s — undamental value, especially when doing so can be — ramed as an attack on the mega-rich. Meanwhile, anyone with a Twitter account can bring attention to perceived corpor- ate wrongdoing and drive millions o — people to sell that stock or even boycott the company. While investors and corporations always had to be concerned about their public image, social media investing greatly raises the risk that a variety o — behavior
rom taking short positions to donating to certain political candidates will result in a social media backlash that can eradicate value in record time. Ordinary investors thus — ound themselves between a rock and a hard place. On the one hand, regulations give wealthy investors more access and options to beat the market than ordinary investors had. On the other hand, power — ul and in — luential personalities can move markets while common — olk can at best come along — or the ride – or get drowned in the wake o — resulting market turbulence. With such a narrow route to — inancial success, investors began looking — or ways make money outside o — the regulated public marketplaces. They — ound such an opportunity in the nascent cryptocurrency market.
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https://doi.org/10.1017/9781316597736.009 Published online by Cambridge University Press 9
Cryptographic Theory and Decentralized Finance
When bitcoin was --- irst announced in 2008, only a --- ew anarcho-capitalists gravitated
to its notions o --- a decentralized global currency. But the technology powering
bitcoin – the blockchain – proved to be an incredibly e ---
ective means o —
acilitating transactions between anonymous or pseudonymous parties. In general, it is — oolish to contract with someone that is not trustworthy. But blockchains enables “trustless” transactions by using a combination o — cryptography, digital signatures, and incen- tives. As a result, people are willing to transact with strangers using cryptocurrency. Companies are now using cryptocurrency — or corporate — inancing. Is this a return to the era o — rugged individualism, or will big data and the internet pave the way — or a new — orm o — regulation? The Times 03/Jan/2009 Chancellor on brink o — second bailout — or banks. – Bitcoin Genesis Block, “Satoshi Nakamoto,” 3 January 2009
Cryptocurrency markets are sel --- -regulated, and increasingly popular, digital market-
places --- or ordinary investors to conduct transactions – similar to the Wild West o --- the
First Era. While sel --- -regulating markets have some desirable aspects, the anonymity
eature o — cryptocurrency markets has its drawbacks which can lead to more — raud and corruption i — le — t completely unchecked. The “crypto” part o — the word cryptocurrency re — ers to cryptography, which is the practice o — writing and deciphering codes in order to keep messages secret. Although the concept is thousands o — years old, it has evolved dramatically thanks to modern computing power.
origins o --- cryptography
Cryptography dates back at least as --- ar as ancient Greece, where it secured wartime
communications between Generals. Spartans would wrap leather or parchment
around a wooden cylinder, known as a scytale, and then write a message while the
parchment was wrapped around it. When the message was unraveled --- rom the
scytale it would be meaningless because the letters were no longer aligned up in
112 https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press
Cypherpunks 113
the proper places. The only way to decode the message was to wrap it around another
scytale o --- the same shape and diameter, that only the intended receiver possessed, so
the letters in the message could be properly aligned again. Even i --- the parchment
was made public, its message would remain private to anyone who did not have the
scytale.
But the scytale had serious limitations. It is a symmetric cipher system, meaning
the encryption and the decryption is done using the same scytale. Both the sender
and the receiver must have scytale that match exactly. I --- multiple people are
sharing coding messages, each must have a copy o --- the same scytale. When the
system gets large enough, it is hand to ensure con --- identiality. For example, i ---
a Spartan general was captured, the enemy might also capture a copy o --- the
scytale. Not only would that enable the enemy to read encrypted messages, but
would also allow the enemy to send --- alse codes. This actually happened on May 9,
1941, when British captured a German U-110 submarine and --- ound on board the
Enigma machine that the Nazis used to encode and decode messages between
German command ships.
cypherpunks
To understand the origins o --- modern cryptocurrency and the nature o --- this unique
technology, one must understand the motivations o --- its creators: the Cypherpunks
and the ever-elusive “Satoshi Nakamoto.” As Chapter 6 explained, computer sci-
ence research and development accelerated during World War II. The British
needed computers to decrypt Nazi code. The American needed computers to
build the atom bombs that would decimate Nagasaki and Hiroshima. Computer
science in its in --- ancy was thus thrust into acts o --- war. Some --- eared that computer
science, although developed --- or the sake o --- saving democracy, would be used by
state as a --- orce o --- oppression against its own people.
The people known as the Cypherpunks developed their own computer
science resistance movement and used cryptography to --- ight --- or the --- reedom
o --- privacy. Cypherpunks originated as civil libertarians and privacy advocates
resisted government e ---
orts to control the emerging internet in the so-called Crypto Wars. The U.S. Government classi — ied cryptography – computer tech- nology that encrypts in — ormation and thereby makes in — ormation unavailable even to government agencies – as a “munition.” Cryptographic devices, so — t- ware, and components were listed on the United States Munitions List, banned alongside nuclear weapons. Export o — cryptographic technology was e —
ectively banned until 1992. (Export o — cryptographic technology remains restricted today.) Eric Hughes, Timothy May, and John Gilmore started the organization in 1992, meeting monthly in San Francisco. They created a mailing list where they could virtually meet and discuss their hopes — or the — uture with their — ellow cryptography
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enthusiasts. Hughes wrote “A Cypherpunk’s Mani --- esto” in March o --- 1993. Elegantly,
he said in the opening paragraph:
Privacy is necessary --- or an open society in the electronic age. Privacy is not secrecy.
A private matter is something one doesn’t want the whole world to know, but a secret
matter is something one doesn’t want anybody to know. Privacy is the power to
selectively reveal onesel --- to the world.
The mani --- esto speaks directly to the tension between cryptocurrency and regulation,
and it boldly proclaims that cryptography will eventually prevail over e ---
orts to regulate encryption: Cypherpunks deplore regulations on cryptography, — or encryption is — unda- mentally a private act. The act o — encryption, in — act, removes in — ormation
rom the public realm. Even laws against cryptography reach only so — ar as a nation’s border and the arm o — its violence. Cryptography will ineluctably spread over the whole globe, and with it the anonymous transactions systems that it makes possible.
Ironically, the Cypherpunk movement itsel --- was not especially secretive or private.
Most o --- their technology was open source. They created code that anyone can
download. Writing computer code is the --- irst step in developing so --- tware. The
computer code can be read and understood by humans. Then the code is compiled
into a machine-readable --- orm called an application or simply an app.1
The Cypherpunks published their code so that users could see --- or themselves how
that code --- unctioned be --- ore compiling it themselves. This open-source strategy
allowed the movement to grow quickly, but it also put additional demands on the
technology they created. In a sense, the Cypherpunks also encoded their political
philosophy in their cryptography e ---
orts. The processes and products they developed contains — eatures o — classical liberalism, democracy, and anarchy within the struc- ture o — its code. Cypherpunks needed to ensure that open-source code could be used to create private in — ormation. The solution, blockchain technology, discussed in depth later in this chapter, required an innovation in public-key cryptography. The technology used to power the — irst success — ul cryptocurrency, Bitcoin.
1
Apps must be run by computers and cannot be read by human beings. (Although apps can sometimes
be partially decompiled back into human-readable code, this is an imper --- ect and di ---
icult process.) This means that app developers can hide ne — arious programs in apps that cannot be hidden so easily in code. Recent scandals include, — or example, the popular TikTok app. Security researchers discovered that TikTok was programmed to secretly access the clipboards on users’ devices. I — TikTok is active, even i — it is just running in the background, then it can read anything written on that device. Passwords, sensitive messages, con — idential emails, and — inancial in — ormation could thereby be secretly copied by the app and sent to TikTok’s headquarters in China. The Chinese government may be able to accesses in — ormation that enters its jurisdiction, thus exposing tens o — millions o — American’s most private and sensitive in — ormation to the world’s largest communist government.
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bitcoin
Bitcoin is by --- ar the world’s most --- amous and success --- ul cryptocurrency today. As o ---
February 2021, Bitcoin alone accounted --- or more than two thirds o --- the total market
cap --- or all cryptocurrencies. But, even though the market cap --- or Bitcoin is almost
a trillion dollars, most people don’t know how it originated or how it works.
Bitcoin was created by Satoshi Nakamoto, who stated purpose was to create
a monetary regime that made it unnecessary --- or people to use the current centralized
inancial system. The technology allows parties to cut out costly middlemen, namely the banks, and replace them with a decentralized system that can operate beyond the borders o — any centralized authority. Moreover, transactions were per — ectly veri — iable yet totally private. Bitcoin is a network system that enables a decentralized system o — trust veri — ication between users, coupled with desirable privacy — eatures. With a system o — decentral- ized trust between users, there was a reduced need — or a centralized — inancial
igure 9.1 Market share o — the top — i — teen cryptocurrencies in February 2021.
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authority acting as the middleman. Many have opined that Bitcoin’s e ---
iciency and its decentralized ledger have the capability to signi — icantly reduce transaction costs in addition to eradicating corruption in the current legal, political, and transactional regimes. This may have indeed been part o — its creator’s intentions.
satoshi nakamoto: what’s in a name?
On Halloween, 2008, someone using the name Satoshi Nakamoto sent an email to
the Cypherpunks mailing list. Nakamoto wrote, “I’ve been working on a new
electronic cash system that’s --- ully peer-to-peer.” The mysterious email directed
those who read it to a website with a nine-page “white paper” document describing
the plans in greater detail. That was the beginning o --- the dramatic roller coaster that
we know today as the Bitcoin Revolution. It started as nothing more than an email to
a --- ew people who enjoyed programming, cryptography, and privacy.
Satoshi Nakamoto is a pseudonym. Understanding why Nakamoto used
a pseudonym, as opposed to using a true name or posting anonymously, reveals
much about why Cypherpunks and other --- locked to Bitcoin. Anonymity, pseudo-
nymity, and nonymity represent three states in which people can share in --- ormation.
Anonymity is untraceable privacy. Authors may write books or letters anonymously
to avoid personal repercussions --- or stating controversial views. Such works are
attributed “Anonymous.” No speci --- ic name is given to the work’s author. The
amous novel Frankenstein was originally published anonymously, perhaps because its author Mary Shelly was concerned that people in eighteenth-century England would not take seriously a novel published by a woman.2 Anonymity may be use — ul
or works that speak — or themselves, such as — acts that lead to arrest o — a criminal.
Anonymity
Anonymity is also use --- ul --- or committing crimes and getting away with it. Those who
know about Bitcoin have probably heard o --- Silk Road, the online black-market
website shut down by the FBI in 2013, but which keeps popping back up with various
names and --- orms. Silk Road was run through an anonymous network known as Tor
which e ---
ectively made traceability impossible. Without — ear o — arrest, anonymous criminals transacted among one another without being tracked. Tor’s anonymity was lauded by privacy-driven people, but its connection to Silk Road and other
raudulent activity overshadows those bene — its — or many others.
2
I --- Shelly was indeed concerned that her gender would discredit her novel’s political contribution, she
was right. The British Critic e ---
ectively dismissed the novel because it suspected the author was — emale, writing “The writer o — it is, we understand, a — emale; this is an aggravation o — that which is the prevailing — ault o — the novel; but i — our authoress can — orget the gentleness o — her sex, it is no reason why we should; and we shall there — ore dismiss the novel without — urther comment.” https://uminn pressblog.com/2019/01/18/ — rankenstein-and-anonymous-authorship-in-eighteenth-century-britain/
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Moreover, anonymity is unsuitable --- or transactions where trust is required.
A person would likely not entrust an anonymous person with their valuables. Most
people would not lend their car to a total stranger or give an anonymous person cash
to pay a bill on their behal --- . A newspaper might not trust an anonymous source
because it is not possible to veri --- y whether the source provided true in --- ormation. By
putting one’s name to something, one is e ---
ectively providing some basis — or trust. One can consider another’s reputation as a proxy — or determining whether to trust that person. But an anonymous person has no reputation and there — ore no innate basis — or trust.
Pseudonymity
Pseudonymity di ---
ers — rom anonymity in that instead o — providing no name a — alse name is given. Although the pseudonym initially has no reputation, that pseudonym can develop a reputation over time. Pseudonymous writings have long been used to inspire political action. In 1769, someone using the pseudonym “Junius” published scathing letters attacking the Prime Minister o — England, who resigned in 1770 citing the Junius letters as one o — the most signi — icant reasons — or his departure. During the debates over the design o — the United States Constitution, many arguments were published under pseudonyms, including Publius (used by Alexander Hamilton, James Madison, and John Jay), Brutus (Robert Yates), Senex (Patrick Henry), and An Old Whig (an unknown Anti-Federalist). In more recent times, — amous author J. K. Rowling used the pseudonym Robert Galbraith, who said that “being Robert Galbraith has been such a liberating experience. It has been wonder — ul to publish without hype or expectation, and pure pleasure to get — eedback under a di —
erent name.” Pseudonyms develop a reputation and a perception over time, such that people might tend to trust or at least better understand a well-known pseudonymous author more than an anonymous one.
Nonymity
Nonymity, a term created --- or the purposes o --- this chapter, is the use o --- one’s true
identity. In a realm o --- nonymity, users lack all privacy. There is no hiding ideas and
actions. There are no secret transactions. Everything may be tracked and monitored.
Nonymity is not identical, but bears the closest resemblance to the current state o ---
the world. Banks and other --- inancial institutions have a hand in almost every aspect
o --- one’s li --- e. They know people’s names, where they live, their occupation, their
amilial status, how much they are worth, and even the digits o — their social security number. That, o — course, is aside — rom other personal in — ormation most people disclose to their doctors, lawyers, accountants and business partners – all o — that is tracked too. Even to the extent that outline activities are individually anonymized,
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arti --- icial intelligence can o --- ten employ mosaic theory to --- igure out who is who
regardless.
Like Junius, Publius, and Senex, Satoshi Nakamoto assumed a pseudonymous
identity in order to push --- or economic and social change. All o --- his emails were
encrypted and untraceable. Just as mysterious as his arrival, so too was his exit.
One day he randomly appeared with an idea; another, completely vanished –
never sending another email. We can say “he,” “she,” or even “they” when
re --- erring to Satoshi. The search has pointed --- ingers at many people like Neal
King, Vladimir Oksman, and Charles Bry, three men who --- iled --- or encryption
patents around the time Bitcoin came to be. They could be Nakamodo.
Shinichi Mochizuki, a Japanese math pro --- essor at Kyoto University, could be
him. Or perhaps, as others suggest, she is an unknown woman or even a group
o --- people.
nakamoto’s emails
We may never solve the mystery o --- Nakamoto’s identity, but the emails that were
apparently sent by Nakamoto are recorded and can be read by anyone. Since they
are pseudonymous, not anonymous, these emails can be traced back to the same
mysterious source. These writings give clues as to the political and economic
philosophy behind the making o --- Bitcoin. The February 11, 2009 email illustrates
that decentralization and perhaps even anarchy motivated the Bitcoin project.3
Nakamoto apparently detested the centralized banking system and set out to create
Bitcoin as a solution. The community o --- trust was born when Satoshi set the --- irst
“node” in the Bitcoin blockchain, commonly re --- erenced as the “Genesis Block.” But
a transaction system cannot exist in a vacuum. By de --- inition, a transaction requires at
least two people. Moreover, Bitcoin’s novel strategy requires user participation. The
system needs to be large enough that no one person can control the in --- ormation.
Nakamoto returned to the Cypherpunk mailing list and announced his creation.
Hal Finney became the second to join when he received the --- irst trans --- er o --- Bitcoins
rom Nakamoto. As time went on, the community continued to grow. A larger community meant more people were checking and veri — ying transactions in the system. This meant communal trust, — rom a conceptual standpoint, was rising exponentially. Although we may never be sure who is Satoshi Nakamoto, we credit him, her, or it
or developing Bitcoin and ushering in a new era o — digital — inance.
3
“The root problem with conventional currency is all the trust that’s required to make it work. The
central bank must be trusted not to debase the currency, but the history o ---
iat currencies is — ull o —
breaches o --- that trust. Banks must be trusted to hold our money and trans --- er it electronically, but they
lend it out in waves o --- credit bubbles with barely a --- raction in reserve. We have to trust them with our
privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make
micropayments impossible.”
https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press Cryptocurrency: Private, not Secret 119
cryptocurrency: private, not secret
Modern cryptography uses asymmetric cryptography. Unlike symmetric cryptog-
raphy, which uses one key such as a scytale or an Enigma machine --- or both
encryption and decryption, asymmetric cryptography uses two types o --- keys:
a private key and a public key called a wallet address.
The Bitcoin system --- irst generates a private key, which is a 256-bit number. A bit
(short --- or “binary digit”) is the smallest amount o --- data in a computer. One bit has
a single value o --- either 0 or 1. A 256-bit number could be represented by a string o ---
256 binary digits, but it can also be represented in a shorter number that uses
hexadecimal digits (where each bit has the value 0–9 or A-F), Base64 (where the
value can be any letter or number, plus the symbols +, /, and =), or ASCII (which
includes symbols, letters, and numbers). This means that a more complex represen-
tation can store more in --- ormation in a shorter string. Bitcoin private keys are based
on the secp256k1 ECDSA standard, which uses a modi --- ied version o --- Base64 called
Base58 that omits the characters 0, O, l, I, + and / because o --- the risk o --- visual
con --- usion and to improve human readability.
As you can see --- rom the chart above, all the encoding schemes produce the
same in --- ormation in a shorter value than binary encoding. This is called com-
pression, as it enables in --- ormation to be stored and transmitted in a shorter --- orm.
Accordingly, a 256-bit private key that is written in Base58 may be only 52
characters long, whereas that same in --- ormation written in binary would be 304
characters long.4
A --- ter the system generates a random private key, it then runs a hash --- unction on
that private key to generate a cryptographically linked public key. A hash --- unction is
a computer program that scrambles data o --- any length and returns a result that is
always the same length. Bitcoin uses the SHA256 and RIPEM160 hash --- unctions to
table 9.1 Encoding schemes
Encoding Scheme Value
ASCII Bitcoin
Binary 01000010 01101001 01110100 01100011 01101111 01101001 01101110
Hexadecimal 42 69 74 63 6F 69 6E
Base64 Qml0Y29pbg==
Base58 3WyEDWjcVB
4
C. --- . L2tUqZzNbBR6WKXskUTxyjRqu3YW --- LRqPcn8LgLKpLtenLuc6QhD (Base58) with 10000000
10101001 00100001 10110101 11111000 11110111 00111110 11001010 01100011 10000001 10100101 10110010
10011101 10100000 00011110 01011000 10000111 11100010 00000110 10011011 00101001 00000110 11000101
11011001 11011000 00010101 11001111 00011011 11110110 11010110 10011010 01010000 11110101 00000001
11000100 10011010 11001110 00010000 (binary code).
https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press 120 Cryptographic Theory and Decentralized Finance
igure 9.2 Illustration o — public and private cryptographic keys.
generate public keys through an elliptical curve digital signature algorithm that are
always 160 bits long.5 The public key is a unique identi --- ier associated with a person.
It --- unctions like a street address or an internet-protocol address. In --- act, the public
key is called the Bitcoin address.
The public and private keys are mathematically linked in one direction, meaning
it is easy to generate a public key given a private key, but it is nearly impossible to
reverse the process and create a private key --- rom a public key. In other words, the
private key has more in --- ormation than the public key. This makes it possible --- or one
person to encrypt in --- ormation using another’s public key, such that the in --- ormation
can only be decrypted by that person’s private key.
For example, imagine that an admiral wants to send a coded message to the
commander o --- a nuclear submarine. I --- the commander sends his public key to the
admiral, the admiral can encrypt a message using the commander’s public key.
Then that in --- ormation can only be decrypted using the commander’s private key.
Since the commander does not have to send his private key to the admiral, the
private key is more secure than a scytale or an Enigma machine.
I --- a ne --- arious hacker had enough time and computing power, he could attempt to
discover a private key through a hacking process called brute --- orce. In a brute --- orce
hack, the hacker simply tries di ---
erent passcodes until one works. There are 2^256 possible private keys, although the public key reveals some in — ormation about the private key such that 2^128 private are — unctionally possible. Conservative estimates suggest that it would take over a hal — billion years to try all these combinations using modern computer power. To hack the Blockchain it would require computing power — ar too costly to run than the potential reward, making the blockchain a sa — e and secure system — or veri — ying transactions – — or now.6
5
For example, 15sn --- utJNc4zJS1EaGVLLtA ---
HDkPdp96F. 6 Bitcoin and Blockchain Technology are generally regarded as in — allible systems that are impossible to hack. Today, the cost incurred to su —
iciently power computers attempting to hack the Blockchain is, simply put, not worth the e —
ort – the cost — ar outweighs the reward. This is why Bitcoin is regarded as “unhackable.” However, as technology develops it become more e —
icient. Quantum computers pose a risk to the security o — blockchain as they gain computing power e —
iciency. See Kotow, E., Quantum Blockchain, Hedgetrade, June 8, 2019.
https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press Digital Currency’s Double-Spend Problem 121
digital currency’s double-spend problem
Although cryptographic solutions --- or sa --- ely sharing in --- ormation between novel
parties was developed in the 1970s, it was not readily applicable to digital currency
because o --- a phenomenon called the double-spend problem. Put simply, holders o ---
digital currency can spend the same coin twice or more due to the --- act that
electronic communication is not instantaneous. To solve this problem, Nakamoto
developed blockchain technology, which solves the double-spend problem by
implementing a universal ledger with a con --- irmation mechanism.
For illustration, consider going to Talia’s Video Arcade. You put a --- ive-dollar bill
in the token dispensing machine, and out comes --- ive plastic Talia Tokens. These
tokens have no --- inancial value per se. You cannot take them to the corner store and
exchange them --- or a pack o --- gum. But you can insert one into a Skee ball machine
and get the opportunity to play that game. At the end o --- the night, a TVA employee
retrieves all the Talia tokens --- rom all the video game machines and puts them back
into the dispensing machine. In this simple example, the Talia token can only be
spent once because it returns to a central authority be --- ore being reissued. The
dispensing machine acts like a mint. This is --- ine so long as the mint works, but it
is not a robust solution, because the mint is a bottleneck. I --- the dispensing machine
breaks down, the entire video arcade ceases to --- unction until it is replaced. The
dispensing machine is also vulnerable to attack because it is a centralized store o ---
value. It could be literally “hacked” open with a hacksaw. Is there another way to
track these tokens?
Instead o --- using physical tokens that are stored in a central location, we could use
digital tokens. While we could still task a central mint to track the ownership o --- all
those tokens, we have also unlocked a new solution by going digital. Digital tokens
can be recorded in in --- initely many places at once at virtually no additional cost. The
record o --- who owns what tokens is called a ledger, and such a record that exists in
many places at once is called a distributed ledger. For example, both the Skee Ball
machine and the air hockey machine could have a copy o --- the distributed ledger.
When you sign away your digital Talia Token by agreeing to play a game o --- Skee
Ball, you should no longer own that token to play a game o --- air hockey. But the
Internet does not transmit in --- ormation instantaneously. Nothing can travel --- aster
than the speed o --- light, so the message that you spent your token on a game o --- Skee
Ball could take several seconds to reach an air hockey machine on the other side o ---
the world. An enterprising American --- raudster could partner with a comrade in
China so they both hit “play” on their video game machines at the same time. The
transaction at the air hockey table is not transmitted (or “published”) to the Skee Ball
table until the balls have been dispensed, and our --- raudster will get to enjoy a --- ree
game. In other words, your Talia Token has been double spent.
Double spending seems like a trivial matter when it relates to video games, but
what i --- that token represents one million dollars? Obviously, a solution to the
https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press 122 Cryptographic Theory and Decentralized Finance
double-spend problem is necessary i --- distributed ledgers are to be use --- ul, and digital
signatures are not enough. Blockchain thus adds two --- eatures, a timestamp server
and proo --- -o --- -work, that solve the double-spending problem.
A timestamp server widely publishes all the transactions that occurred in a prior
period o --- time. Each publication constitutes one block. For example, this Talia
Block will show two transactions: the spending o --- one Talia Token to play a Skee
Ball game in America, and the spending o --- the same Talia Token to play an air
hockey game in China. Blockchain technology is programed to invalidate double-
spend transactions, so neither video game machine will accept the token, and our
raudster will be thwarted. However, our timestamp solution has created a new problem: we cannot validate a transaction until a block is published. That makes instantaneous transactions impossible. While our — raudster is thwarted, TVA’s legit- imate customers will be — rustrated by waiting ten minutes or more to play a game o —
Skee Ball.
But our technologically savvy --- raudster is not done yet. In a last-ditch e ---
ort to get one — ree play, the — raudster attempts to publish a — alse block that erroneously shows ownership o — two tokens. Proo — -o — -work is a cryptographic solution to this problem. Digital in — ormation o — any length can be converted into a — ixed-length hexadeci- mal code by a process called “hashing.”7 It is very easy to create a hash value based on any given set o — input data. But it is very hard to determine the input data given only the hash value output.8 Blockchain technology is programmed only to accept published blocks whose hash value begins with several zeros. This requires block publishers to add an arbitrary number (a “nonce”) to each block until the block returns a hash value starting with the speci — ied number o — zeros. Scanning — or a nonce that returns an acceptable hash value — or the block takes a huge amount o — computing power. It would be cheaper — or our — raudster to simply buy a second Tali Token legitimately than to spend more money on computer hardware and electricity. However, this also creates a new problem: block publishers have to spend huge amounts o — money on electricity to solve the blockchain hash problem, which is not only costly but also bad — or the environment. To summarize, blockchain technology uses proo — -o — -work to prevent double spending on a peer-to-peer network o — digital signatures. Blockchain has the advan- tage o — a decentralized system that is ine —
icient to hack. But it has the disadvantage o — being too slow — or some applications and o — being extremely energy intensive. Technologists are working on solutions to these and other problems with 7 For example, the input data “ — ox” results in the output hash value “776cb326ab0cd5-
0a974c1b9606044d8485201 — 2db19c — 8e3749bdee5 — 36e200” when put through the SHA256 hash algo- rithm. The input data “The quick brown — ox jumps over the lazy dog.” Results in the hash value “e — 537 — 25c895b — a782526529a9b63d97aa631564d5d789c2b765448c8635 — b6c.” Note that the hash values are exactly the same length (64 characters) even though the input data are di —
erent lengths. 8 This — eature o — “one-wayness” is more technically described as “preimage resistance.” Peters, G.W., Panayi, E. (2015) Understanding Modern Business Banking Ledgers through Blockchain Technologies: Future o — Transaction Processing and Smart Contracts on the Internet o — Money, at 4.
https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press Investing in Cryptocurrency 123
blockchain, and there are myriad new applications --- or the blockchain ledger that go
above and beyond transactions in digital currency. In the meantime, it remains an
in --- allible system o --- security that is virtually impossible to hack and can provide the
security we need to --- acilitate transactions between people. The blockchain technol-
ogy that undergirds Bitcoin, rather than Bitcoin itsel --- , it more likely to trans --- orm
society.
blockchain technology
A --- ter downloading the proper so --- tware, any computer can join the existing Bitcoin
network with the ability to add or withdraw --- unds through a “digital wallet.” Each
computer in the network is re --- erred to as a “node.” When a transaction occurs, it is
publicized to the entire network. Details about the transaction are collected by each
node and reduced to a “hash.” Finally, a new “block” is created and is virtually
attached to the previous block in the chain, and the public ledger is updated. Each
node has its own copy o --- the ledger; when the public ledger is updated in one node it
is updated in all o --- other nodes too. Since the decentralized ledger is public it
becomes extremely di ---
icult to cheat the system.
investing in cryptocurrency
Bitcoin was not created to operate as an investment vehicle. The ups and downs o ---
the stock market were never truly relevant to the nature o --- cryptocurrencies, nor were
the considerations o --- Bitcoin as a borderless currency. At the heart o --- cryptocurren-
cies and blockchain technology is the prospect that they provide a level o --- anonymity
rom the rest o — the world, and more importantly, — rom governments. To that end, it creates the potential — or a shi — t — rom the centralized — inancial systems we currently use, to a decentralized publicly distributed ledger — ree — rom any centralized in — luence. Despite the original intentions o — the Cypherpunks to use cryptocurrencies like Bitcoin as a means to avoid centralized — inancial systems, others began using cryptocurrency as an alternative investment strategy. In March 2010, the price per Bitcoin was only $0.003. I — you spent just $100 on Bitcoin at that time, you would have received over 33,000 Bitcoins. By 2017, your stake would have skyrocketed to more than $625 million. Some early adopters become billionaires, such as the Winklevoss twins who are otherwise — amous — or their involvement in the genesis o —
Facebook, and who invested heavily in Bitcoin and as a result became billionaires.
Roger Ver, regarded as the “Bitcoin Jesus,” bought in around $1 per Bitcoin to the
tune o --- $25,000. Today, a virtual wallet with 25,000 Bitcoins stored in it would be
worth over $167.5 million. Celebrities such as 50 Cent, Snoop Dog, Johnny Depp,
and Ashton Kutcher, among many others, have bene --- ited --- rom the proli --- eration o ---
Bitcoin as well.
https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press 124 Cryptographic Theory and Decentralized Finance
In January o --- 2017, Bitcoins were valued at just over $900 each. By
December 2017, the per-Bitcoin price skyrocketed to over $19,000. In
February 2021, the price cracked $50,000. The drastic rise in Bitcoin’s valuation
was widely broadcasted, leading to an in --- lux o --- new speculative investors purchasing
Bitcoin at unprecedented volumes. Individuals who bought in early and sold late
pro --- ited extraordinarily. The math is even more mind boggling i --- you set your sights
on the price o --- Bitcoin as a whole, --- rom the moment the genesis block was placed.
This promise o ---
ast riches has attracted many newcomers to Bitcoin and other cryptocurrency investments, even i — they are unable to understand its technological
oundation. One reason why cryptocurrency is popular — or investing is that doing so is easy. Just a — ew clicks on the Internet and you will be set up with a virtual wallet in mere minutes on sites like Gemini, Coinbase, or Robinhood. As a result o — hype and ease o — use, Bitcoin trans — ormed — rom an underground movement to a popular and seemingly legitimate — inancial product almost overnight. But Bitcoin was still new and virtually unregulated. It took some time — or — ederal agencies to — igure out who should regulate this new — inancial product, much less how it should be regulated. Although the idea o — sending encrypted messages is ancient, its incorporation into
inancial transactions has a pro — ound impact on — inancial markets. Initially, block- chain was created to subvert the in — luence o — major — inancial institutions. However, today these same institutions have begun to incorporate their own blockchain technology in an e —
ort to increase security. These e —
ects will continue to proli — erate as the burgeoning cryptocurrency market grows. The next chapter will discuss the government’s response to this novel digital technology and the legal and constitu- tional challenges that have been and will likely be raised.
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https://doi.org/10.1017/9781316597736.010 Published online by Cambridge University Press 10
Cryptocurrency Regulation
Cryptocurrency arose --- rom open-source technology developed by anarchists. But its
anti-government origins will not stop governments --- rom trying to regulate cryptocur-
rency – or --- rom creating GovCoins, cryptocurrencies owned by governments. As
various cryptocurrencies go mainstream and because a larger part o --- national econ-
omies and international commerce, the question is by who and how – not whether –
they will be regulated. In America, there are Constitutional constraints that should
impact the answer to this question. The First Amendment ensures the right o ---
ree speech, and the Supreme Court has ruled that spending money constitutes speech. That same amendment provides an implied right to privacy. Since cryptocurrency involves spending money in a private way, it must have some Constitutional protec- tions. Other Amendments and Constitutional principles bolster these rights to use cryptocurrency. But that right is not unlimited and might be regulated by some agency or another. Many agencies are vying — or authority over cryptocurrency, but none seems ideally suited — or the task. Perhaps some new cryptocurrency regulator should be created, lest — oreign governments seize the initiative and assert themselves as the global authority over this nascent — inancial technology. You can’t stop things like Bitcoin, it’s like trying to stop gunpowder. It will be everywhere, and the world will have to readjust. World governments will have to readjust. – John McA — ee, — ounder o — McA — ee Inc., who was later arrested — or tax evasion
The last chapter introduced you to cryptocurrency and blockchain technology and
discussed its impact on --- inancial markets. This chapter --- ocuses on the regulatory and
constitutional aspects o --- cryptocurrency.
As we have seen --- inancial markets evolve over the last two centuries, so have
legal landscapes. In the digital age, “Crypto” and encryption technologies pose
an array o --- constitutional questions, although --- ew have been litigated thus --- ar.
This chapter explores the various agency, legal, and constitutional --- rameworks
that could be applied to answer di ---
icult questions regarding these novel technologies.
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130 Cryptocurrency Regulation
who regulates digital assets?
Cryptocurrency is so new that it still has not been totally decided who should
regulate cryptocurrency transactions and how they should be regulated. Moreover,
the number o --- di ---
erent kinds o — cryptocurrencies have exploded in recent years. Although major cryptocurrencies in 2021 include Bitcoin, Ethereum, Ripple, Bitcoin Cash, Cardano, Stellar, and Litecoin, and these make up the majority o —
the cryptocurrency market, there are thousands o --- other cryptocurrencies. Each
cryptocurrency has its own --- eatures that make it seem more or less like existing
inancial instruments that are already regulated by one — ederal agency or another. There are several U.S. — ederal agencies who vie — or top candidates — or cryptocur- rency regulator. They include the Securities and Exchange Commission (SEC), the Federal Trade Commission (FTC), and the Commodity Futures Trading Commission (CFTC). In addition, — oreign government agencies (FGAs), inter- national government agencies (IGAs), and nongovernmental organizations (NGOs) may attempt to assert some jurisdiction over certain aspects o — cryptocur- rency regulation. But note that cryptocurrencies were invented and designed to avoid regulation. Comprehensive regulation o — cryptocurrencies requires a new way o — thinking about how — inancial regulation works in this third era o — international and internet — inan- cial regulation. Governments cannot simply demand command and control o —
igure 10.1 Regulation o — Digital Assets.
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cryptocurrency; rather, they must intelligently design systems that make socially
bene --- icially cryptocurrency use pre --- erable.
The primary challenge with regulating cryptocurrencies is that they can be used
or di —
erent purposes and come in di —
erent — orms. Our regulatory agencies are generally set up to have jurisdiction over certain kinds o — transactions and instru- ments. Cryptocurrencies and more broadly digital assets do not neatly — all into any one category. Each digital asset must there — ore be analyzed individually to under who may regulate it and how it should be regulated.
sec regulation o --- crypto-securities
The SEC, as its name implies, regulates securities. What, then, is a security? The
Court created a --- our- --- actor test to determine whether or not something is a security.
The so-called “Howey Test” considers whether the scheme involves (1) an invest-
ment o --- money, (2) an expectation o --- pro --- it --- rom that investment, (3) the investment
o --- money in a common enterprise, and (4) pro --- its --- rom the e ---
orts o — a promoter or third party. Cryptocurrencies come in many varieties with unique properties. Some cryptocurrencies meet the “Howey Test,” de — inition, while many do not, making them hard to categorically regulate. The SEC is responsible — or en — orcing current securities laws, proposing new securities rules, and providing general oversight o — the investment industry. It monitors the nation’s stock exchanges as well as publicly traded companies to ensure compliance. The Commission seems, at least initially, to be the ideal agency to regulate cryptocurrencies. Under current law, however, the SEC’s jurisdiction is limited by the Howey Test.
SEC v. Howey
The Howey Test was created by the Supreme Court in the 1946 case Securities and
Exchange Commission v. W. J. Howey Co. et al. The Howey Company owned large
tracts o --- land in Florida where it planted orange groves. They planted some acres --- or
themselves, but then o ---
ered hal — o — the groves — or sale to the public. Howey Co. promised to cultivate the land, harvest the crops, and distribute accrued pro — its to those who purchased the parcels. The Court — ound that this was an investment masquerading as a sale. This was similar to purchasing stock in a publicly traded company because the parcels o — land acted as stock, thereby representing partial ownership in The Howey Company. The pro — it distributions — unctioned as divi- dends paid to investors. The Court held that the purchases o — land in the Howey case were securities because individuals invested money with an expectation o — pro — it
rom a common enterprise as a result o — The Howey Company’s labor to cultivate and care — or the orange groves. Being classi — ied as securities, the orange groves were thereby subject to SEC regulation.
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This had the e ---
ect o — an investment even though it did not — ollow any traditional
orm o — investment. Howey teaches us that substance and not — orm o — an instrument determines whether it is a security. Whether cryptocurrencies are securities depends on how a particular cryptocurrency — unctions. But it is hard to predict how a court would apply the Howey Test to a novel cryptocurrency technology. This uncertainty leads some companies to ignore SEC regulations, while it discourages others — rom — orming in the — irst place. Many ICOs have been speci — ically designed to — ail the Howey Test so they can avoid the classi — ication as securities, thereby skirting SEC guidelines. November 2017, SEC chairman Jay Clayton stated, “I have yet to see an ICO that doesn’t have a su —
icient number o — hallmarks o — a security.” With this statement, the SEC is explicitly exerting regulatory control over ICOs and Security Tokens. Ultimately, however, many cryptocurrencies exist outside the SEC’s reach because the Howey-Test is not an all-encompassing test.
Co ---
ey v. Ripple Labs Inc. The threat o — securities litigation against cryptocurrency issuers may be heightened by the Superior Court o — Cali — ornia’s decision in Co —
ey v. Ripple Labs Inc. (2018). The plainti —
in that case alleged that Ripple created XRP “tokens” and then engaged in an ongoing “scheme” to sell XRP to the general public. The plainti —
contends that XRP tokens constitute a security because purchasers o — the tokens invested their
iat currency into a common enterprise, Ripple, and expected to derive pro — its — rom their ownership o — XRP. What distinguishes the purchase o — XRP — rom purchasing stock in any other publicly traded company is that in purchasing XRP, however, the XRP purchaser does not receive any ownership stake in Ripple. Instead, acquiring XRP merely provides the purchaser with a cryptocurrency they can use over the RippleNet as a means o — exchange with other entities that also exchange XRP tokens. For this reason, XRP appears not to meet the Howey test — or a security. However, the SEC — ound that Ripple managers made “undeniably signi — icant” e —
ort to curate valuable opportunities on which XRP tokens could be spent on RippleNet. This curation process, according to the SEC, elevated XRP to the status o — a security. Ripple’s CEO Brad Garlinghouse wrote a blog post explaining why, in his opinion, the SEC is simply wrong. As o — the time o — this book’s publication, the case is still playing out in — ederal court. In the meantime, however, XRP’s value has been dashed. The cloud o — uncertainty that hangs over XRP has driven many would- be investors to other, less contentious prospects.
initial coin o ---
erings The SEC has maintained that two o — the most popular cryptocurrencies, Bitcoin and Ethereum, are not securities. Instead, they are viewed as commodities, which are
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erings 133
regulated by the CFTC. Initial Coin O ---
erings (ICOs), on the other hand, are transactions in securities according to the SEC and — all under relevant securities laws. This distinction between commodity or security is important because most issues arise when cryptocurrencies are misclassi — ied as securities. Understanding why an ICO o — a cryptocurrency is a securities transaction even when the crypto- currency itsel — is not a security provides vital insights into understanding how cryptocurrencies may and should be regulated in the — uture. A distinction must be made to separate the term “cryptocurrencies” — rom ICOs. Standing alone, the term “cryptocurrency” is a digital asset created and designed to be a means o — exchange utilizing advanced cryptographical procedures to veri — y and secure the trans — er o — value between users – Bitcoin, Litecoin, Ether, to name a — ew. On its own, Bitcoin and other many other cryptocurrencies are not securities. They are “replacements — or sovereign currencies” similar to U.S. dollar, the yen, or the euro. In this capacity, cryptocurrencies are no di —
erent than any other currency we use every day, aside — rom the — act that they do not come in a physical — orm. As long as two contracting parties agree to use a particular cryptocurrency, they are — ree to exchange it — or goods or services in the same — ashion as we exchange U.S. treasury bills — or a particular good or service with a local business. Divergence — rom this straight — orward manner o — use is where it gets murky. One major divergence occurs where cryptocurrencies are used as investments instead o — as means o — exchange. Initial Coin O —
erings (ICOs) can be likened to the Initial Public O —
erings (IPOs) discussed in Chapter 7. Both are designed to help companies raise — unds — or a particular business venture. In a traditional IPO, a corporation creates and registers new issue o — stock with the SEC. The corporation creates then sells that stock to an underwriter at the underwriter’s price. Then the underwriter quickly resells that stock on a public stock market like the New York Stock Exchange or the NASDAQ — or the issue price. When the issue price is at least 5 percent greater than the underwriter’s price, the IPO is considered to be a hot issue. I — the issue is hot, the stock price is likely to rise as the people who initially bought the stock at the issue price — rom the underwriter resell it — or a higher price. Eventually, the price stabilizes at the market price. In this way, underwriters take most o — the risk and get most o — the reward — or the change in stock price immediately a — ter the IPO. An ICO is similar to an IPO inso — ar as they both involve the creation o — a new security which is sold to the public who may then resell it. But these two — inancial transactions are very di —
erent in that IPOs are highly regulated and almost com- pletely standardized, whereas ICOs are almost totally unregulated and can range
rom IPO-like transactions to — lat-out scams. Although one might expect investors to pre — er IPOs to ICOs because IPOs are more regulated and there — ore sa — er, there are many reasons why IPOs are inappro- priate and even impossible — or most — undraising operations. Conducting an IPO, however, is no simple — eat. Companies should expect to spend one to — ive million dollars on out-o — -pocket costs associated with going public through an IPO.
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Moreover, the regulatory requirements may occupy the company’s executive lead-
ership --- or several months. Given that they inter --- ere with doing business while
costing millions o --- dollars, IPOs have grown less popular as public-company regula-
tions have increased.
The great di ---
iculty in orchestrating an IPO is consistent with the theme that too much regulation sti — les innovation and decreases e —
iciency. Congress has set — orth heavy burdens in their mandatory disclosure requirements — or companies who wish to become publicly traded. Although Congress’ intent was to protect unsophisticated investors — rom the dangers o — the — ree market, the requirements — or an IPO have become unduly costly in our in — ormation age. This is evidenced by the — act many organizations choose to hold private o —
erings through one o — the Securities Act exemptions, rather than listing publicly. Those private-o —
ering exceptions are dis- cussed in Chapter 7. But not all companies and transactions — it into one o — the private-o —
ering exemp- tion regulatory sa — e harbors. Some such companies and transactions sought ICOs as a means to — undraise where traditional legal avenues were closed to them. The cryptocurrency world cra — ted the new ICO mechanism to solve the costly IPO dilemma. The SEC is just beginning to understand and explain how to regulate these ICOs. Blockchain startups have embraced ICOs as a vehicle to raise early capital — or a wide varied set o — roles on di —
erent plat — orms. Part o — the challenge with regulating IPOs is that they come in so many di —
erent — orms. In a typical ICO, to the extent that one can truly call an IPO typical, an entrepreneur presells virtual tokens which will later serve as the medium o — exchange on a peer-to-peer plat — orm. Some tokens are similar to currencies while others act more like securities in a publicly traded company, and even more have properties that are entirely new. The sheer volume and speed o — ICOs allow people to raise millions o — dollars in as short as thirty seconds. It is tempting to — ind — alse parallels between IPOs and ICOs. For example, in an IPO, the issuer and the underwriter must produce a voluminous prospectus, which includes all the marketing, accounting, business, legal, and other in — ormation that an investor needs to make an investment decision. The contents o — the prospectus are governed by decades o —
ederal statutes, SEC regulations, stock exchange rules, generally accepted accounting principles, and established expectations and tradi- tions. The SEC may subject the prospectus to a — ull cover-to-cover review. SEC sta —
may provide comments that must be addressed by the company in order to enhance
compliance with applicable requirements. I --- an issue engages in --- raudulent conduct
during an IPO, the SEC can investigate and press civil and criminal charges.
ICOs might go o ---
without any regulatory review at all. Although most ICOs are backed up by so-called white papers, a term that apparently originated in England around 1920 to describe policy documents, such as Winston Churchill’s 1922 plan titled “Palestine. Correspondence with the Palestine Araba Delegation and the
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erings 135
Zionist Organisation,” which maintained England’s commitment to the Bal --- our
Declaration and its promise o --- a Jewish homeland in Israel. In cryptocurrency white
papers, coin issuers concisely explain their novel technology. But these white papers
are not even subject to peer review, much less government review. ICOs may be
conducted by anonymous or pseudonymous parties, limiting, or eliminating, the
ability to bring these issuers to court to answer --- or --- raud or other crimes. Or they can
be entirely legitimate and pro --- itable. The issue with all these di ---
erent ICOs is the same problem we see with cryptocurrencies as a whole: there is no one size — its all test to determine whether or not they — all under SEC regulatory reach. Even ICOs can be broken down into smaller classes. There are at least two types o —
tokens issued in ICOs. First there are Utility Tokens which allow buyers to access
and pay --- or usage o --- the blockchain so --- tware. Second, there are Security Tokens.
Security Tokens are more akin to shares listed in an IPO. They are distributed to
purchasers and grant voting power just like shares in a publicly traded company
permit the shareholder to vote. In some cases, ICOs even o ---
er a share o — the company’s pro — its. ICOs are rapidly growing as the red tape- — ree method to raising capital quickly with the potential to dwar — Venture Capital — undraising in the coming years. Un — ortunately, even though ICOs have been labeled as securities, it is di —
icult — or the SEC to properly regulate them because many operate outside o —
the United States.
Investors in ICOs generally do not have much in --- ormation about the venture – all
that is needed is a “white paper” providing basic in --- ormation about the project.
Contrast this with the extensive mandatory disclosures required --- or IPOs. As a result,
white papers vary in style and in what they disclose. With zero legislative structure
or guidance, hackers and other ne — arious — raudsters have taken advantage o — ICOs as exit scams.
ICO Fraud
A wide range o --- examples already exist regarding ICO --- raud. The ICO advisory --- irm
Statis Group recently published a study claiming more than 80 percent o --- ICOs
conducted in 2017 were scams. In November o --- 2017, Con --- ido, a cryptocurrency
startup, raised $375,000 through one such ICO be --- ore vanishing with investors’
money. Another company, Benebit, pulled a similar scam and made o ---
with at least $2.7 million. The SEC stepped in and — roze the assets o — PlexCoin in December o —
2017 a --- ter they raised over $15 million and promised investors pro --- its o --- 1,354 percent
within a single month. In 2015, two --- ederal agents were indicted and charged with
wire --- raud, money laundering and the --- t o --- virtual currency during their joint
investigation into the Silk Road.
There have been some instances o --- judicial action. A --- ederal judge in Brooklyn
re --- used to throw out a case in 2018 where the de --- endant argued two cryptocurrencies
were beyond the reach o ---
ederal securities laws. Although Judge Raymond Dearie
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stopped short o --- de --- ining RECoin and Diamond, the two cryptocurrencies at issue,
as securities, he did say that a jury should be able to assess them using existing laws,
namely, the Howey Test.
The distinction between currency or security is important because most
issues arise when cryptocurrencies are misclassi --- ied as securities. IPOs are too
costly and too time consuming. Only large corporations can a ---
ord to host an IPO. The disparity in one’s ability to raise — unds has led to the swing away — rom the nonymous environment o — the current market. Instead, people choose to operate in an unregulated space because it is cheaper. Some scammers may incidentally pre — er that it is a pseudonymous alternative, i — not entirely anonymous. Although some endeavors are credible, there is still a high risk involved.
regulation o --- cryptocurrencies
Cryptocurrencies are novel and varied, making them hard to de --- ine. This de --- in-
itional problem leads to overlapping authorities by various regulatory bodies. The
United Stated Congress, the Federal Bureau o --- Investigation (FBI), the Commodity
Futures Trading Commission (CFTC), the Internal Revenue Service (IRS), the
Federal Trade Commission (FTC), the O ---
ice o — the Comptroller o — Currency (OCC), individual states, cities, and even — oreign governmental agencies (FGAs) have asserted their jurisdiction over cryptocurrencies and imposed regulations according to this purported authority. In addition, cryptocurrencies are privately regulated by miners and other market participants. To make matters even more con — using, there is always the prospect o — some new agency being created to regulate cryptocurrencies. Moreover, cryptocurrencies are decentralized. They are designed by crypto-anarchists to resist regulation by anything other than consensus amid users.
Congressional Regulation o --- Cryptocurrencies
There has been little statutory intervention against cryptocurrencies as whole. This is
true, at least in some part, because con --- usion still exists around blockchain technol-
ogy and cryptocurrencies. U.S. Rep. Darren Soto, (D-FL), and U.S. Rep. Ted Budd,
(R-NC), cosponsored two bipartisan bills in 2018 that sought to alleviate some o --- that
con --- usion. The bills titled “The Virtual Currency Consumer Protection Act o --- 2018”
(VCCPA) and “The U.S. Virtual Currency Market and Regulatory Competitiveness
Act o --- 2018” (VCMRCA) were aimed to allow --- or innovation in the developing
market while protecting U.S. consumers. They also were designed to --- acilitate the
development o --- a description and classi --- ication system that would grant current
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agencies the ability to regulate cryptocurrencies. The two separate pieces o --- legisla-
tion work in tandem to accomplish the goal o --- creating a sa --- e market. The legislation
states that virtual currency means any digital representation o --- value that does not
have legal tender status and that --- unctions as a medium o --- exchange, a unit o ---
account, or a store o --- value.
Two important provisions exist in the VCCPA, which are intended to aid in
promoting the policymakers’ goal o --- providing sa --- e innovation in this arena. The --- irst
provision states that the CFTC, along with the SEC, will submit a report that will
help position the United States to implement policies to become a leader in the
virtual currency market while protecting consumers. This report will include a brie ---
description discussing manipulation o --- the prices o --- virtual currencies, an analysis o ---
how the CFTC and other agencies currently address virtual currencies and provide
recommendations on --- uture legislation to increase the e ---
ectiveness o — regulation in this realm. The bill aims to identi — y possible issues in the virtual currency sphere, analyze what is currently being done to address those issues, and then create new solutions — or those issues. It is mainly geared toward research so that the United States can better understand cryptocurrencies in general. To properly regulate cryptocurrencies, we must — irst — ully understand them.
FBI Regulation o --- Cryptocurrencies
The FBI is charged with conducting domestic intelligence and is the primary
security service o --- the United States. As the lead agency in day-to-day national
security --- unctions, the FBI must prevent cryptocurrencies --- rom being used --- or
ne --- arious ends, such as domestic terrorism, the drug trade, and organized crime.
The --- irst intervention by the U.S. government over cryptocurrencies occurred in
2013 when the FBI shut down the Silk Road – the dark web black market. Then in
2014, Mt. Gox’s CEO, Mark Karpeles, had his U.S. assets --- rozen a --- ter over
1.75 million Bitcoins vanished --- rom the Mt. Gox website.
But the FBI does not have a cybercrime strategy that comprehensively addresses
cryptocurrency. In --- act, the Department o --- Justice O ---
ice o — Inspector General (OIG) issued a report to the FBI in December 2020 calling — or the FBI to develop a plan to systematically disrupt illegal activities on the web, including those — acili- tated by the anonymous and pseudonymous nature o — cryptocurrencies and block- chain transactions. Thus, one might expect the FBI to more aggressively seek to regulate cryptocurrencies in the — uture.
CFTC Regulation o --- Cryptocurrencies
The CFTC is another independent --- ederal agency that could potentially regulate
the cryptocurrency market. The CFTC was created to regulate the commodity
utures and options markets. It is tasked with “the promotion o — competitive and
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e ---
icient — utures markets and the protection o — investors against manipulation, abusive trade practices, and — raud.” They, along with the SEC and the Financial Crimes En — orcement Network (FinCEN), recently issued a joint statement regard- ing cryptocurrencies. In it, the agencies set — orth a reminder that activities involving “digital assets” are still subject to the anti-money laundering obligations — inancial institutions must abide by under the Bank Secrecy Act. The release also noted that the CFTC has jurisdiction over commodity — utures and a wide array o — derivatives, such as interest rate swaps. The CFTC’s jurisdiction over cryptocurrencies is not clear, but recent legislation seeks to clari — y its dominion over cryptocurrency regulation. H.R. 923, the U.S. Virtual Currency Market and Regulatory Competitiveness Act (VCMRCA) o — 2019, is a bill that would direct the CFTC to report on virtual currency markets and U.S. competitiveness. It is directly — ocused on making the U.S. a leader in the global virtual currency market. This bill tasks the CFTC, in consultation with other agencies, to provide a report to congressional committees in order to better under- stand what cryptocurrencies are and how to regulate them. The report will include: (1) a comparative study o — U.S. regulation on the virtual currency industry and o — the regulation o — the virtual currency industry by — oreign countries, (2) an analysis o — the possible bene — its o — virtual currencies and the underlying blockchain technology in the U.S. commodities market, then (3) conclude with recommendations on legisla- tive changes to promote competitiveness in the industry. The bill is designed to encourage growth o — virtual currencies, clari — y virtual currencies as commodities — or existing and — uture currencies, and to create a new regulatory structure — or virtual currency markets.
IRS Regulation o --- Cryptocurrencies
U.S. Rep. Soto and U.S. Rep. Budd joined U.S. Rep. Warren Davidson, U.S. Rep.
Josh Gottheimer, U.S. Rep. Scott Perry and U.S. Rep. Tulsi Gabbard in introducing
“The Token Taxonomy Act” in 2019, around the same time as the VCMRCA. The
bill explicitly de --- ines “digital token” as a digital unit that is not a representation o ---
a --- inancial interest in a company, and then proposes amending the Securities
Exchange Act to exclude “digital tokens.” U.S. Rep. Davidson stated, “as blockchain
technology continues to emerge, it is clear that there must be a --- ramework in place
that not only provides a much clearer path --- orward --- or open blockchain projects, but
also will establish the United States as a leading --- orce in this space.”
FTC Regulation o --- Cryptocurrencies
The Federal Trade Commission (FTC) was created to protect consumers and
promote competition. It en --- orces antitrust laws and --- ederal consumer protection
laws to prevent --- raud or un --- air business practices. Perhaps the FTC is best suited to
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become the agency that exerts control over the cryptocurrency world. In 2018, the
FTC --- iled a complaint against --- our individuals who were alleged to be promoting
deceptive “money-making schemes involving cryptocurrencies.” The FTC was able
to target those individuals because, as a single agency, the FTC is a ---
orded a larger range o — oversight so they are able to adequately protect and promote competition. Yet, despite having this broader reach, it does not extend — ar enough to cover all cryptocurrencies.
OCC Regulation o --- Cryptocurrencies
The O ---
ice o — the Comptroller o — the Currency (OCC) was created to “ensure that national banks and — ederal savings associations operate in a sa — e and sound manner, provide — air access to — inancial services, treat customers — airly, and comply with applicable laws and regulations.” The OCC may be better suited — or regulating cryptocurrencies used in the United States by current banks and — inancial institu- tions. In February 2019, JPMorgan created the “JPM Coin,” a digital token they intend to use — or settling transactions instantly between clients within their network, similar to the use o — XRP. The JPM Coin only operates on a private network within JPMorgan, and only between JPMorgan business units, in contrast to Bitcoin which operates on a public network that any person can join. The OCC might be the agency that could regulate this arena most e —
ectively when cryptocurrencies are localized to private institutional networks such as JPMorgan’s. This, o — course, will not solve the entire problem because there are — ew cryptocurrencies that exist in such a controlled and localized — ormat, necessitating a broader — ocus.
Local Regulation o --- Cryptocurrencies
In other cases, intervention came in the --- orm o --- blanket regulatory action. One such
instance occurred in 2018 when the City Council o --- Plattsburgh, New York issued an
eighteen-month moratorium on new cryptocurrency mining operations.
Cryptocurrency mining is the process o --- rewarding people --- or validating crypto-
currency transactions. Without detailing how mining works varies based on how
each cryptocurrency itsel --- works, the overall concept is that people with a huge
amount o --- computer power use those computers to con --- irm that transactions posted
to a blockchain must have been authentically created. In the case o --- Bitcoin, the --- irst
miner to validate the current block o --- transactions is rewarded with a new Bitcoin (or
a --- raction o --- a Bitcoin) attributed to them in the next block. A vast amount o ---
electrical power is required to operate such computers.
The quiet town o --- Plattsburgh was --- irst targeted by bitcoin mining companies
because it o ---
ered cheap rates per kilowatt consumed thanks to its proximity to the St. Lawrence River and the neighboring hydro-powerplant. When cryptocurrency mining companies came to town the citizens o — Plattsburgh saw a spike in their
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energy prices by as much as 50 percent. Mining rigs consume enormous amounts o ---
energy. The City Council imposed the moratorium to li --- t the energy burden the
Bitcoin mining rigs placed on their independent citizens.
Non-U.S. Regulation o --- Cryptocurrencies
The VCCPA and the VCMRCA are not straight --- orward regulations that actually
regulate the industry, they are designed to enhance our nation’s understanding.
While the United States has not enacted legislation to actively regulate cryptocur-
rencies, other countries have gotten the ball rolling. Abu Dhabi’s Financial Services
Regulatory Authority (FSRA) stated that, “i --- an ICO has the characteristics o ---
a security, such as giving a person ownership o --- shares in the company, then the
FSRA will regulate it” just as it would i --- they were a company issuing stock.
A company wishing to execute an ICO is required to approach the FSRA to see i ---
it will --- all under their purview and publish a prospectus just like a --- irm entering into
an IPO would be required to do.
China, on the other hand, has put an outright ban on ICOs --- rom being used to
raise --- unds. The China Securities Regulatory Commission, China Banking
Regulatory Commission, People’s Bank o --- China and China Insurance Regulatory
Commission released a joint statement where they said ICOs will be regarded as
illegal --- und-raising activity. In stark contrast, Japan has embraced cryptocurrencies.
In September 2017, Japan’s Financial Services Agency o ---
icially recognized eleven companies as registered cryptocurrency exchange operators. In registering, the companies are required to build a “strong” computer system to support their cryptocurrency and check the identity o — users to prevent money laundering. Japan even o —
icially recognized Bitcoin as legal tender. In February 2018, Venezuela’s government launched the world’s — irst sovereign cryptocurrency dubbed “The Petro” (₽). The Venezuelan government claimed that ₽ is linked to the value o — its — iat currency (the bolivar) and backed by the country’s reserves o — crude oil and precious metals. But ₽ provides no ownership stake in these natural resources, nor did the government explain how such a cryptocurrency could be “linked” to — iat money while acting as an independent reserve currency. The Brookings Institution analyzed ₽ and — ound it pretends to create a reserve currency — rom thin air. Famous economists and even Bloomberg news concluded that ₽ was a sham and a — raud. It seems that even sovereign nations can use the hype o — cryptocurrency to deceive investors. This casts serious doubts on whether we can rely o —
oreign nations to make cryptocurrencies sa — e and e —
icient through their regulations.
Private Regulation o --- Cryptocurrencies
Blockchains are controlled by miners and users. Both groups utilize the blockchain
and manage the distributed public ledger --- or all to see. They do so through a variety
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o --- economic incentives, relying on sophisticated so --- tware, hardware, and other
intermediaries, like Internet service providers, to keep the entire system going.
The companies and organizations that service these technologies usually sit in at
least one jurisdiction and there --- ore are subject to its laws whether that be state or
ederal. It could be easier to regulate these companies rather than regulate crypto- currencies as a whole. Internet service provider Comcast, — or example, has their headquarters in Philadelphia, thereby subjecting themselves to Pennsylvania and
ederal law. I — the government regulates cryptocurrencies and the blockchain, it might be most reasonable to regulate it on a — ederal level to avoid additional con — usion because o — varying laws between all the states. It was only recently that such regulation has been proposed in the legislature.
A New Cryptocurrency Regulator?
There does not seem to be a clear-cut answer to the question: Who is best suited to
regulate cryptocurrencies? Each organization described above can claim
a relationship to cryptocurrencies in some way, yet none have the broad reach
needed to cover the entire cryptocurrency arena. The best solution may be to
combine the capabilities o ---
ered by each independent department into a hybrid agency. Congress could create a new agency: The Virtual Asset Commission (VAC). The VAC could have a board o — administrators that oversee everything related to cryptocurrencies. The SEC, OCC, FTC, FDIC, and CFTC would each nominate one individual — or appointment to the board o — administrators, to be approved by the President, and — unction as a joint task — orce. Each nominee would be selected as representative — or their prior agency’s interests within the VAC. That is, each administrator would have an area o — expertise that aligned with the goals o — the agency they were nominated — rom. The VAC members would have their own areas o — expertise allowing them, as a group, the ability to cover a comprehensive range o —
issues under one roo --- . The FBI may even have a part to play considering they already
have experience shutting down criminal activity like Silk Road. The FBI could be
the criminal arm, en --- orcing laws while preventing --- raud.
The hypothetical Virtual Asset Commission presents an interesting option --- or
Congress to consider. On the other hand, a di ---
erent approach might be by regulat- ing classes o — individuals, or large corporations. Instead o — trying to control the entire Bitcoin ecosystem, the government could extend regulatory authority on individual criminals directly, just as the FBI did with Silk Road, or when they shut down Mt. Gox. However, with over one-hundred thousand nodes within the Bitcoin network alone, it is reasonable to assume monitoring them all would be extraordinarily di —
icult. With millions o — users worldwide, regulating cryptocurrencies on such an individual level seems ine —
icient. O — course, this is in addition to the — act that such a style o — oversight too closely resembles the type o — surveillance per — ormed by the National Security Agency (NSA).
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Direct and individual en --- orcement is probably not the ideal method --- or regula-
tion. Presumably, it would be very costly and labor intensive. Instead, what i --- we
exerted control over cryptocurrencies through corporate mandates, perhaps through
an amendment to an already existing Act? Cryptocurrencies do not have the same
physical attributes as paper money. They depend on computer code to create the
architecture o --- their existence. One angle that could be exploited is the code itsel --- .
The government might enact legislation targeting so --- tware developers at large
inancial and technology institutions who work directly with cryptocurrencies or with blockchain technology. For example, “new laws could mandate that so — tware developers introduce speci — ic — eatures – such as a government backdoor – directly into a blockchain’s underlying protocol.” The government would be permitted to shut down blockchain-based applications or even autonomous smart contracts when they are not in compliance with relevant laws. Only one thing is — or certain: there is much work that needs to be done i — we, as a society, are ever to — ully understand or regulate the cryptocurrency universe. The United States already has a number o — agencies who have the potential to exercise oversight — or cryptocurrencies and blockchain technology. As the virtual cryptocur- rency landscape continues to grow and evolve, it becomes increasingly important — or the government to take decisive action and provide supervision over this unregulated space. Whether that be through an already existing department, by means o —
a conglomerate-like hybrid --- ormed by several agencies, or through direct legislation
against people and corporations, it is time --- or legislators to start tackling the question
o --- who should regulate cryptocurrencies.
cryptocurrency markets
As discussed above, there is an absence o --- legislative oversight over the cryptocur-
rency realm. Without regulations in place, there has been a growing trend o ---
consumer con --- usion regarding cryptocurrencies. The average, and --- requently unin-
ormed, citizen can buy and sell cryptocurrencies just as they would buy or sell stock in a publicly traded company. Robinhood already boasts their capabilities as a cryptocurrency exchange aside — rom their core business o —
ee- — ree trading — or investors in publicly traded companies. Traditional stock investment plat — orms like E*Trade and Vanguard are not — ar behind – both are building out their existing plat — orms as they reach — or a piece o — the crypto-pie market share. The barriers to entry are low — or sophisticated and unsophisticated investors alike, which means everybody could be vulnerable to loss.1
1
For instance, investors can sign up --- or Robinhood and instantly have access to a hand --- ul o --- crypto-
currencies like Bitcoin, Litecoin, Ethereum, and more. The “disclosure” they provide is lackluster at
best. Essentially, Robinhood warns that cryptocurrencies are volatile and are not covered by either
FDIC or SIPC insurance. Even the most basic limitation to entry is diminished – price. Some may
avoid buying bitcoin because o --- the sheer cost. At over $50,000 per share, only the wealthy can “invest.”
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The astonishing growth in the cryptocurrency market in the past decade has
inevitably led many to investing in essentially a virtual stake o --- nothing. Many
have invested substantial sums o --- cash in cryptocurrencies despite the --- act they do
not meet the traditional de --- inition o --- “a security.” This is important because it could
determine the proper regulatory authority responsible to regulate cryptocurrencies.
Speci --- ically, i --- not determined to be a security, the SEC cannot protect investors
under securities laws. For the SEC to en --- orce securities regulations on cryptocur-
rencies, they must be securities. Numerous lawsuits have been --- iled as a result o --- this
consumer con --- usion, and lead us to ask and evaluate the question --- irst at issue here:
What is a security?
The Howey Test can be applied to all publicly traded companies today. I --- you
were to purchase 100 shares o --- Microso --- t Corp. (MSFT), you would be (1) paying an
investment o --- money – stock is not --- ree. You would be doing so with (2) an
expectation o --- pro --- it --- rom that investment. It would be --- oolish to invest in anything
i --- you anticipated it would depreciate in value. The (3) investment o --- money in
a common enterprise element has been explored more extensively and has been
summarized as the presence o --- an “investment contract.” In this case, the third
element is satis --- ied. Finally, you (4) expect pro --- its --- rom the e ---
orts o — a promoter or third party. Your investment appreciates in value through the e —
orts o — Microso — t employees by means o — product development, via sales o — those products, and through the corporation’s management within the company, including the oversight provided by the board o — directors. The Howey Test remains the landmark assessment used today when we ask the question, “What is a security?” Yet, despite this seemingly straight — orward analysis, con — usion persists. Lawmakers have — ound it challenging to evaluate cryptocurren- cies as a class in accord with the Howey Test. This is because “[p]ublic watchdogs and legislatures lack the capacity to keep up with emerging FinTech like blockchain and cryptocurrency.” The problem is exacerbated by the — act that Bitcoin is not alone in the crypto-space. Today, there are thousands o — “Altcoins” in virtual circulation, each touting themselves as the superior alternative to Bitcoin. Some were created to operate similar to cash, that is, as a medium o — exchange. Others were created with their own unique sets o — characteristics setting them apart — rom other cryptocurrencies. The proli — eration o — Altcoins is relevant because, with so many existing variations, it makes it di —
icult to determine i — one Altcoin is, or is not, a security under the Howey Test. This means it is impossible — or a one-size- — its-all test; each must be considered independently because each exhibits distinguishing traits. Some o — the most notable altcoins include Litecoin, Ethereum, Dogecoin, and XRP, albeit over 5,000 other
Robinhood’s solution: allow purchases o ---
ractional shares. I — you do not have enough — or a single Bitcoin, but maybe have $500 instead, you could put that amount down and receive a — raction o —
Bitcoin. Although seemingly insigni --- icant, this illustrates the low bar to entry in the cryptocurrency
investing realm.
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altcoins exist at the time o --- this writing. An extensive list can be --- ound through
CoinMarketCap.
constitutional questions
Now that we have discussed the various legal --- rameworks and agents who may have
the power to regulate cryptocurrency, we can explore the constitutional issues posed
by this novel technology. Does one have the right to anonymous --- inancial dealings?
And i --- so, under what doctrinal theory? What are the Constitutional limits imposed
on agencies who would seek to regulate such anonymous transactions?
Cryptography and the Freedom Not to Speak (Publicly)
Some argue that a right to pseudonymous --- inancial transactions --- inds support in the
First Amendment.2 Most Americans know that the Constitution assures citizens the
right to --- ree speech. But this implies an equal right not to speak. Legal scholar
Milton Konvitz argued that “ --- reedom not to speak, not to pro --- ess belie --- s, may be
more important than the --- reedom to speak, since the pro --- ession o --- belie --- s that one
does not maintain may do more violence to the conscience than the --- ailures to
express belie --- s that one does not maintain.”
The --- reedom not to speak has been routinely upheld, --- rom the right to re --- use to
say the pledge o --- allegiance and salute the American --- lag3 to the right to re --- use to
pro --- ess a state motto on a license plate.4 The salient question is how these rights
extend to the digital realm, especially with regards to the competing interests o ---
balancing economy interests, public policy, and e ---
iciency in — inancial markets. The Supreme Court has emphatically pronounced that spending money is a — orm o — speech. In simple terms, people “vote with dollars” by making consumer decisions that accord with their belie — s. People literally put their money where their mouth is when they purchase — ree-range chicken and organic broccoli. In Buckley v. Valero, 424 U.S. 1 (1976), the Court — ound that making donations to a political candidate counts as political speech. The Court extended the doctrine that spending money is speech through several later cases, including the contentious decision o — Citizens United v. Federal Election Commission, which struck down bans or limits on campaign contributions by corporations.
2
“Congress shall make no law respecting an establishment o --- religion, or prohibiting the --- ree exercise
thereo --- ; or abridging the --- reedom o --- speech, or o --- the press; or the right o --- the people peaceably to
assemble, and to petition the government --- or a redress o --- grievances.”
3
West Virginia State Board o --- Education v. Barnett, 319 U.S. 624 (1943).
4
Woodley v. Maynard, 430 U.S. 705 (1977) (note Justice’s Robert’s dissent that New Hampshire’s
mandate that the State motto be present on a license plate without violating a person’s constitutional
rights because the law only required it be present in order to own the vehicle, not that the person
express their belie --- in the motto.)
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The Court expressly held that the right not to speak extends to not to be compelled
to spend money on social and political activities that go against core belie --- s. In
Abood v. Detroit Board o --- Education, 431 U.S. 209 (1977), the State o --- Michigan had
a law permitting unions to extract dues --- rom members, and these dues were used to
und political activities. The Court held that the members had the right o — “negative association” and could not law — ully be compelled to pay — or political activities. While there are deeper tensions in the jurisprudence o —
reedom not to speak that are beyond the scope o — this book, the key takeaway — or present purposes is that there is some right not to publicly speak, and that includes the right to spend or not to spend money on certain kinds o — activities. This relates directly to cryptography because cryptography is a technology that keeps speech private. By encrypting a political message, two people can privately communicate without that in — ormation becoming public. As illustrated later in this chapter, people right — ully — ear that their private communications will be intercepted by the state or publicized by other actors. Without cryptography, people right — ully — ear that their private communica- tions will be intercepted by the state or publicized by other actors. This — ear may chill people’s general willingness to express dissident views. This logic extends to — inance. One may want to support a political message or to purchase a good or service that supports an ideological agenda, but one may not want that support to become public. Cryptocurrency arose precisely to give people the ability to spend money without easily being identi — ied. While anonymous (or, more accurately, pseudonymous) tools can be used — or ne — arious ends, such tools can also be used to — und unpopular political positions. There is, there — ore, an argument that there is some constitutional right to use cryptocurrencies — or anonymous transactions under the First Amendment. However, contrary to popular opinion, there are limitations to the — reedom o —
speech. For example, it is commonly understood that one cannot shout “ --- ire” in
a crowded theatre. Less understood is the --- reedom not to speak, especially when the
right is outweighed by other concerns. At present, it is not clear whether the right not
to speak would extend to the right to have pseudonymous --- inancial transactions.
Courts may look to other doctrinal basis to support the assertion that one has a right
to remain anonymous in a --- inancial setting.
Cryptography Regulation and the Freedom o --- Association
The First Amendment also protects people’s right to assemble. In the seminal
decision, Nat’l Ass’n --- or Advancement o --- Colored People v. State o --- Ala. ex rel.
Patterson, decided in 1958, the Supreme Court held that requiring the National
Association --- or Advancement o --- Colored People (NAACP) could not be compelled
by the Alabama government to publicly disclose its membership documents because
it would jeopardize its member’s sa --- ety and ultimately lead to a decline in
membership.
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Things get more complicated, however, when national security interests are at
stake. The government’s modern ability to spy on its citizens in the name o --- national
security can be traced back to the Foreign Intelligence Surveillance Act o --- 1978.
Despite its name, FISA actually allows the National Security Association (NSA) and
the Federal Bureau o --- Investigation (FBI) to tap into domestic phone lines. A --- ter
terrorists attacked the World Trade Center on September 11, 2001, Congress passed
the USA Patriot Act. Title II o --- the Patriot Act is entitled “Enhanced Surveillance
Procedures,” and it greatly expands governmental ability to tap phone lines and
listen into private communications. The extent to which the --- ederal government
leveraged FISA and the PATRIOT Act to spy on American citizens was --- amously
exposed in 2013 by Edward Snowden, who revealed that Verizon Wireless provided
detailed domestic call records to the NSA on a daily basis. Snowden subsequently
penned an essay --- rom his sel --- -imposed exile in Russia titled “Without Encryption,
We Will Lose All Privacy. This Is Our Next Battleground.”
Encryption via cryptography makes it more di ---
icult — or governmental agents to tap into private communications because, even i — they can intercept those commu- nications, they cannot understand them. This is obviously a problem when, — or example, terrorist groups can use commonly available encrypted-communication so — tware like WhatsApp to secretly plan mass atrocities. One key — unction o — govern- ment (and some would say its only — unction) is to ensure domestic tranquility by monopolizing the use o —
orce and preventing acts o — violence. This critical ability may be stymied by cryptography. While there may be some reasonable legislative approach that balances the policy goals o — domestic security with personal — reedom, such legislation has not yet been advanced. On the other hand, citizens clearly have rights to conduct their non-terrorist a —
airs in private. A person is permitted by the Constitution to join the Communist Party USA and to peace — ully advance the goals o — that political organizations. This right to — reely associate requires some privacy, as public association with these groups could result harms ranging — rom reduced career opportunities to assassin- ation attempts. Yet a person is not — ree to associate when the purpose o — that association is to conspire to commit a crime. Cryptography is necessary to keep membership lists and communications private, but it can also obscure ne — arious and criminal behavior. This tension continues to play out in courts and legislatures today. Cryptocurrency is directly implicated in the — reedom o — association because payment o — membership dues or donations to organizations can make association public. I — associations are to remain private so that membership in them is not unduly chilled, payment o — dues and other — inancial support must also remain private. Cryptocurrencies are designed to ensure maximum privacy in payment systems. This privacy is desirably and in — act mandated by the Constitution where the association is — or protected ends such as peace — ul political protest and legislative change. Cryptocurrency’s — inancial privacy is dangerous when used to — unnel cash to
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terrorist organizations. But such --- inancial mobility could have saved countless
re --- ugees --- rom dire poverty. Un --- ortunately, it is di ---
icult to tell the di —
erence be — ore the encryption is cracked.
Search and Seizure o --- Cryptocurrency
Government seizure o --- electronic assets will likely invoke the Fourth Amendment.5
In general, the Fourth Amendment provides the right to security in one’s papers and
e ---
ects. The Fourth Amendment has thus been interpreted by the Supreme Court to create “a right to privacy, no less important than any other right care — ully and particularly reserved to the people.” Because the Fourth Amendment provides this right to privacy o — one’s possessions, it prohibits unreasonable searches and seizures, and governmental agencies must obtain a search warrant prior to intruding on one’s person or property (although there are a great many carveouts that allow police to per — orm stock-and- — risk searches, search motor vehicles, etc.). In general, in order — or a violation o — this right to occur, the individual must have (1) an actual (subjective) expectation o — privacy and (2) the expectation was one that society is prepared to recognize as reasonable. Recently, the Fourth Amendment has been applied to data. Scholars have argued that the Fourth Amendment does not create a reasonable expectation o — privacy in cyberspace. Although strong cryptography makes it nearly impossible — or an unin- tended party to read and understand the encrypted message, cryptography does not make it di —
icult — or the government to access that communication. The messages are private, not secret. Consider Bitcoin as an example. When two parties transact in Bitcoin, the Blockchain ledger records that transaction and propagates that ledger entry to every system on the Bitcoin networks. The in — ormation itsel — is unreadable to anyone who does not have the private key, which is a sort o — password that will descramble the encoded transaction into readable text. But the in — ormation is widely accessible. In — act, by design, that in — ormation is available to everyone on the network. The government can easily access that in — ormation, and there — ore there is no reasonable expectation — or the in — ormation itsel — to be protected against unreasonable search and seizure. The government can there — ore retrieve and attempt to decrypt this in — ormation without violating the Fourth Amendment. The Supreme Court has not yet decided whether encrypted in — ormation that is on the internet is protected by the Fourth Amendment, but other courts recently ruled
5
“No person shall be held to answer --- or a capital, or otherwise in --- amous crime, unless on a presentment
or indictment o --- a grand jury, except in cases arising in the land or naval --- orces, or in the militia, when
in actual service in time o --- war or public danger; nor shall any person be subject --- or the same o ---
ense to be twice put in jeopardy o — li — e or limb; nor shall be compelled in any criminal case to be a witness against himsel — , nor be deprived o — li — e, liberty, or property, without due process o — law; nor shall private property be taken — or public use, without just compensation.”
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that records o --- virtual currency transactions do not enjoy Fourth Amendment
protections. In 2017, the Internal Revenue Service (IRS) served a subpoena on
Coinbase Inc., a virtual currency exchange, to provide customer in --- ormation
and transaction logs --- or approximately 13,000 taxpayers who were potentially
using Bitcoin transaction to avoid paying taxes. In July 2020, The Fi --- th Circuit
ruled that Bitcoin data in the hands o --- a third party is not protected by the
Fourth Amendment.6 This accords with Zietzke v. United States, a Fourth
Circuit decision --- rom 2019 which held that the government may subpoena
records --- rom the virtual currency exchange Bitstamp because an individual
does not have a reasonable expectation o --- privacy in --- inancial records that were
already exposed to a third party, even when those records were in an encrypted
orm. While the Fourth Amendment may not prevent the government — rom attempting to decrypt and use encrypted in — ormation including records o — cryptographic trans- actions, that does not mean this in — ormation cannot be protected. Rather, state and
ederal legislatures are able to protect this in — ormation by passing new laws. Whether or not they should do so is a matter o — policy.
Cryptography and the Freedom --- rom Sel --- -Incrimination
The Fi --- th Amendment7 in its Sel --- -Incrimination Clause enables the citizen to create
a zone o --- privacy which government may not --- orce him to surrender to his detri-
ment. Griswold v. Connecticut, 381 U.S. 479, 484 (1965). Whether or not this
protection extends to encrypted in --- ormation in general or to cryptocurrencies in
particular is an unsettled issue that has little precedent in law. However, there are
analogies that help illustrate the constitutional issues with government investigation
o --- cryptocurrency transactions.
In the 1966 case o --- Miranda v. Arizona, the Supreme Court determined that
police must in --- orm people o --- their Fi --- th Amendment rights when they are taken into
police custody. This so-called Miranda warning stipulates --- our basic rights: (1) you
have their right to remain silent; (2) anything you say can and will be used against
you in a court o --- law; (3) you have the right to an attorney; and (4) i --- you cannot
a ---
ord an attorney, one will be appointed — or you. These are sometimes summarized as the right against sel — -incrimination. These rights are challenged by changes in technology. For example, the question o — whether police may — orce you to unlock your iPhone using your passcode, 6 United States v. Gratkowski. 7 “No person shall be held to answer — or a capital, or otherwise in — amous crime, unless on a presentment or indictment o — a grand jury, except in cases arising in the land or naval — orces, or in the militia, when in actual service in time o — war or public danger; nor shall any person be subject — or the same o —
ense to be twice put in jeopardy o — li — e or limb; nor shall be compelled in any criminal case to be a witness against himsel — , nor be deprived o — li — e, liberty, or property, without due process o — law; nor shall private property be taken — or public use, without just compensation.”
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ingerprint biometrics, or Face ID has not yet been settled. At least one district court ruled that — orcing a person to unlock their phone violates the Fi — th Amendment rights against sel — -incrimination, but these lower court decisions are not binding on all courts. There — ore, it is not clear whether the state can — orce the owner o —
encrypted in --- ormation to decrypt that in --- ormation using their private key, which
unctions like a sort o — passcode. Things get more complicated, however, when a third party has that passcode or private key. In 2015, Syed Rizwan Farook and Tashkent Malik attempted to bomb the San Bernardino County Department o — Public Health and then shot a group o — employees at a Christmas party there. Fourteen people were killed and twenty-two were seriously injured. The couple — led. Police pursued them and killed them in a shootout. The o —
icers recovered Farook’s iPhone 5C, but they were unable to unlock it due to its encryption and security — eatures. The FBI sought a court order compelling Apple to unlock the phone on the grounds that it is likely to lead to in — ormation about other terrorist activities. Apple re — used, and the legal battle persisted until the FBI eventually cracked the passcode themselves, thus rendering the legal battle on whether Apple must crack the encryption moot. A similar event happened again when FBI asked Apple to unlock and decrypt iPhones belonging to Mohammed Saeed Alshamrani, the terrorist gunman who killed three people at a naval base in Pensacola, Florida. Alshamrani was shot dead at the scene, so he couldn’t be asked to unlock his iPhone. Apple once again re — used to cooperate, and once again the FBI managed to crack the code themselves. Although the FBI — ound in — ormation on that phone linking Alshamrani to Al Queda, it did not resolve whether a third party must provide — ederal assistance in decrypting such in — ormation. Cryptography cases might come out di —
erently. Unlike Apple, who does not keep individual passcodes or biometric identi — iers on — ile, Bitcoin exchanges like Coinbase and Bitstamp do maintain their users’ private keys. The private key to a unit o — cryptocurrency acts like its passcode, enabling the users to transact with the cryptocurrency. The exchange needs to know the private key in order to engage in transactions on behal — o — its users. It would there — ore seem more likely that a court would — orce Coinbase to reveal users’ private keys than — orcing Apple to crack an encrypted iPhone. The cryptocurrency community seems concerned with this lack o — Fi — th Amendment protection. Most websites advise storing private keys in “cold wallets,” which are maintained on personal computers that are not connected to the internet, or even written down in physical books that are kept in a private sa — e. Private keys stored in these ways are more likely to be immune to police search and seizure due to Fourth and Fi — th Amendment protections. Cryptography in — orma- tion stored on third-party exchanges, however, are more likely to be subject to government subpoena.
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Cryptography as a Natural Right
8
The Ninth Amendment has been construed to broaden the privacy protections
under the --- irst eight amendments to the Constitution. Some legal scholars argue that
the Ninth Amendment checks --- ederal power and guarantees individual liberty by
granting to the people all the unenumerated natural rights that they possessed prior
to the --- ormation o --- the United States government.
I --- this argument9 is correct, then a historical look at the civil liberties that people
enjoyed prior to 1787 (when the U.S. Constitution was rati --- ied) might illuminate
whether the Ninth Amendment gives some private rights to engage in encoded
transactions. Un --- ortunately, such a historical study does not appear to have been
conducted yet. Moreover, not all legal scholars, judges, or lawmakers believe that the
Constitution and the Bill o --- Rights can be best understood through the lens o --- its
original meaning. There have not yet been any cases where the Supreme Court has
decided whether the Ninth Amendment grants a right to privacy above and beyond
what the preceding eight amendment provide. There --- ore, the question o --- what the
interaction between the Ninth Amendment and cryptocurrency is will remain
unanswered --- or a time.
Cryptocurrency and Freedom --- rom Economic Slavery
The Fourteenth Amendment is not --- ound in the original Bill o --- Rights. The
Fourteenth Amendment came nearly 100 years later a --- ter the country --- ormed itsel ---
into a nation. In its Section 1, the states are required to provide people with equal
protection under the law.10 This was a direct response to --- orces that threatened to
tear the union asunder, in Civil War.
The result o --- several more years o --- Reconstruction-era wrangling was the
Fourteenth Amendment, which e ---
ectively made the Bill o — Rights applicable to the States. Its Due Process Clause prohibited state and local governments — rom depriving persons o — li — e, liberty, and property without — air procedures. Its Equal Protection Clause requires states to provide equal protection under law to all people, including noncitizens. The Fourteenth Amendment thus became the legal basis — or many antidiscrimination lawsuits. It is germane to our study our corporate — inance
8
“The enumeration in the Constitution, o --- certain rights, shall not be construed to deny or disparage
others retained by the people.”
9
Randy B. Barnett, “The Ninth Amendment: It Means What It Says.” He argues that this amendment
should be understood literally: “The enumeration in the Constitution, o --- certain rights, shall not be
construed to deny or disparage others retained by the people.”
10
“All persons born or naturalized in the United States, and subject to the jurisdiction thereo --- , are
citizens o --- the United States and o --- the state wherein they reside. No state shall make or en --- orce any
law which shall abridge the privileges or immunities o --- citizens o --- the United States; nor shall any state
deprive any person o --- li --- e, liberty, or property, without due process o --- law; nor deny to any person
within its jurisdiction the equal protection o --- the laws.”
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because courts have --- ound that the Fourteenth Amendment includes a right to
privacy.
A series o --- cases beginning in the 1970s laid the --- oundation --- or a Constitutional
right to privacy in general. Whether a woman has the right to induce an abortion was
the central issue in Roe v. Wade, 410 U.S. 113 (1973), which held that the Fourteenth
Amendment “protects against state action the right to privacy, including a woman’s
quali --- ied right to terminate her pregnancy.” Finding that such a right existed, the
Court reasoned that i --- the Fourteenth Amendment gives a woman the right to have
an abortion, it must also give her the right to keep the --- act o --- that abortion private, as
she might be intimidated into not having that abortion by --- ear o --- its --- act becoming
public. Subsequently, Planned Parenthood o --- Se. Pennsylvania v. Casey, 505 U.S.
833 (1992) clari --- ied that privacy is a --- undamental right, even while it recategorized
the right to have an abortion as a matter o --- personal autonomy and not a matter o ---
privacy. And Washington v. Gluckberg, 521 U.S. 702 (1997) --- urther established that
the Fourteenth Amendment speci --- ically provides a right o --- privacy o --- the home and
the --- amily li --- e, while re --- using to extend that right to assisted suicide.
This book is not about induced abortion or assisted suicide, so it will not discuss
the merits o --- those decisions. However, the Roe decision and its progeny clearly
indicated that the Fourteenth Amendment includes a right to privacy. That right to
privacy applies to economic and well as --- amily matters. It could be extended to the
right to privacy in personal transactions. Although a Fourteenth Amendment right to
economic privacy has not yet been tested in our nation’s highest court, it could be
applied to cryptocurrency ownership and transactions. Accordingly, the right to use
cryptocurrency may be protected by the Fourteenth Amendment.
In --- act, the right to privacy may be --- ound in various Constitutional sources.
Cryptography, the use o --- codes to keep messages private, and cryptocurrency,
which keeps transactions private, thus may well be deemed --- undamental rights
that are part and parcel o --- the American pursuit o --- li --- e, liberty, and happiness.
Indeed, the US government has long recognized that economic --- reedom is
essential to the --- ul --- ilment o --- people’s inalienable rights. This has occasionally led
Congress to enact laws that enhance people’s ability to earn a living through
entrepreneurship. Entrepreneurship is the ability to “make something” o --- onesel --- ,
and this has o --- ten been symbolic o --- the American dream. Although the merits o ---
cryptocurrency to --- ul --- ill this dream are still being debated, other laws enabling
“crowd --- unding” were recently enacted to give a wider range o --- people access to
the ability to make something o --- themselves through entrepreneurship. This new
phenomenon o --- crowd --- unding will be addressed in the next chapter.
bibliography
Complaint, SEC v. Ripple Labs, Inc. (January 22, 2020) (No. 20–10832), available at https://
perma.cc/AY35-9LXF.
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Department o --- Justice O ---
ice o — the Inspector General, Audit o — the Federal Bureau o —
Investigation’s Strategy and E ---
orts to Disrupt Illegal Dark Web Activities (2020). Garlinghouse, Brad, The SEC’s Attack on Crypto in the United States, RIPPLE.COM (2020), available at https://perma.cc/6TKK-8HLN. Kerr, Orin S., Applying the Fourth Amendment to the Internet: A General Approach, 62 STANFORD L. REV. 1005 (2010). Martin, Vince, Even I — Ripple Beats the Charges, XRP Is No Longer Worth the Risk, INVESTOR PLACE (2021), available at https://perma.cc/R5M6-TQAU. Snowden, Edward, Without Encryption, We Will Lose All Privacy. This Is Our New Battleground, THE GUARDIAN (October 15, 2019), available at https://perma.cc/Q6WN- V9QZ.
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Crowd --- unding
Congress designed and passed The Jumpstart Our Business Startups (JOBS) Act o ---
2012 to help a broad range o --- entrepreneurs leverage the internet to gain access to
capital. Corporate --- inance was to be democratized by emerging growth companies,
digital investing, crowd --- unding, and mini-IPOs. But these simple principles got
bogged down in rulemaking processes that resulted in over 1,000 pages o --- rules and
red tape, leaving investors and entrepreneurs --- rustrated by their narrow prospects.
The JOBS Act will allow Main Street small businesses and high-growth enterprises to
raise capital --- rom investors more e ---
iciently, allowing small and young — irms across the country to grow and hire — aster. – President Barack Obama White House Press Release, April 5, 2012
Crowd --- unding – raising money --- rom a large number o --- people via the internet –
went online just as the Dot-Com Bubble was beginning to hyperin --- late. In --- act,
crowd --- unding may have arisen because the internet challenged traditional ways --- or
artists to bene --- it --- rom their cra --- t. Although there has always been copyright in --- ringe-
ment and the --- t o --- intellectual property, the internet made it --- ar easier to illegally
distribute creative content like books and songs. What started as a response to this
intellectual property problem eventually turned into an entirely new means o ---
corporate --- inance.
crowd --- unding’s origins in the dot-com era
Napster was --- ounded in 1999, amid the Dot-Com Bubble, to --- acilitate sharing o ---
digital audio --- iles on the internet. Although Napster ended up in legal trouble --- or
acilitating copyright in — ringement, the threat to the traditional music industry became clear by the turn o — the millennium. A — ter Napster shut down, decentralized projects including LimeWire, Freenet, Gnutella, Soulseek, and others popped up like mushrooms a — ter a storm.
153 https://doi.org/10.1017/9781316597736.012 Published online by Cambridge University Press
154 Crowd — unding
Donative Crowd --- unding
Artists are by nature creative, and some got creative about how to deal with copyright
in --- ringement. Some turned to a new way to --- inance music. Instead o --- creating music
and then selling access to songs, artists began raising --- unds to create music, which
would then be shared --- or cheap or --- ree. To raise awareness, bands turned to the
internet. In 1997, the rock band Marillion deployed a crowd --- unding campaign to
raise money --- or a U.S. tour. The band raised $60,000 in donations --- rom --- ans who
simply wanted to see the British act come to America.
Rewards-Based Crowd --- unding
Donative crowd --- unding remains popular today, while other entrepreneurs realized
that many --- ans want to receive something exclusive in exchange --- or their contribu-
tion. This led to a number o --- crowd --- unding websites with di ---
erent business models. One o — the — irst was ArtistShare, which was co — ounded by the artist and activist Willie Nelson. ArtistShare pioneered the notion that — ans would not only — inance costs — or album production and tours, but they also would receive unique rewards such as an autographed copy o — the record, a prop — rom a movie set, their names in the credits, or some other reward that is not otherwise available — or sale. This reward crowd-
unding business model remains popular today, where it is also employed by IndieGoGo and GoFundMe.
Pre-purchase Crowd --- unding
In 2009, however, a startup named Kickstarter would take crowd --- unding in a new
direction. Kickstarter did not rely on charitable impulse, as donative crowd --- unding
did. It did not rely some people’s desire to get a unique or personalized reward either,
as rewards crowd --- unding did. Instead, Kickstarter --- ocused on pre-purchase crowd-
unding, which appealed directly to many people’s consumer desires. In pre-purchase crowd — unding, startups would o —
er consumers a lower pre- purchase price — or an item they intend to bring to market. I — the product is success — ully designed, Kickstarter patrons receive the product — irst and — or a discount. I — the product — ails, however, many patrons may be surprised when they get nothing. Since the pre-purchase crowd — unding model is more transactional than donative crowd — unding (where no one expects anything in return) or rewards- based crowd — unding (where one receives a talisman or keepsake that is symbolic o —
a relationship with the creator), startups who --- ail to deliver on pre-purchase crowd-
unding products end up in a heap o — trouble. Perhaps the biggest — iasco in crowd — unding was the 2014 campaign — or the Coolest Cooler. Although its promoters received over $13 million to build a portable battery- powered beverage cooler, they were unable to get the product to market. The startup
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eventually called it quits, o ---
ering its 60,000 backers only a $20 payment in return — or their $200 “investment.” The pre-purchasers were — urious. It seems that they did not understand the risk that they could end up with nothing. They did not treat Coolest Cooler as a startup that — aced a substantial risk o —
ailure. Rather, “investors” treated this project as a consumer would treat a mature company. They expected a guaranteed return. This was an error.
Crowdlending
More recently, crowdlending arrived on the scene. The entire industry o --- peer-to-
peer lending originated with LendingClub, which was --- ounded in 2005. Under the
crowdlending or debt crowd --- unding model, an entrepreneur, small business, or
individual posts a business or project on a web site via Lending-Club or another
crowdlending plat --- orm and asks to borrow a certain amount. The plat --- orm estimates
the risk that the borrower will not be able to repay the debt and assigns an interest rate
accordingly. Then, it matches this borrowing with dozens, hundreds, or even thou-
sands o --- lenders who believe that interest rate represents an attractive investment.
Here’s how it worked. People who want to borrow money create a loan listing on
LendingClub’s website. The listings usually provide both --- inancial and personal
details, sometimes including a photo o --- the prospective borrower. LendingClub
evaluates the borrower’s ability to repay the loan based on --- actors including the
borrower’s credit score, credit history, loan amount, debt-to-income ratio, and other
actors, and it scores the borrower with a grade — rom A to G and a subgrade o — 1 to 5, such that A1 is the highest score and G5 is the lowest. Investors then visit the LendingClub website to — ind borrowers they want to loan to. Depending on lender’s risk pre — erences, then can select an A1 borrower, who will pay the lowest interest rate but has the highest chance o — repaying the loan, a G5 borrower, who pays the higher rate but also is the most likely to de — ault on the loan, or anyone in between. Each lender commits only a small — raction o — the total loan, with a minimum investment o — just $25, so it may require hundreds o — even thousands o — lenders to cobble together a loan — or the borrower. Although LendingClub was initially set up as a social networking service that simply played matchmaker between borrowers and lenders, it quickly pivoted its business plan. In 2008, LendingClub registered with the SEC so it could make loans itsel — . Once enough lenders have made commitments, LendingClub acts as an intermediary, lending money to borrower members and through its partner WebBank. LendingClub then issues a promissory note (a promise to pay) its lending members, which it pays to their member account regularly. LendingClub pro — its by charging its borrower members an origination — ee and by charging its lender members a service — ee. In this way, the borrowers and the lenders never interact except via their usernames on the LendingClub plat — orm.
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This --- inancial model puts the plat --- orm --- ront and center. The plat --- orm adds a great
deal o --- value not only by connecting borrowers with a network o --- lenders, but also by
analyzing basic deal attributes like a reasonable interest rate and payment schedule.
Ordinary lenders with no signi --- icant --- inancial experience would otherwise --- ind it
very hard to price the risk o --- nonrepayment.
Equity Crowd --- unding
LendingClub’s success as a social media lending plat --- orm opened the door to
a new type o --- online investing which would eventually become known as equity
crowd --- unding. This requires a brie --- distinction between lending debt and buying
equity.
When a lender makes a debt investment, the borrower commits to make a stream
o --- regular payments over time, until the loan is repaid, plus any applicable interest.
Most personal loans are at a --- ixed rate, which does not vary based on the borrower’s
ability to use the loaned money pro --- itably. The lender takes the risk that the
borrower will become unable to pay, and the interest is meant to o ---
set this risk. But interest rates are limited by state statutes. For example, Pennsylvania residents may be charged a maximum o — 24 percent per annum, according to state consumer
inance laws. This means that loans have some limitations. Some projects or borrowers are simply too risky — or a 24 percent loan. Some businesses might not be able to make monthly payments. A brand-new startup company that is not yet generating any pro — its would be making these payments out o — the loaned — unds, which de — eats the purpose o — getting a loan to use — or research and development. And some investors may want a higher-risk and a higher-return investment to meet the needs o — their port — olio. Equity investments address these limitations. When an investor purchases stock in a company, there is usually no expectation that the investor-stockholder will be paid back on a regular basis. Rather, the investor-stockholder expects the stock value to increase because o — the e —
orts management makes to improve the business. There is virtually no limit on how much the company can improve. Early-stage companies might sell initial shares o — stock — or one dollar and then go on to have a share value o —
ive hundred dollars or more within a — ew years. Equity investing is potentially very lucrative. But until 2015, regulations made it in — easible to o —
er and purchase equity invest- ments via a social media plat — orm like LendingClub did with loans. Soliciting equity investors such as stockholders is highly regulated under numerous securities regula- tions. Solicitations — or the sale o — stock must either be registered under the Securities Act o — 1933 or subject to an exemption thereto. From 1933 to 2012, there was no signi — icant exemption through which startups could sell stock to the general public. This began to change, however, when Congress passed the Jumpstart Our Business Startups (JOBS) Act o — 2012, and when the SEC promulgated in — inal rules allowing equity crowd — unding in May 2015.
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the jobs act
Although the --- inancial crises o --- the Third Era generally led to legislation that made it
harder and more expensive to issue stock to the general public, the JOBS Act o --- 2012
represented a counterpoint to this regulatory trend. Lawmakers across the aisle
realized that --- inancial markets were becoming increasingly inaccessible --- or ordinary
investors and main street entrepreneurs. To address this, Representative Patrick
McKenry (R-NC) and Representative Carolyn Maloney (D-NY) introduced the
JOBS Act. This bipartisan bill would eventually become the law that at least
theoretically allowed the general public to invest in startups. In President Obama’s
words, “These proposals will help entrepreneurs raise the capital they need to put
Americans back to work and create an economy that’s built to last.”
The JOBS Act permitted the general public to invest in the market --- or entrepre-
neurial --- inance through several means, including equity “crowd --- unding,” “mini-public
o ---
erings,” and an “IPO on-ramp.” Crowd — unding can be generally understood as the practice o —
unding a project or venture by raising many small amounts o — money — rom a large number o — people, typically via the Internet. Equity crowd — unding – which involves selling a relatively small amount o — stock to a large number o — people via web sites called — unding portals – is a more speci — ic application where the reward to the investors in the — undraising is the opportunity to share in the pro — its o — the venture. It is worth brie — ly reiterating that the JOBS Act did not only enable equity crowd — unding. Title I gave “emerging growth companies,” public startups with annual gross revenues less than $1 billion per year, a slight break on certain manda- tory disclosure requirements. Title II allowed startups to raise money via internet “ — unding portals” — rom accredited investors. This resulted in Regulation D Rule 506(c), which led to Plat — orms including AngelList, Manhattan Street Capital, Crowdstreet, and Ourcrowd. Title III, also known as Regulation Crowd — unding or Reg CF, is the — ocus on this chapter. Title IV allows companies to raise $25– 50 million via a “mini-IPO” that essentially has — ewer disclosure requirements that a traditional IPO and a limited o —
ering amount. Title V increased the number o —
stockholders that a private company may have be --- ore it needs to publicly register
with the SEC, while Title VI increased the threshold --- or total assets. Title VII
ordered the SEC to improve its web presence and to reach out to small businesses,
woman owned businesses, veteran owned businesses, and minority owned busi-
nesses to in --- orm them about the JOBS Act. But none o --- the other provisions held
as much promise as Regulation Crowd --- unding.
equity crowd --- unding in 2021
Equity crowd --- unding promised to make --- inancial markets --- airer and more equal.
But regulators were desperately a --- raid that equity crowd --- unding campaigns would
de --- raud the most vulnerable members o --- our --- inancial society. To avoid this risk,
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regulator wrapped equity crowd --- unding in miles o --- red tape. Although the equity
crowd --- unding portion, Title III, o --- the JOBS Act is only nine short pages (with two-
inch margins), the SEC’s --- inal rules --- or Regulation Crowd --- unding spans 685 pages.
Equity Crowd --- unding was illegal in the US until the JOBS Act created a new
exemption to the Securities Act o --- 1933. Speci --- ically, the JOBS Act amends
Section 4(a)(6) o --- the Securities Act o --- 1933 (the Securities Act) to allow a private
corporation to o ---
er and sell up to $1 million worth o — equity securities (stock) in a twelve- month period to the general public without registering the securities with the SEC. The SEC increased this limit to $5 in on November 2, 2020, e —
ective January 1, 2021. This very recent change (as o — the printing o — this book) makes it di —
icult to say whether the higher thresholder will make crowd — unding use — ul. In my 2015 article, “Bridge — unding: Crowd — unding and the Market — or Entrepreneurial Finance,” I argued that raising the limit in this manner would make equity crowd — unding much more success — ul. I am eager to see whether crowd — unding become more use — ul with this higher limit. On that same day, the SEC also clari — ied what “demo day” means, which give startups com — ort that they can attend certain events without violating securities laws. I expect these changes to increase the use o —
Regulation CF.
According’s to the SEC’s --- inal rules on equity crowd --- unding, individuals who
have between $100,000 and $1 million in annual income or net worth may invest
10 percent o --- it each year in startups through equity crowd --- unding. Individuals who
have or annually earn less than $100,000 may invest the greater o --- $2,000 or 5 percent
o --- their annual income each year in this way.
The JOBS Act requires the development o --- a new kind o --- website called “ --- unding
portal,” which is a --- inancial intermediary that can sell startup stock online to
nonaccredited investors. A private company raising capital under the crowd --- unding
exemption --- rom the Securities Act must sell the stock through either a registered
broker-dealer or a --- unding portal. Any broker-dealer or --- unding portal that engages in
crowd --- unding must register with the SEC and the Financial Industry Regulatory
Authority (FINRA). The --- unding portal may not solicit transactions --- or securities
displayed on its website or portal, compensate anyone --- or soliciting investors, pay
compensation based on the sale o --- securities on its website or portal, hold customer
unds or securities, or o —
er investment advice or recommendations. Recall that President Obama proclaimed that the JOBS Act would — urther the policy goal o — democratizing startups, which means providing more capital to diverse entrepreneurs – including women and minorities in novel geographies outside o — Silicon Valley – — or new business projects beyond high technology. But this promise has not been realized. Although women obtain a higher share o —
venture capital through equity crowd --- unding then they receive --- rom angels and
VCs, women still receive less than their pro rata share. Moreover, the total amount
raised via Reg CF is so miniscule that it cannot make more than a nominal impact.
Companies raised more than $1.7 trillion – $1,700,000,000,000 – via Reg D in 2018
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alone. Meanwhile, --- rom its inception in May 2015 to 2020, the entirety o --- Reg CF
capital raised to date is only $337 million. Equity crowd --- unding is there --- ore less than
0.0000198 percent as --- inancially signi --- icant as Reg D – however, this may change,
thanks --- or the 2021 updates to Reg CF.
Why did such a promising idea as equity crowd --- unding turn out to be less than
a blip on the global --- inancial radar, at least so --- ar? On the company side, the
government hamstrung Reg CF with some many protocols and precautions that it
cost more than it was worth to most startups. The high cost o --- equity crowd --- unding
was compounded by the originally low --- undraising limit o --- $1 million per year. With
the newly changed higher --- undraising limit, the e ---
ective cost o — capital is lower, since most o — the — inancing costs are — ixed, so we may see more use o — Reg CF with o —
erings o — $5 million. On the investor side, the lack o — liquidity is a dealbreaker — or many. Ordinary investors cannot easily a —
ord to hold onto stock inde — initely. Without a resale market, it is harder to imagine buying these stocks in the — irst place. Investor groups typically worked through illiquidity and other economic issues (such as rational apathy and agency costs) by creating Special Purpose Vehicles (SPVs), but — or reasons that were never explained SPVs are illegal under the JOBS Act. More recently, however, the SEC received comments that SPVs should be allowed under Reg CF. In 2016, legislators were exploring how to correct — or the SEC’s regulatory excesses with the Fix Crowd — unding Act. Un — ortunately, that bill seems to have been pigeonholed. But anyone who wants to reboot the Fix Crowd — unding process should consider the issues involved in equity crowd — unding.
limited --- undraising
As designed by the dra --- ters o --- the JOBS Act, the $1 million cap is intended to protect
the general public --- rom investment --- raud or --- rom simply making outright poor
investment decisions. Instead, it makes crowd --- unding expensive, complicated, ine --- -
icient, and risky — or unsophisticated investors. Some reports suggest that complying with JOBS Act costs startups up to $150,000 (e.g., to obtain independent audits, disclosure documents, — iling — ees, and legal — ees) be — ore selling equity via crowd-
unding. Raising money — rom angel investors is not only up to six times cheaper than crowd — unding, but angel investment costs are mostly incurred a — ter — inancing is assured, whereas startups have to sink costs up — ront in order to try crowd — unding. Under current regulations, there — ore, it seems that only startups that are unable to get — unding — rom other sources will seek crowd — unding. Fortunately, that cap was recently raised. On November 2, 2020, the SEC voted to increase the limit to $5 million. While it is still too early to empirically determine the magnitude o — this e —
ect o — the marketplace, it is very likely that this change will make Reg CF equity crowd — unding into a viable option — or entrepreneurs across America.
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lack o --- resale options
One --- oundational problem with startup securities in general, and equity crowd --- und-
ing securities in particular, is a lack o --- resale options that creates a --- inancial problem
called “illiquidity discount asymmetry.” Illiquidity discount asymmetry means that
an investment is harder --- or some people to unload than it is --- or others. A simple
example can illustrate this problem. Imagine there are two investors who both have
one share o --- Microso --- t stock (MSFT). One investor has a physical stock certi --- icate,
which he keeps in a lockbox under his bed, in his isolated cabin in the woods, with
no internet access. The other has a digital record o --- stock ownership through his
Merrill Lynch brokerage account, which he accesses on the smartphone in her
pocket via high-speed 5G wireless connectivity. I --- the tech stock market suddenly
crashes, who will be able to respond quicker? Our tech savvy investors will likely be
able to know and respond much quicker than our investing hermit. The connected
investor may be better able to take advantage o --- daily market movements and protect
against sudden sells o ---
s. The ability to sell may, ex ante, impact one’s desire to buy. Our savvy investor knows that he can easily track MSFT and sell it i — its value goes too low, while our hermit investor is in the dark. Knowing that he might not be able to respond to market moves, such that his stock might be worth nothing when he — inally gets into town, might discourage him — rom making this investment in the — irst place. While some investments are designed to be long-term buy-and-hold strategies, not all investments can be ignored. A rational investor who does not have time to monitor a volatile investment will value that investment to be worth less than would an investor who has the time and expertise to monitor it and sell it, i — needed. A less abstract way o — putting this is through another example. Imagine two brothers, Joe and Frank. Joe works sixty hours per week as a highly paid dental surgeon. Frank is a — ormer bricklayer who is now unemployed. Both receive the opportunity to purchase a rundown house that needs repairs. Who is this investment better suited to? I — Joe purchases the property, he will have to add home renovations to his already overwhelming work schedule, which would either come at a great cost to his personal li — e or simply be an obligation he ignores — rom time to time. I — Frank purchases the property, he now has a valuable way to spend his — ree time and perhaps can also ply his trade in — urtherance o — his investment prospects. All else being equal, Frank should value this investment opportunity more than Joe does, because Frank has the time and ability to monitor and oversee it and ensure it succeeds, whereas Joe does not. What i — , however, the ability o — one investor to see and respond to market moves was not the result o — a personal li — estyle choice but rather the consequence o —
economic law or government mandate? In startup investing, not all investors are
equal. Ordinary investors have many disadvantages. First, they only purchase small
amounts o --- stock, so they cannot e ---
ectively command or discipline management.
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Second, they do not have the time or geographic possibility o --- visiting the invest-
ment’s headquarters to meet with management and con --- irm that things are on track.
Third, they do not own enough stock to make it worth their time to spend hundreds
o --- hours tracking the startup and its competitors.
Fourth, the government limits ordinary investors’ access to resale markets, while
mega-wealthy investment corporations have almost unlimited access to make mar-
kets. As a result, startup stock is worth substantially less when held by employees and
poorer investors, yet that exact same stock is worth much more in the hands o --- upper
management and the wealthiest investors. This raises obvious --- airness concerns. It
also --- rustrates the JOBS Act by chilling venture investment by poorer investors.
The un --- ortunate truth o --- our securities regulations is that they require poorer
investors to hold private stock --- or longer than the wealthiest investors. Laws --- urther
restrict poorer investors’ access to resale markets. This causes private stock to have
a bigger illiquidity discount and thus be less valuable in the hands o --- poorer investors
than in the hands o --- wealthier ones, who can access the resale market quicker and
easier. Ironically, this is the unintended consequence o --- securities regulations that
were designed to protect poorer investors, yet those regulations have the actual e ---
ect o — creating an illiquidity discount asymmetry — avoring wealthier investors over poorer ones. Securities regulations create the illiquidity discount asymmetry by allowing large banks to host private stock markets — or their Quali — ied Institutional Buyers (QIBs), who must have more than $100 million in net investments. Smaller stockholders, and employees with stock options, are systematically disadvantaged by Rule 144A, which creates the QIB restriction on private-stock resale. The lack o — an equal-access sa — e-harbor exemption harms poorer stockholders and employees disproportionately more than it harms wealthier stockholders and management. And the lack o —
a general solicitation provision keeps transactions o ---
exchanges, so trading mainly occurs in over-the-counter transactions in private stock markets called “dark pools.” In short, Rule 144A’s sa — e harbor provides liquidity only — or QIBs, who are large institutions that own over $100 million in net investments. It does not provide liquidity to many other startup investors. Angels, who invest about twenty- — ive billion dollars annually in startups, are be classi — ied as accredited investors (AIs). Each AI must have at least one million dollars in net assets (not including primary residence) or $200,000 in annual income ($300,000 joint i — married) to purchase private- company equities in the large Regulation D market. Wealthy angels and small venture capital — unds may also be classi — ied as quali — ied purchasers (QPs), but even QPs with ninety-nine million dollars in net investments cannot purchase equities on a 144A market. This disparity in access to a resale market means that even AIs and QPs have an “illiquidity discount” on their shares, while QIBs enjoy the — ull value o — their shares. Meanwhile, ordinary investors have an even larger illiquidity discount, e —
ectively giving the poorest investors the worst deal as a matter o — law. Startup employee might
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have the worst o --- the lot, as they o --- ten --- orgo cash compensation in exchange --- or
securities that might turn out to be worthless and, in any event, cannot be sold --- or
years at a time. The 144A regime makes private-company stock most valuable to the
wealthiest class o --- investor and least valuable to the poorest class o --- investor. This
problem makes crowd --- unding unattractive. No one wants to cast lots when one is
preordained to get the short straw.
no special purpose vehicles
For reasons that are not clearly stated, the SEC --- orbid the use o --- Special Purpose
Vehicles (SPVs) in equity crowd --- unding. SPVs are business entities that are --- ormed
or the sole purpose o — organizing investors. Members — und the SPV by contributing money, then the SPV uses that money to purchase stock in a target business. The SPV is the stockholder, which simpli — ies the target business’s capital structure, stockholder ledger, and voting mechanisms. The SPV can be pro — essionally man- aged, so the investing members take a more passive role. SPVs have been misused in the past; perhaps this makes regulators cautious about allowing them in the — uture. For example, Enron Corporation used an SPV to trans — er some o — its riskiest assets into an SPV, which took that risk o —
its main balance sheet. This was just one part o — Enron’s massive accounting — raud, but it gave SPVs a bad name. Perhaps because o — this negative attitude toward SPVs, the SEC prohibits their use in investment crowd — unding. Although there is bipartisan, bicameral support in Congress to allow SPVs in equity crowd — unding, and despite the — act SPVs are common in investing generally, the SEC has not yet allowed it. Until that happens, we might expect equity crowd — unding to remain inconsequential. This is a shame, however, given that it would not be so hard to — ix crowd — unding, and doing so could produce bene — its — or a wide range o — investors and entrepreneurs.
how crowd --- unding could work
Regulators have suggested that allowing ordinary people to invest via the internet
generates untold new risks --- or --- olks who are unable to protect themselves. But there
are economic reasons to believe that investing in startups over the internet might
actually be sa --- er than investing in startups in more traditional ways, such as attending
demo days and negotiating a pre --- erred stock purchase agreement. To understand
why, --- irst we must establish why startup investing is dangerous in general. Then we
can see how the internet helps solve these problems.
Startup investors have three economic problems, which pro --- essional- and public-
company investors can generally mitigate, but ordinary investors might not be able
to avoid. First, there is an in --- ormation asymmetry problem: entrepreneurs know
more than investors about what entrepreneurs will do. Pro --- essional investors join the
board and oversee the entrepreneurs, so they gain in --- ormation about how hard and
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how well the entrepreneur is working, but ordinary investors do not get board seats.
Second, there is great uncertainty as to whether the venture will succeed.
Pro --- essional investors invest in stages, over time, but ordinary investors may not
have the cash or the time to per --- ormed staged investments. Third, there are agency
costs, speci --- ically, residual loss: entrepreneurs have incentives to shirk and sel --- -deal,
especially when the investor does not understand the entrepreneurs’ technology.
Pro --- essionals generally invest in --- amiliar technical areas, but ordinary investors
might not have technical expertise.
Ordinary investors probably cannot mitigate this trio o --- problems in the trad-
itional ways. Given a legal limit o --- $10,000 per investor per year, it is doubt --- ul that
they will have the time, inclination, or ability to join two or three corporate boards,
manage a multistaged private-investment port --- olio, and get technical expertise in
the latest app-coding languages. In addition, crowd --- unding theoretically has the
additional problem o --- competition with pro --- essional investment. The most promis-
ing startups receive multiple o ---
ers — rom the most prominent venture-capital invest- ors, who contribute not only money but also pro — essional services, workspace, mentorship, advice, management, and, o — course, access to yet more money. O —
line, nodes o — well-connected venture capitalists (VCs) with MBAs — rom Stan — ord share in — ormation about leads over lattes in Palo Alto. They meet — ounders daily, and their — inancial resources are virtually unlimited. Their associates process data — rom expensive, manicured databases into custom analytics reports, — ine-tuned to each principal’s predilections. Ordinary investors who want to invest in startups, on the other hand, go, — or example, Crowd — under.com, click “Search,” and are presented with a long list o —
companies and projects that are soliciting investors. Can the ordinary investors who
are by de --- inition amateurs compete with investment pro --- essionals in --- inding, acquir-
ing, servicing, and monitoring the best investment opportunities?
Crowd --- unding investors, however, can collaborate in new ways that could mitigate
this trio o --- problems. There are three ways that crowd --- unding investors might solve the
trio o --- problems: (1) harnessing the wisdom o --- the crowd, (2) crowdsourcing o --- in --- orma-
tion, and (3) leveraging online reputation. These crowd --- unding investment strategies
may come into play both during the campaign and a --- ter the company receives the
money, and they give reason --- or hope that crowd --- unding might work out a --- ter all.
Wisdom o --- the Crowd
Groups o --- people can act as wise crowds or --- oolish mobs. In general, a large group o ---
diverse individuals who are able to communicate e ---
ectively will come up with better predictions and more intelligent decisions than would a skilled person acting alone. But this obviously comes with many conditions and caveats. The wisdom o —
the crowd is only expressed where crowds can grow su ---
iciently large, evaluate in — ormation that can be per — ectly known, or are organized around a thought leader.
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When these conditions are not met, however, crowds degrade into herds and
mobs. Like the proverbial lemming who runs o ---
a cli —
because the group is running in this direction, members o — crowds can also make — atal errors. When one member o — a group witnesses the behavior o — another, the — irst member may assume the second member is acting on in — ormation that is private to that second member. The — irst member, who may also have some private in — ormation, may in — er the second member’s private in — ormation — rom the action that is observed. The
irst actor may then take a similar action based both on private in — ormation and in — erred in — ormation. A — amiliar example makes this theory clear. When a person decides to watch a video on a website like YouTube, that person can see how many others have watched that video, which suggests something about the quality o — that video. That person may decide to watch the most-watched video because the group in — ormation suggests that video is the highest quality. This may seem quite innocuous, but as the crowd gets larger, the in — ormation
rom crowd behavior begins to overwhelm the prospective viewer’s private in — orma- tion. The extreme — orm o — this group-think behavior is called an “in — ormation cascade,” where even rational individuals will choose to abandon their private in — ormation (or not make e —
orts to gather private in — ormation in the — irst place) and instead to — ollow the crowd. In this case, the wisdom o — the crowd can be sublimated into herd behavior. Crowd science theory deems a crowd “success — ul” when it aggregates “asymptotic in — ormation.” In other words, — rom a systems-sciences perspective, a “wise” crowd is one that e —
iciently produces and distributes unique in — ormation about the true state o — the world.
Avoid Crowd Failures
Crowds --- ail due to “herding” or “in --- ormation cascades.” Herding is when individ-
uals merely mimic others’ actions, ignoring their own private in --- ormation, as
opposed to “learning aggregation,” when the crowd converges on the right result
by leveraging both public and private in --- ormation.
Are crowd --- unding investors likely to be wise crowds or dumb mobs? That
depends on the other --- actors discussed in this section. I --- equity crowd --- unding is
worthwhile enough that large groups o --- ordinary investors consider investment
crowd --- unding opportunities, then the in --- ormation produced by that large group is
more likely to solve in --- ormation problems. I --- equity crowd --- unding is deemed
a --- ringe activity, crowds may never grow large enough to produce superior results.
In this way, crowd --- unding is a sel --- - --- ul --- illing prophecy. Success will generate
a positive --- eedback loop leading to more success, while --- ailure will generate
a negative --- eedback loop. This is a typical chicken-egg problem that many new
markets --- ace.
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To alleviate this problem, regulations could allow or even encourage crowd --- und-
ing networks to grow large. An alternative solution is to require crowd --- unding
companies to have an in --- luential agent. A single in --- luencer can have an outsized
impact on the entire crowd. This can be --- or good or bad, so it is better not to be le --- t to
chance or drive. Rather, in --- luencers on crowd --- unding plat --- orms should require
some sort o --- accreditation. These modi --- ications to the law will help ordinary invest-
ors bene --- it --- rom the wisdom o --- the crowd.
Crowdsourcing
As mentioned earlier, the JOBS Act not only permitted equity crowd --- unding. It also
permitted companies to generally solicit investment --- rom accredited investors like
angels and VCs. Prior to the JOBS Act, private companies could not put an ad --- or the
sale o --- stock in the newspaper or post about an investment opportunity on social
media. Now there is a new Regulation D Rule 506(c) that allows private companies
to publicly advertise investment opportunity, so long as the stock is only sold to
wealthy accredit investors.
This new rule has resulted in an interesting new type o --- web portal. The largest
506(c) web portal is Angel List. On this portal, you can “ --- ollow” --- amous venture
capital investors or join an investment syndicate, which is a group o --- investors who
share the workload o --- sourcing and negotiating deals.
Following lead investors and joining investment syndicates has emerged as a key
aspect o --- online investing because this solves some o --- the problems with investor
group dynamics. Crowd --- unding might need to take a page --- rom Angel List’s book, i ---
it is to succeed.
Rational Pathos
Small shareholders have a problem that economists call “rational apathy.” To put
this problem simply, i --- you only have $100 invested in a company, it’s not worth more
than $100 o --- your time to monitor that investment. Monitoring the investment does
not guarantee that you will not lose your money, while simply ignoring the invest-
ment and spending your time working on a lucrative project or even simply doing
something that gives you $100 o --- enjoyment is a better bet. In --- act, it would be
irrational --- or you to spend countless hours obsessing over your $100 investment. That
time would be better served, as an economic matter, but engaging in some other
activity that has a higher return on the investment o --- your time.
Reg CF has, un --- ortunately, built rational apathy problems into the equity crowd-
unding system, and this problem is worse — or the less wealthy participants in the system. The average American — ull-time worker earned about $25 per hour, totaling about $50,000 per year, in 2019. Pursuant to Reg CF, such a person can only invest up to $2,500 per year in crowd — unding. Since crowd — unding is risky (it carries an
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especially high degree o --- idiosyncratic risk), a wise investor will diversi --- y and invest
in approximately twenty companies. That adds up to a $125 per company investment
or the wise average investor. Such an investor should not spend countless hours sourcing, diligencing, negotiating, and monitoring crowd — unding investments. In
act, he or she would be ill-advised to spend more than — ive hours thinking about any one company, as spending this time would have negative expected returns. Rational apathy will likely lead to additional problems — or crowd — unding. Limitations on the dissemination o — in — ormation, primarily when the cost o — acquir- ing the in — ormation is greater than the bene — it received, and the lack o — incentives to produce and share in — ormation, may hinder the potential bene — its o — crowdsourcing behavior. Pro — essional analysts are generally better trained in analyzing equities than an average person who may participate in crowd — unding. Accordingly, the in — orma- tion — rom crowd — unding investors shareholders is likely to be weak, in — requent, and unreliable. But there is a — lip side to rational apathy, which I call rational pathos, or caring, where an investor has natural incentives to monitor investments at an appropriate level. I — we allowed crowds to — orm naturally as investor groups, members would specialize in certain tasks and share in — ormation — or the mutual pathos. In other words, the total amount o — pathos produced by a crowd can be more than the sum o —
the individual’s rational apathy. Under these conditions, the group makes smarter
decisions than rational individual investors would make.
The SEC should revise Reg CF to encourage the kind o --- behavior we see in Reg
D Rule 506(c) markets like Angel List. Instead o ---
orbidding investors to share in — ormation, the SEC should encourage investors to take the lead and organize investment syndicates that divvy up the work. Instead o — each single investor spend- ing up to — ive hours reviewing — inancial in — ormation — or twenty companies, totaling a whopping 100 hours o — work to make a measly $2,500 investment, a syndicate o —
twenty investors could each review one company and then share the results with
others. Now, each average investor in the syndicate can spend --- ive hours o --- work on
a $2,500 investment. This represents a twenty-times increase in e ---
iciency, and it could result in better in — ormation that sets o —
the positive — eedback loop discussed in the section above on Wisdom o — the Crowd. And that was just as small example o — allowing existing synergies to make invest- ment groups more e —
icient. We could even kick the crowd — unding system into hyperdrive by allowing Special Purpose Vehicles (SPVs). As discussed above, SPVs are legal entities (usually limited liability companies) that are — ormed — or the sole purpose o — organizing an investment group. The SPV LLC typically has one manager, who makes decisions on behal — o — the group, and an unlimited number o — members, who put in money but then o — ten have an otherwise hands-o —
role. The manager might be compensated — or her time through a common venture-capital
ormula called the Two and Twenty (or “2 and 20”). This means that the manager gets 2 percent o — the assets under the SPV’s management plus 20 percent o — the SPV’s
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pro --- its. I --- twenty ordinary investors each invest $25,000 to become members in
a crowd --- unding SPV, the SPV could pay a manager $1000 plus 20 percent o --- pro --- its.
The manager would thus be incentivized to keep proper tabs on the investment
companies, and these desirable incentives increase as the SPV adds more members.
Moreover, the manager should be a person who has special --- inancial skills.
A pro --- essor manager who is trained in analyzing equity securities could do a better
job than an average person who does not have this training or experience.
Currently, it is di ---
icult to — orm syndicates under Reg CF because the law does not permit investors to — orm special purpose vehicles (SPVs) or special purpose entities (SPEs). These obstacles will have to be addressed i — equity crowd — unding is to make a meaning — ul impact.
Reputational E ---
ects Even i — the SEC were to permit lead investors to create SPVs and manage an investment group in crowd — unding, the severe limits on how much each person can invest could limit incentives to manage these groups well. However, receiving the Two and Twenty is not the only reason to manage a small — und care — ully. Managers also care about their reputation. I — they manage well, they might be rewarded with the opportunities to manage more and larger — unds later. Reputational e —
ects are a signi — icant driver o — human behavior. Designing invest- ment plat — orms that allow users to build reputational status may encourage superior results. Moreover, the SEC should continue to increase crowd — unding limits as the technology provides to be e —
ective at eliminating — raud.
Gami --- ication
Gami --- ication – the use o --- game design elements in non-game contexts – is another way
to motivate online investors to organize and share in --- ormation. Gami --- ication methods
create a positive user experiences that improve user retention and utilization – but it
also can over-stimulate users and encourage gambling behavior.
Gami --- ication is already becoming popular in higher education. For example,
Goose Chase is a new company that o ---
er mobile-powered scavengers hunts — or K-12 students. Students use their smartphone to watch videos, answer riddles, and — ind prizes. Along the way they learn skills like reading comprehension, time manage- ment, and map reading. RobinHood, the — ree stock trading plat — orm discussed in Chapter 8, applies gami — ication to make stock trading more — un and approachable — or millennials and Gen Z users. For example, it sends daily push noti — ications reminding users to participate, and showers users with a virtual rain o — con — etti when they trade. Articles about stock in — ormation include emojis and simple language, and noti — ications push users to lists o — “top mover” stocks. But, as discussed in Chapter 8, RobinHood users
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do not necessarily tread stocks as investments. Rather, they might alternate between
playing games like Candy Crush, betting on apps like SportsBets, and “investing” on
RobinHood, all while sitting in a waiting room or taking the bus to work. The casual
nature o --- RobinHood makes it much --- riendly --- or people to invest, but it may result in
people taking investment less seriously and treating it as a game and not a pro --- ession.
Gami --- ication can --- acilitate online reputation by “scoring” the reputation o --- users;
in --- act, there are business-method patents pending to this e ---
ect. Gami — ication o —
reputation has been applied in varied contexts such as encouraging so --- tware devel-
opers to include comments in their code and creating leaderboards to encourage
classroom learning. This could be applied to social media investing, where an
ordinary users can become an in --- luencer by virtue o --- scoring highly in peer
reputation.
Gami --- ication has even been used to attract and retain reliable crowdsourcing
tasks such as relevance assessment, which could be directly applied to crowdsour-
cing --- or online investors. Relevance assessment is the process o --- attributing
a relevance level to a set o --- in --- ormation, so that users can access the most relevant
in --- ormation --- irst, instead o --- wading through hours o --- irrelevant in --- ormation looking
or the proverbial needle in the haystack. There is so much in — ormation about investment opportunities that ordinary investors may elect to review none o — it, since without a way to sort what is relevant — rom what is irrelevant it would take an unreasonable amount o — time to learn anything meaning — ul — rom the data. Gami — ication — or relevance assessment already exists on social media — orums like Reddit. Users can save, comment, and even give an award to use — ul posts, while hiding, reporting, or downvoting irrelevant ones. Future users see more o — the posts deemed relevant by the prior ones, and — ewer o — the irrelevant ones. This could be applied to crowd review o —
inancial in — ormation, or large-scale discussions about investment opportunities. It could also lead to users earning a relevance score based on how relevant other users — ind their posts to be, thus identi — ying and elevating in — luencer.1 While the SEC does not mandate relevance or reputation scoring systems, it also does not prevent it. So long as there is su —
icient competition in the market — or crowd — unding portals, some enterprising portals may employ gami — ication to encourage crowd — unding investors to contribute high-quality e —
orts to investment crowdsourcing, which may indeed help crowd — unding in general overcome in — or- mation asymmetry and agency costs in crowd — unding. These techniques, however, must be used care — ully. RobinHood is currently under scrutiny — or making investors too much — un. According to allegations, the con — etti and leader boards causes some users to trade too o — ten and maybe even become “addicted” to trading. Whether these allegations are true is yet to be
1
Elevating in --- luencers could also create an echo chamber, where misin --- ormation cascades are com-
mon, i --- the social media plat --- orm is improperly designed, or i --- it has the wrong economic incentives.
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determined, but plat --- orms should be care --- ul regardless because the optics o ---
employing gami --- ication techniques may seem un --- avorable to some investors’ and
regulators’ eyes.
why should we care about crowd --- unding?
Fixing crowd --- unding seems like a lot o --- work. Why should we bother? Because
crowd --- unding has the potential to make corporate --- inance sa --- er and more equitable
or ordinary investors. I — we do not — ind a way to — ix crowd — unding, — rustrated ordinary investors will continue to probe deeper into the nether regions o — cyberspace, looking — or opportunities — ar beyond the reach o — regulators or — inancial police. Meanwhile, entrepreneurship in America is at a critical point. Small businesses that were already su —
ering have recently been ravaged by COVID-19. The demise o —
small business means the death o --- the American dream --- or many o --- our most
vulnerable citizens. Crowd --- unding could help save American small business and
restore the American dream to a wider range o --- entrepreneurs.
Protecting Investors
At --- irst blush, it may seem that the best way to protect ordinary people --- rom losing
their money in bad investments is to prevent them --- rom investing in the --- irst place.
A --- ter all, one cannot make a bad investment i --- one cannot invest at all. However, this
thinking is --- lawed on many levels.
First, this ignores the reality that most people must make investments i --- they are to
survive li --- e events including illness and retirement. Unlike most --- irst-world nations,
America does not have a public pension system. Indeed, most o --- America’s employ-
ers no longer provide pensions – also known as de --- ined-bene --- it plans because they
guarantee a speci --- ic pay out or lump sum bene --- it – but rather American employers
provide de --- ined-contributions plans like a 401(k), where the employer contributes
some percentage o --- an employee’s salary to a retirement account and the employee
determines how and where he wants to invest the --- unds. Whether that retirement
account is su ---
icient to carry that employee through retirement, there — ore, is subject to market — orces. In other words, even our de — ined-bene — it plan system is still subject to investment risk. Second, relatively sa — e investments, like keeping money in an FDIC insured bank or buying government bonds, generate relatively low returns these days. The Federal Reserve committed to keeping interest rates low — or the — oreseeable — uture. With so much cheap cash available to borrowers, it is very di —
icult — or lenders (working savers) to charge pro — itable rates. Ultra-sa — e investments can actually lose money over time because o — in — lation. In 2019, the annual in — lation rate was about 1.8 percent. Meanwhile, as o —
September 2020, government-backed treasury bonds return about 1.25 percent
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per year. That means that someone who invests in treasury bonds will e ---
ectively lose about 0.5 percent o — their spending power annually. This is hardly a way to prepare
or retirement! Until interest rates rise again, pensioners need access to higher- reward investment opportunities. Third, and most relevant to the lessons — rom this book, it is no longer reasonable to assume that Americans can be prohibited — rom investing in too-risky assets. The internet has eroded geopolitical barriers. Nowadays, investors in Omaha, Nebraska can invest in startups in the United Kingdom via web sites like Seedrs.com just as easily as they might purchase publicly traded stocks on eTrade. Moreover, investors now have access to much more exotic and risky investments, including initial coin o —
erings and decentralized autonomous organizations. While regulators might mean to protect people, in reality they are driving them to explore these exotic
inancial markets, because there seems to be no lucrative and reasonably sa — e space to invest domestically. The securities regulators need to wake up to the Third Era o — corporate — inance. In this era, ordinary people see venture capitalists and a hand — ul o — Silicon Valley startup — ounders getting incredibly rich, while big banks keep getting bigger. Meanwhile, opportunities — or ordinary investors to make decent returns through traditional instruments like savings accounts and treasury bonds have disappeared. Even stock market investing seems like a losing proposition where high- — requency traders with super- — ast computers are able to make short-swing pro — its at the expense o — long-term buy-and-hold investors. The solution cannot be more red tape and tighter controls. As this book has shown, controls did not prevent recent crisis and crashes. Moreover, we cannot keep people — rom investing in Bitcoin, Ethereum, and other harder-to-understand cryp- tocurrency assets. We cannot stop people — rom participating in initial coin o —
erings. We cannot keep everyone sa — e — rom exploring possibilities to strike it rich in a world that presents no sa — e alternatives to generate meaning — ul wealth. Rather, we should shi — t our thinking. By recognizing the reality that ordinary investors in America — eel that they have no government-backed investment options that can generate substantial wealth, while recognizing that it is easy — or domestic investors to invest abroad or in cyberspace, we can start to shi — t toward generating competitive regulations – regulations that make investing in America attractive again.
Forming Capital --- or Entrepreneurs
Entrepreneurship provides a path to prosperity --- or many people.2 In particular,
women and minorities pre --- er entrepreneurship as their path to achieve the
2
Entrepreneurship is the ability to “make something” o --- onesel --- . As coined in 1931 by John T. Adams,
entrepreneurship symbolized the democratization o --- opportunity that is the American Dream.
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American Dream. In their striving, their startups and small businesses bene --- it our
entire society.3 Entrepreneurial innovation has a positive impact on social wel --- are.
For these reasons, the --- ederal government has implemented numerous policies
designed to support small businesses and promote startup innovation. In --- act,
President Obama expressly stated improving access to capital --- or startup entrepre-
neurs and small business is a primary goal o --- the JOBS Act.
However, these policies appear to be inadequate. Recent studies have shown that
startups and small businesses are less success --- ul than large, incumbent --- irms.
Despite what the shows Shark Tank and Silicon Valley depict, outside o --- certain
high-tech --- ields, American entrepreneurship is declining. It is well documented that
startups have an access-to capital-problem. The JOBS Act was designed to --- ix this
problem, but, as the result o --- overregulation, the JOBS Act has so --- ar --- ailed to
produce a meaning --- ul amount o --- capital --- or entrepreneurship.
SEC regulators including Commission Luis A. Aguilar have recognized that
small businesses need greater access to capital and liquidity. But the securities
regulator’s inability to cra --- t a system that works demonstrates a seemingly irreconcil-
able tension between the agency’s goals. The SEC states it has three goals: protecting
investors, maintaining orderly capital markets, and --- acilitating e ---
icient capital
ormation. In the case o — equity crowd — unding, the SEC, who promulgated a 685- page Reg CF, have — ocused too much on investor protection at the expense o — capital
ormation. This is due in large part because the SEC — ailed to consider how the internet changes investment.
summary
This chapter has shown how the internet ushered in a brand-new in --- ormation era.
Instantaneous multilateral worldwide communication networks are not just plaus-
ible, they already exist. Admittedly, these in --- ormation networks su ---
er — rom problems o — their own – — or example, consider the rise o —
ake news shared on Facebook – but they also solve traditional problems in new ways. The — uture o — investment on the internet may be bi — urcated. While some plat — orms will seek SEC approval and o —
er strong anti- — raud protections, others will avoid registration and liability and o —
er a laissez — aire (hands-o —
) marketplace on the principles o — caveat emptor (buyer beware). We are already seeing this bi — urcation today, with some registered investment portals like AngelList and
Rebecca Gill, The Evolution o --- Organizational Archetypes: From the American to the Entrepreneurial
Dream, 80 COMM. MONOGRAPHS 331, 337 (2013).
3
Entrepreneurship positively impacts social wel --- are in two ways: by major innovations that shock the
equilibrium through creation o --- a new product or process, which is also re --- erred to as Schumpeterian
entrepreneurship or creative destruction, and by minor innovations that bring the market price close to
equilibrium, which may be called Kirzner entrepreneurship. See Samuel Bostaph, Schumpeter vs.
Kirzner on Entrepreneurs, MISES INST. (May 16, 2019), https://mises.org/wire/schumpeter-vs-kirzner-
entrepreneurs [https://perma.cc/D2GY-YRFP]; see also in --- ra Part III.
https://doi.org/10.1017/9781316597736.012 Published online by Cambridge University Press 172 Crowd — unding
Manhattan Street Capital --- ocusing on Reg. A and Reg. D o ---
erings, while operat- ing as unregulatable decentralized autonomous organizations that have market- places — or cryptocurrency, non- — ungible tokens, digital property, and other assets that are not subject to securities regulations. While both constitute crowd — unding, the plat — orms’ incentives to protect investors by in — orming them o — risks, policing against — raud, and engendering productive research and conversation vary widely.
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https://doi.org/10.1017/9781316597736.012 Published online by Cambridge University Press Conclusion
This book journeyed through time to show how many o --- the seemingly new and
incomprehensible --- inancial technologies in the modern world have analogues in the
past. The goal o --- this journey was to make those seemingly abstruse and inexplicable
current events more readily understandable. Hope --- ully, this gives readers the con-
text needed to make better --- inancial decisions. But the greater goal is to show that
current events demonstrate that the era o --- traditional --- inancial regulation is over.
This is a call to action --- or scholars, lawyers, judges, and policymakers to rethink law
and regulation in light o --- a digitally connected world.
The story o --- American --- inancial history un --- olds across three eras. The First Era
(1791–1932) is characterized by --- inancial markets that were loosely regulated by the
states and subject to --- ew national regulations. The Second Era (1932–2002) is de --- ined
by the rapid expansion o --- the national regulatory apparatus in political responses to
the --- inancial crises, beginning with the Great Depression. The Third Era (2002–
present) was also born --- rom --- inancial crises, the Dot-Com Bubble and the Great
Recession, but is characterized by a private, technological response to perceived
over-regulation and over-reach by a government that has decayed --- rom --- ree-market
capitalism to cronyism. We are now living in the Third Era, when technology o ---
ers alternatives to — ederally regulated — inancial markets – and when millions o — people are choosing to migrate — rom regulated markets onto the vast unregulated — inancial internet. The First Era began when America’s — ounding — athers enacted the Constitution o —
the United States, which became e ---
ective in 1789. This supreme law created a small national government and reserved many — inancial powers — or the states who were recently colonies. This new style o — government, called — ederalism, allowed di —
erent states to experiment with various — inancial regulations. States, in turn, created various laws that allowed people to charter corporations. Corporations are entities that are treated by law as separate — rom their owners. Corporations are necessary — or industrial society because they allow people to contribute money (capital) and e —
ort (labor) toward a joint enterprise. Investors in corporations today enjoy limited liability, meaning investors cannot lose more than 174 https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press Conclusion 175
their investment. This encourages investment and productivity, but it also has
a social cost. I --- a corporation cannot pay its debts or otherwise meet its obligations
to credits, then creditors lose their claim. In technical terms, corporations external-
ize risks onto society.
States sought (and still seek) to balance the social bene --- it o --- corporations –
enhanced productivity, --- aster innovation, lower costs o --- goods and services, etc. –
with the social cost o --- externalized risk. In the early days o --- the First Era, state
legislatures needed to authorize the creation o --- every new corporation. This resulted
in the creation o ---
ew corporations, many o — which were created by rich and power — ul people. For example, Alexander Hamilton, who was the state representa- tive — or New York be — ore the Constitution and a primary — orce — or the Constitution’s rati — ication, — ounded the Bank o — New York. Corporations, money, and politics were thus closely intertwined — rom America’s origin. During Hamilton’s tenure as the — irst Secretary o — the Treasury o — the United States, New York developed toward being the — inancial center o — the — ledgling nation. A group o — stockbrokers and merchants — ormed the New York Stock Exchange in 1792. In that same year, the Federalist party — ormally organized itsel —
as the --- irst political party in America. Known as the party o --- merchants and bankers
(contrasting with the Je ---
ersonian anti-Federalists who tended to be landowners and
armers), the Federalists dominated the early national government and enacted policies — avoring banking corporations and stock markets. Congress, which was majority Federalist at the time, created the First Bank o — the United States in 1971. The Federalists did not maintain power — or long. President Thomas Je —
erson, a notable anti-Federalist, de — eated incumbent President John Adams in 1800. Je —
erson, a wealthy landowner, opposed the national bank in particular and invest- ment in general, which he decried as speculation. He ostensibly pre — erred product- ive labor, such as — arming — or crops, even those this labor was to come — rom the hundreds o — slaves he owned over his li — etime. President James Madison, another slaveowner, succeeded Je —
erson in 1808. Both men shared views about abrogating the national bank. Madison succeeded in this ambition in 1811, when the Senate voted not to renew the bank’s charter. Madison’s timing turned out to be terrible, as the nation needed — unds — or the upcoming War o —
-
Without a national bank to borrow
rom, the national government borrowed — rom private banks. This led to a boom in private banks, which is ironic, considering that the policy was established by two men who wished to shi — t power — rom the bankers to the landowners. This is just one o — many examples o — unintended consequences in the history o —
inance. Madison apparently recog- nized this — olly, however, and oversaw the charter o — the Second Bank o — the United States in 1816. In 1929, however, President Andrew Jackson, co — ounder o — the Democratic party, de — eated President John Quincey Adams (a son o — John Adams who shared many o —
his --- ather’s Federalist belie --- s, including that slavery is morally wrong). Jackson
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ollowed in Je —
erson’s and Madison’s — ootsteps: Jackson owned slaves and despised bankers. He campaigned to destroy the Second Bank o — the United Stated, and he succeeded in 1832, when Jackson vetoed a bill to renew the bank’s charter. The connection between pro-slavery and anti-national-bank is no coincidence. Leading politicians o — the time believed that a national bank could undermine slavery. Nathaniel Macon (Democrat-North Carolina) remarked, “I — Congress can make banks, roads and canals under the Constitution, they can — ree any slave in the United States.” John Tyler (Democrat-Virginia) concurred, “i — Congress can incorp- orate a bank, it might emancipate a slave.” Jackson’s campaign succeeded in destroying the national bank, but it did not help the economy o — his pro-slavery constituents. Rather, it led to the Panic o — 1837, a — inancial crisis. Ironically, this crisis harmed the agrarian Southern states more than the industrial Northern states. Cotton plantations, which were powered by slave labor, had a particularly had time selling their goods, since merchants could not borrow money to buy them. States responded to the Democrat’s opposition to national banking by passing new state laws allowing state banks to be easily created. This led to an explosion in new state banks, many o — which issued their own currency. About hal — the banks — ailed in the next crisis, the Panic o —
-
Now armed with evidence that
ree banking did not prevent crises, states rescinded — ree banking laws. This pendulum swing in policy re — lects the general tenor o —
inancial regulation that persists to this day: whenever there is a — inancial crisis, governments seek to change policy to prevent it — rom happening again. But politicians do not always learn — rom the past. The result o —
ailing to learn lessons — rom history is a — lip- — lop in policy — rom crisis to crisis, but not an end to — inancial crises at large. The national division between slave states and — ree states proved unsustainable. In the early 1860s, Southern states — ormally seceded — rom the Union to — orm the Con — ederacy, and this “house divided” went to war on July 21, 1861. To — und the Union war e —
ort, the U.S. Congress passed the Legal Tender Act o — 1862, which permitted the — ederal government to issue the — amiliar “greenback” dollar bills we still have today. Controlling the money supply helped the Union pay — or and eventually win the Civil War. The end o — the Civil War marks the beginning o — the period known as the Reconstruction Era. To knit the war-torn United States back together, Congress helped — und the Transcontinental Railroad. Private investors built a rail network that connected East and West, North and South. Railroads, however, are expensive to build. To raise — unds — or these ambitious projects, — inanciers developed a new — orm o — investment contract called pre — erred stock. Unlike common stock, which re — lects ownership rights in a corporation and conveys rights to pro — its and limited voting rights, pre — erred stock includes “pre — er- ences,” such as greater governance rights, rights to be paid a dividend, rights to inspect books and records, and rights to sit on the board o — directors. This hybrid o —
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common stock and debt was initially criticized --- or --- avoring the wealthy who could
a ---
ord to purchase such pre — erences over the common people who could not. But pre — erred stock appealed to moneyed interests, who — unded rail projects across America with this investment vehicle. Over time, more pre — erences evolved, such as liquidation rights and rights o —
irst re — usal, and there is now a complex venture capital industry that deals mainly in this once-innovative — orm o — stock. Alongside the railroads, Western Union built telegraph poles. Through a network o — electric wires strung on these poles, people could communicate almost instantly used a telegraph. The — irst telegraphs could only make and receive a buzzing noise, and people used Morse code, a series o — short and long sounds, to communicate messages. Then, David Edward Hughes developed a telegraph that could translate these electrical signals into letters and numbers, which it printed on reel o — tape. One o — the predominate use cases — or this new communication device was to transmit — inancial in — ormation. The New York Stock Exchange began sending out in — ormation about current stock prices, and people everywhere began “watching the ticker.” The stock ticker created a heightened interest in — inancial markets, but ordinary people still were not able to easily participate. The New York Stock Exchange, — or example, only permitted eleven hundred stockbrokers to trade on the exchange. At its First Era peak, a “seat” on the New York Stock Exchange cost the equivalent o —
over ten million dollars today. Stockbrokers had to recoup these costs by charging
commissions. Since it was no more di ---
icult to trade ten thousand shares than one hundred shares, commissions decreased on a per share basis as order size increased. Orders o — less than one hundred shares were considered odd lots and subject to additional — ees. This cost structure, which discouraged small transactions and encouraged large ones, made it di —
icult — or low-wealth investors to a —
ord stock- brokers and thus to participate in stock markets. It was likely — rustrating — or many to watch the ticker and hear about others becoming wealthy through stock ownership with no real means o — investing. Some such people who could not invest with established stockbrokers — ound other means to parlay their money in bucket shops, which was akin to gambling. By the 1900s, bucket shops had popped up across America. Although cleverly designed to look like high-end stockbrokerage — irms, bucket shops were merely gambling dens. Unlike stockbrokers, who are paid — or making trades or when clients make money, bucket shop traders only pro — it when their clients lose. What’s more deleterious and unethical, the bucket shop traders manipulated the market to earn pro — its — or themselves. Although bucket shops were eventually shut down as the First Era o — unbridled — inancial markets ended, their popularity shows that the distinction between investing, speculating, and gambling can easily blur. This also hints at the unintended consequences that may arise where people are kept — rom investing. Investing can be a sa — e and socially productive activity. Investors who purchase stock in a corporation get legal rights, and the directors o — the corporation owe duties
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to those investors as a matter o --- law. Invested money helps corporations do business.
Gambling, on the other hand, lacks legal protections and o ---
ers — ew social bene — its. Instead o —
unding innovation, money goes to whoever is luckier or less scrupulous. In the First Era, people were not able to invest simply because it was too expense, and so they gambled. Soon, however, in the Second Era, governments prohibited people — rom investing as a matter o — law. Now, in our Third Era, these prohibitions are under tension. People who lack access to investment opportunities are once again gambling, although now they are doing this on the internet, where govern- ment prohibitions are hard to apply. America’s First Era and its investment craze ended abruptly in late October 1929, when the New York Stock Exchange suddenly crashed. Premier stocks in — amous corporations lost 11 percent o — their value in a single day. Lower quality stocks — ared worse. Then the market kept crashing. Over the course o — three brutal years (1929– 1932), the premier stocks lost almost 90 percent o — their value. (The market did not
ully recover until 1959.) In this — ace o — yet another — inancial crisis, the government once again — lip- — lopped on its — inancial policy. First, President Franklin Delano Roosevelt, a Democrat, beat incumbent President Herbert Hoover, a Republican, by a landslide election in 1932. Then, Roosevelt, who campaigned in 1932 as a — iscal conservative who promised traditional economic policies including balancing the
ederal budget, changed his politics radically. During his twelve years in o —
ice Roosevelt oversaw the largest expansion o — the — ederal government in American history. He even threated to subvert the Supreme Court o — the United States i — they dared opine that his — ar-reaching policies were unconstitutional. His tactics worked, inso — ar as Roosevelt changed America — rom a — ederalist system, with a relatively weak central government compared with the power o — the states, to an administrative system, with a large central bureaucracy. In this time known as the New Deal – which this book identi — ies as the begin- ning o — the Second Era in American — inancial history – Roosevelt oversaw the creation o — the Securities and Exchange Commission (SEC), a — ederal agency with sweeping power over — inancial markets. He charged the SEC with the triumvirate purpose o — protecting investors; maintaining — air, orderly, and e —
icient markets; and — acilitating capital — ormation. These purposes are o — ten at odds with one another. For example, the SEC prevents — raud by requiring corporations to disclose in — ormation about their business to stockholders, which protects investors; but this disclosure regime is costly, making capital markets less e —
icient and inhibiting capital — ormation. In the Eastern United States, New York became the — inancial center — or publicly traded corporations, which pre — erred to list on the prestigious New York Stock Exchange. Listed corporations must comply with SEC disclosure requirements and stock exchange requirements. These expensive requirements result in only relatively large corporations being able to pro — itably list on a stock exchange and trade publicly. Commissions — or small orders remained high, and this made it
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di ---
icult — or small investors to be su —
iciently diversi — ied by investing in many di —
er- ent corporations. To overcome this challenge, Massachusetts Inventors Trust created a new — inan- cial technology: the mutual — und. A mutual — und is a pro — essionally selected bundle o — stocks. By purchasing a share o — a mutual — und, investors get a smaller share o — all the stocks in the bundle. In this way, investors can get broad exposure to the stock market without purchasing hundreds o — individual shares. In 1939, Nazi Germany invaded Poland. Thus began World War II. World War II demonstrated some o — the worst qualities o — humankind. Yet the war also motivated nations to develop new technologies that might give them an edge on the battle — ield. Some o — these technologies have — inancial uses that provided bene — its a — ter the costs o — war are paid. World War II prompted the U.S. government to partner with universities and invest massively in developing computer technologies. Early com- puters solved a very simple problem: how to calculate ballistic — iring trajectories. Alongside the well-known Manhattan Project, the research and development project that produced the nuclear bombs that were detonated over Hiroshima and Nagasaki, the government also sponsored research and development on computers. The ENIAC (Electronic Numerical Integrator and Computer) project resulted in the world’s — irst general-purpose computer. When it was — irst switched on in 1946, it could solve ballistics problems in thirty seconds that would have taken a human twenty hours to solve. But despite ENIAC’s power, it was extremely clunky and unreliable. The machine weighed thirty tons, and it was dys — unctional — or about hal — o — its ten-year service li — e. ENIAC’s huge size and problematic reliability stemmed — rom its use o — vacuum tubes to per — orm computations. Vacuum tubes look like complicated light bulbs, and, like conventional light bulbs, they require heat to operate. This heat causes them to burn out easily. Taking the next step in computing technology required developing an alternative to vacuum tubes. In 1947, Bell Labs developed a — ield- e —
ect transistor (FET), a device that could replace some o — the — unctions o —
a vacuum tube without relying on heat to per --- orm calculations. In 1949, Siemens
AG developed a way to arrange several transistors on a single chip called an
integrated circuit (IC) chip. In 1959, Fairchild Semiconductor presented the --- irst
IC chip that was made o --- silicon.
From 1961 to 1965, NASA’s Apollo Program used silicon ICs to per --- orm the
various calculations needed to send men into space and return them sa --- ely to
earth. The space race encouraged --- urther advances in computer power, and industry
responded by researching new chip technology that was easier to miniaturize and
mass produce. In 1968, RCA revealed the complementary metal-oxide-
semiconductor (CMOS), which --- eatured both a more e ---
icient — abrication process and less heat waste. This product marks a breakthrough, the beginning o — the so- called MOSFET (metal-oxide-semiconductor — ield-e —
ect transistor) revolution, because — rom this time — orward companies could continue making MOSFET ICs smaller and — aster.
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Gordon Moore, who worked at Fairchild Semiconductor, predicted that, thanks
to MOSFET technology, ICs should double in power every two years. His predic-
tion, now called “Moore’s law,” has so --- ar proved reliable. Thanks to MOSFET
technology, the availability and power o --- computers increased exponentially --- rom
the 1970s. The --- inancial industries quickly adopted this new technology. Computer
engineers --- ound that computers which can solve physics problems can solve --- inan-
cial problems, too. By the mid-1970s, computer technology matured enough to
enable a critical evolution in --- inancial technology: the index --- und.
Index --- unds are essentially mutual --- unds that are managed by computers.
Programmers give computers a set o --- criteria, called an algorithm, to buy and sell
stocks, then computers execute trades according to their program. This presents
several advantages. Computers are not in --- luenced by emotion. Computers do not
get anxious, tired, or --- atigued. Computers can trade stocks at thousands o --- times
per second. Computers do not shirk or sel --- -deal. But while computers do not commit
raud, programmers might. Computers can be programmed to scam markets using various techniques. When the SEC outlaws one index — und scam, another seems to pop up to take its place. That said, — or every scam, there are millions o —
air, value- creating trades. But the story o — the index — und is not all rosy. While computers rarely make mistakes, programmers do. Errant programming leads to strange market move- ments that can destroy billions o — dollars o — value per second. There have been several such “ — lash crashes” in history. Perhaps the — irst occurred on Black Monday, October 19, 1987, when all major world markets experienced a sharp decline. U.S. markets — ell 20 to 40 percent that day. Some o — the blame was — oisted upon index — unds, who were all programmed to sell shares in such an event, causing a sudden market drop to quickly spiral down to new depths. Regulators established circuit breakers, temporary measures to curb panic-selling. Under these regulators, markets automatically stop trading with indexes — all by certain daily limits. These regulators appear to stop panic selling – and such protections are notably absent in cryptocurrency markets today. Despite some drawbacks to index — unds, many experts highly recommend that unsophisticated investors should mainly purchase index — unds — rom reputable — inan- cial companies. There are — ew human investment advisors today who can generate more value than computer-powered index — unds can. While algorithmic trading began in — luencing Wall Street in the 1970s thanks to new computer technology, the computer industry itsel — began developing rapidly on the other side o — the country. In Silicon Valley, a region o — Cali — ornia spanning — rom San Francisco to San Jose, an entrepreneurial spirit and appetite — or taking big risks led investors down a separate path. Instead o — using computers to make a — ew
ractions o — a cent per trade over millions o — trades, why not invest in the next big thing? Instead o — investing in established public companies, perhaps there was a way to earn higher returns by investing in new ventures or startups.
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The American Research & Development Corporation established itsel --- as the --- irst
venture capital --- irm. ARDC --- ocused on investing in startups, nascent businesses with
little track record and big promises. When ARDC --- ormed in 1946, hundreds o ---
thousands o --- soldiers were returning home --- rom war. Many o --- these soldiers decided
to make something o --- themselves through entrepreneurship, and ARDC was intent
on --- inancing them. For a while, it was the only game in town. This gave it a huge
advantage. But investors are not likely to leave money on the table --- or long. An entire
inancial industry would eventually move into Silicon Valley. The early venture capital playbook was hard — or other investors to — ollow, as it required personal knowledge and connections. Investing in this way also involved legal risks. The Securities Act o — 1933 allowed sophisticated investors to purchase stock in unregistered corporations so long as they did not involve a public o —
ering. This legal standard was so vague that the SEC attempted to clari — y it in 1935 by establishing a — our- — actor test. That test also did not provide enough clarity to com — ort investors. Then, in 1982, the SEC promulgated Regulation D, which — inally pro- vided a clear rule regarding who could invest in startups. In short, “accredited” investors (de — ined as having more than one million dollars in net assets, more than two hundred thousand dollars in single income, or more than three hundred thousand dollars in joint-marital income) could invest in private, unregistered corporations so long as there was no “general solicitation” (advertising the sale o —
stock to the public). This legal sa --- e harbor gave the venture capital industry the legal
certainty it needed to grow. Annual contributions to venture capital --- unds rose --- rom
just over one hundred million dollars in the 1970s to over --- our billion dollars by the
end o --- the 1980s.
The United States experienced a brie --- period o --- deregulation in the 1980s.
President Ronald Reagan, a Republican, succeeded President Jimmy Carter,
a Democrat, in 1981 and introduced “Reaganomics,” economic policies that
reduced tax rates, reduced government spending, privatized industries, and deregu-
lated banking. Forty years later, people are still debating the e ---
icacy o — his policies. On the one side, Nobel Prize-winning economists Milton Friedman and Robert Mundell asset that Reaganomics improved the economy into the 1990s. On the other side, Nobel Prize-winning economist Robert Solow asserts that Reaganomics was such a — ailure, at least in the public’s perception, that his successor, President George H. W. Bush, also a Republican, reversed his campaign promise o — “no new taxes.” Bush’s successor, President Bill Clinton, a Democrat, took o —
ice in 1983. But despite the change in party, Clinton did not radically change economic policy during his tenure. In — act, Clinton oversaw the repeal o — the Glass-Steagall Act, which — urther deregulated banking. From the 1980s to the turn o — the millennium, venture capital — irms out West invested in private startup corporations through staged investment until the startups were large enough to go public and list on a stock exchange. When a company goes
rom private to public and lists on a stock exchange, that is called an initial public
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press 182 Conclusion
o ---
ering or IPO. Although traditional companies listed on the prestigious New York Stock Exchange, tech startups were attracted to another innovator: the NASDAQ. The National Association o — Securities Dealers — ormed the NASDAQ in 1971 as an alternative to the New York Stock Exchange. Although it lacked prestige, it made up
or this with innovative — inancial technology. Unlike traditional stock exchanges, which have a trading — loor on which stockbrokers call out buy and sell orders, the NASDAQ used a — ully electronic trading system. It was ready made — or the emerging index — unds because computer trading algorithms essentially plugged into the NASDAQ, allowing — or — ully automated trading. The NASDAQ allowed companies to list using a wider variety o — names. It permitted trades o — just a penny, paving the way — or penny stocks to enter public markets. Perhaps most importantly, it was cheaper to list on the NASDAQ than the New York Stock Exchange. NASDAQ’s advantages led not only to NASDAQ becoming a popular choice — or startup IPOs. It also encouraged more IPOs to occur. The advent o — the Regulation D sa — e harbor — or private — inancing and the NASDAQ listing option — or when it was time to go public correlated with a — ive — old increase in IPO activity: — rom 1973 to 1982 (pre-Regulation D), there were an average o — 66 IPOs per year; and — rom 1983 to 2000, there were an average o — 343 IPOs per year. The IPO market peaked in 1996, where there were almost 700 IPOs. The NASDAQ’s total value also spiked over this period, reaching a peak in March 2000. Then the stock market crashed again. The late 1990s investment craze was later termed the Dot-Com Bubble because there seemed to be a mania — or investing in any company that purported to do business online. Traditional rules — or valuing stocks went out the window and were replaced by convictions that pro — its were not important; rather, growth was the predominant — actor — or Dot-Com investors. Some
ast-growing companies even went public without having any meaning — ul revenues. It is not clear what drove this magical thinking, but the mindset shi — ted — rom
ocusing on — undamentals to growing large as — ast as possible. The idea seemed to be based on the notion o —
irst-mover advantage, that the — irst company to get huge would dominate its sector o — the internet, at which point it could stop burning cash and start making incredible pro — its. This did happen to a — ew companies like Amazon, but most — lamed out quickly. As with seemingly every — inancial crisis, the Dot-Com Bubble was — ollowed by another regulatory attempt to take the risk out o — markets. President George W. Bush, a Republican who campaigned as a — iscal conservative slogans, signed the bipartisan Sarbanes-Oxley Act o — 2002 (SOX) into law, which was designed to protect investors — rom — raud by requiring more — inancial reporting by public corpor- ations and setting tougher penalties on violators. At the signing, Bush declared, “today I sign the most — ar-reaching re — orms o — American business practices since the time o — Franklin Delano Roosevelt.” It seemed like 1932, when popular sentiment drove Roosevelt to abandon his traditional economic policies and grow the admin- istrative state.
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press Conclusion 183
SOX echoes the zeitgeist o --- the Securities Act and its presumption that required
disclosures are the most e ---
ective bulwark against — raud. SOX amped up disclosure requirements, which were already onerous, on public companies. All o — this was expensive, and, in retrospect, seems unlikely to solve the problem that created the Dot-Com Bubble. In the bubble mindset, no one seemed to care that they were buying stock in companies that lost millions o — dollars per year. It was not that this
act was undisclosed; rather, it was disclosed and ignored. The solution o — more disclosures, there — ore, did not seem to — it the problem. Moreover, SOX’s great expense upon public companies strongly discouraged companies — rom going public. In the years immediately — ollowing SOX’s enactment (2003–2007), IPOs — ell by almost two-thirds. The unintended consequence o — this investor-protection regulation was, ironically, even less disclosure and there — ore, according to SOX’s own philosophy, less protection. As the cost-bene — it analysis o —
going public turned negative, companies stayed private. Private companies do not
need to make hardly any disclosures under the securities laws.
This did not mean, o --- course, that investors stopped investing. Rather, they
switched --- rom investing in public corporations, where they had at least some
disclosure requirements and --- ederal oversight, into private corporations and ever
more exotic --- inancial instruments. Prior to SOX, corporations almost always went
public in an IPO be --- ore becoming worth one billion dollars. The rare company that
exceeds one billion dollars in value while still private is called a unicorn. The only
startup company that seems to have accomplished this in the 1990s and prior is
Google, which is now public. But a --- ter SOX, unicorns proli --- erated. There were over
900 unicorns in 2021, collectively worth over three trillion dollars. There are other
actors, o — course, including additional regulations such as the Dodd-Frank Act o —
2010 that made it yet more expensive to go public (and thus --- urther encouraged
staying private). But the --- act remains trillions o --- dollars more wealth is concentrated
in private companies who have no public disclosures requirements a --- ter Congress
passed laws requiring public companies to make more disclosures. The net e ---
ect o —
these disclosures mandates, there --- ore, seems to be less disclosure, which is precisely
the opposite o --- what Congress intended.
Moreover, SOX did not prevent an even worse --- inancial crisis. Less than six years
a --- ter SOX passed, the Great Recession o --- 2007–2008 roiled America and indeed the
world. Financial crises rarely have simple causes, and myriad --- orces cased the Great
Recession. But perhaps the most egregious culprit behind this crisis was a new
inancial instrument called a collateralized debt obligation. In the early 2000s, investment banks on Wall Street, who perhaps were looking — or a new line o — business a — ter the IPO market dried up, decided to get creative and invest in some new, and questionable, — inancial products. The investment banks purchased bundles o — home mortgages — rom retail banks, who make loans to home buyers. The investment banks then per — ormed some complicated math to divide these pools into “tranches” based on risk. Each tranche got a risk rating — rom AAA
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press 184 Conclusion
(best) to F (worst). Tranches with the same rating were combined, and then divided
again, resulting in a new --- inancial product called a collateralized debt obligation
(CDO). Some repeated this process several times, creating CDO2, CDO3,
CDO4, etc.
Ratings agencies gave these CDOs low risk ratings, based on the theory that you
could rari --- y away risk with math. The ratings agencies also got huge --- ees --- or blessing
these products, which makes their ratings at least somewhat suspect. The investment
banks then sold the CDOs --- or much higher prices than they could have sold its
components. It was like turning lead into gold.
But even lead must be mined. It is much easier to sell a photograph o --- lead,
especially i --- you can sell it as real gold. Investment banks realized it would be easier
to create entirely synthetic products. They created the synthetic CDO. These
derivates represent --- uture values o --- CDOs. Like a hologram, synthetic CDOs have
no substance o --- their own. Synthetic CDOs are merely a projection o --- an idea.
Investment banks issued over sixty billion dollars o --- synthetic securities in 2006
alone.
It turned out that investment banks cannot turn F rated “lead” into AAA rated
“gold.” By mid-2007, it became evident that our --- inancial system was riddled with
unanticipated risk. These complex and synthetic --- inancial products, dreamed up by
PhD physicists and mathematicians, had very little relationship to reality.
Back in reality, homeowners who couldn’t a ---
ord their mortgages began de — ault- ing on their loans. These de — aults drove home prices down, which meant more people were underwater on their loans (they owed more than the house was worth). Recognizing that paying the mortgage would — inancially ruin them, homeowners began abandoning properties. That pushed home prices down — urther. This led to more de — aults. Within months, purportedly risk- — ree assets were looking risky. The risk rating agencies — inally acknowledged their error and downgraded thousands o —
CDOs. Now the CDOs were not worth what banks paid --- or them.
The --- ederal government called these CDOs “toxic assets” and, to avoid an
economic meltdown, congress passed the Troubled Asset Relie --- Program (TARP)
in 2008. TARP enabled the U.S. Treasury to purchase these toxic assets, thus saving
Wall Street --- rom total ruin. This turned out to be a good bet --- or the Treasury, who
eventually sold its holdings --- or a pro --- it. Moreover, the global economy did not
collapse, but rather slowed into what is now called the Great Recession.
While the economy did not technically enter a depression because o --- this --- inan-
cial crisis, it did push society into the Third Era o ---
inancial technology. A movement known as the Cypherpunks used computer science to create alternative technologies that resisted government control. The term “cypher” re — ers to a secret code. This movement worked on making secret codes using cryptography, secure communication techniques that enabled anonymous messages and transaction. The loosely a —
iliated group was organized by Eric Hughes, who wrote A Cypherpunk’s Mani — esto (1993), which predicted that “cryptography will
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press Conclusion 185
ineluctably spread over the whole globe, and with it the anonymous transactions
systems that it makes possible.” The group generally believed in decentralized
structures, and they encoded their political philosophy in their digital cryptography
projects. But it would take about --- i --- teen years – and a --- inancial crisis – to push their
technology out o --- the shadows and into the mainstream.
The 2007–2008 --- inancial crisis apparently prompted the Cypherpunks to
redouble their e ---
orts. On Halloween, 2008, someone using the pseudonym Satoshi Nakamoto emailed the group a link to a nine-page paper describing what is now called Bitcoin. On January 3, 2009, Nakamoto started the Bitcoin program. The program then created the Genesis Block, which contained the — irst — i — ty Bitcoins and this cryptic message: “The Times 03/Jan/2009 Chancellor on brink o — second bailout — or banks.” Many interpret this message in the context o — the Bitcoin project to express the Cypherpunks’ distrust o — central banking and desire to create a decentralized currency that governments could not control. The Bitcoin protocol simply allows people to exchange digital currency. Newer protocols have even more advanced — eatures. The Ethereum network, — or example, allows users to write smart contracts that operate on its blockchain. Smart contracts are essentially small computer programs. They automatically exe- cute a command when certain conditions are met. For smart contracts to be really smart, however, they need in — ormation about the outside world. The next generation o —
blockchain technology uses “oracles” to --- eed data --- rom external systems into the
blockchain. Blockchain technology can now react to the happenings o --- the world.
While the Cypherpunks used cryptography to preserve their anonymity, thus
creating Bitcoin and blockchain technology, others use technology to become
amous. Social media technology has created a new means o — in — luencing — inancial markets. “In — luencers” are people who have cultivated a reputation as an expert and leverages that to charge — or endorsements and product placements, and “micro- celebrity” means a person who is — amous within a niche group o — users on social media. Thanks to social media, there are now “insta- — amous” in — luencers, who are
amous — or being — amous. In — luencers can and do a —
ect stock prices, too. For example, when Carl Icahn, the legendary investor, tweeted that he has a large position in Apple Corporation, the stock price immediately rose and hit a six-month high. When Elon Musk, CEO o —
Tesla Corporation, tweeted that he was selling 10 percent o --- his shares to pay taxes,
the stock price --- ell almost 5 percent. The SEC has investigated some o --- Musk’s
tweets because they could violate Regulation Fair Disclosure, which limits what
major public companies can say to a select audience. The SEC --- ined Musk --- or his
impropriety, but he continues to bend the rules to their limits.
Even people who are not already --- amous can impact stock prices --- rom their
desktops. Keith Gill, who posts on the social media plat --- orm Reddit under the
username DeepFuckingValue, drove a --- renzied mob to purchase GameStop stock
in the major “meme” stock event o --- 2021. Gill and others on the Reddit --- orum r/
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press 186 Conclusion
WallStreetBets stoked passions about sticking it to the hedge --- und managers who
took short positions (bets that the stock price will go down) in Game Stock by buying
the stock and driving the price up. The plan worked. In January 2021, users o --- the
RobinHood stock trading app piled into GameStop stock, whose price increased
1500 percent in two weeks. Gill turned his --- i --- ty-three thousand dollar investment into
orty-eight million dollars. Gill’s success set o —
a meme stock craze. Meme stocks are stocks that are popular because they are popular, like how insta- — amous in — luencers are — amous — or being
amous. Even i — there is no underlying value-based reason to buy a meme stock, investors (or gamblers, as the name r/WallStreetBets implies) are expecting the stock price to go up because others expect the price to go up. Meme investing re — lects a herding mentality known in crowd science as an in — ormation cascade, where people make decisions based solely on other people’s decisions. This is dangerous because social media creates an echo chamber environment, where people tend to hear — rom others who already agree with them. Outside the echo chamber, the herd’s behavior might seem bizarre or irrational. Regardless o — whether today’s popular social media channels cause negative behaviors, corporations cannot a —
ord to ignore social media. Accordingly, social media has changed how corporations behave. Corporations used to — ocus on key shareholders, who might threaten to vote — or new management, to sell out their shares, or to purchase enough shares to take over the company. That — ocus has shi — ted somewhat to social media in — luencers who may not own shares at all. “Greentrolling” is mocking, embarrassing, harassing, and otherwise drawing nega- tive attention to corporations perceived not to be environmentally — riendly. Social media users engage in greentrolling campaigns against companies like Exxonmobil to embarrass them into changing corporate practices. This creates new risks — or management, who have an obligation to make pro — its — or shareholders, but also need to maintain a positive brand identity. Although Twitter, Facebook, Instagram, and other plat — orms are designed to generate “likes” and “ — ollowers,” not accurate in — ormation or critical thought, other plat — orms are designed di —
erently. AngelList, — or example, uses social media tools to organize investment groups. Prospective investors — irst need to apply to prove they are accredited to invest. Then, investors must — ollow a listed lead investor who was subject to additional scrutiny. The lead investors present biographies that explain in detail their credentials and strategy. The investors then must apply to
ollow a lead investor, which usually results in personal communication between the would-be — ollower and the lead. Only a — ter the two decide to work together can the investor began looking at prospective deals. At every step o — the way the plat — orm warns, “Investing in startups is risky – most go out o — business.” Startups who are seeking — unds can post on the AngelList plat — orm, then investors critically appraise the company and discuss its value proposition. The lead investor typically negotiates the deal on behal — o — the group.
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press Conclusion 187
AngelList is an example o --- equity crowd --- unding, a new concept in digital invest-
ing that was enabled by the Jumpstart Our Business Startups Act o --- 2012.
Crowd --- unding websites, called portals or plat --- orms, have strong incentives to create
a sa --- e and secure experience --- or investors; otherwise, they can lose their license.
Moreover, investors will leave the plat --- orm i --- it does not ensure some measure o ---
raud prevention. These portals — unction like little islands in the internet where personal trust and a human connection is still valued. Ratings are based on past per — ormance, not on likes, and everyone goes by their real name. So — ar, the experiment in equity crowd — unding is going well. There have been virtually zero stories o —
raud in equity crowd — unding. This is particularly commend- able when compared to what’s happening in highly regulated markets: Bernie Mado —
perpetrated the largest Ponzi scheme under the nose o --- regulations; an anonymous
guy with an expletive --- or a screen name moved public stock markets with the theme o ---
stick it to the --- at cats; and celebrity in --- luencers are promoting exotic cryptocurrency
investments to a hundred million --- ollowers on social media. In comparison to the
highly regulated world o --- public --- inancial markets, where --- rauds, scams, and gambling
appear rampant, the relatively unregulated world o --- crowd --- unding appears tame.
This relative lack o ---
raud in equity crowd — unding conduction on registered portals, as compared with both the highly regulated public markets and the unregu- lated and perhaps unregulatable cryptocurrency markets, merits — urther analysis. It could be — ound that there are alternatives to traditional investor-protection agencies and regulations that are more e —
ective at preventing — raud. In the — uture, scholars might consider whether Web 2.0 and Web3 technology can be employed to simul- taneously reduce regulatory burden, enhance capital — ormation, stimulate e —
icient markets, and reduce — raud. The SEC appears to recognize that crowd — unding is relatively sa — e and e —
ective. On November 2, 2020, the SEC announced it would raise the Reg CF exception
rom one million to — ive million dollars that could be raised per company per year by equity crowd — unding. It simultaneously raised the limit — or Regulation A mini-IPOs and the amount that entrepreneurs can raise — rom — riends and — amily. Meanwhile, it simpli — ied and harmonized much o — its complex set o — rules. It is too early to evaluate how e —
ective these amendments have been at achieving the goal o —
acilitating capital — ormation, or whether they have unintended negative consequences in the
orm o —
raud risks to investors. But preliminarily, there are still no reports o —
signi --- icant --- raud in related --- inancial markets. This should encourage entrepreneurs
and investors to participate more activity in crowd --- unding, which will hope --- ully
prove sa --- er and, in the long run, more productive --- or society than cryptocurrency
and other trending alternative investments.
As this book goes to press, alternative investments are emerging daily. Since
I began writing this book, Cypherpunks developed an entirely new asset class, the
non- --- ungible token (NFT). Facebook changed its name to Meta, and dozens o ---
startups are now racing to build the “metaverse,” which is an immersive digital
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press
igure 12.1 Financial crises, regulations, and the IPO market — rom 1973 to 2020.
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press Conclusion 189
space. Sandbox and Decentraland are new user-generated worlds that --- eature
property rights, their own currency, voting mechanisms, marketplaces, live concerts,
and, o --- course, advertisements. Investors are racing to buy up this new digital
property, resulting in some absurd valuations.
Some people are going to get extremely rich extremely quickly in this Third Era o ---
investing. Others will be tempted to mimic their strategies. Some will lose more than
they can a ---
ord to lose. This is a dangerous game that not everyone should play. While the global market — or goods and services in the metaverse may well be worth a trillion dollars someday, no one can yet say which metaverse, i — any, will succeed in what appears to be a winner-take-all game. The emergence o — the metaverse and the rapid investment into it is yet another data point showing that we cannot simply continue to try and regulate — inancial markets as i — it were still the Second Era. In this Third Era, people can easily choose to leave the protection o — regulated markets — rom the sa — ety and com — ort o — their homes simply by going on the internet. We cannot simply — orce people to be prudent by prohibiting them — rom investing in startups, — or example, because they will — ind new ways to invest that may be even riskier. It is critical to — ind new ways to balance protection and opportunity in — inancial markets because the — uture is likely to be even more tumultuous than the past. The rate o — change seems to be accelerating. Perhaps alternative markets are already mainstream. In the 1990s, a — ringe group o — hackers called Cypherpunks sought to avoid government control by developing cyphers and cryptocurrency. In 2021, millions o — people and corporations are looking to escape — rom the administrative bureaucracy that regulates the American economy by moving their — inancial activ- ities onto an encrypted and anonymous internet. Be — ore dismissing all these people as simply irrational or — oolish, it is worth considering whether this trend re — lects a rational and long-standing — rustration with business as usual. Over the past twenty years, the government has substantially grown its in — luence over — inancial markets to protect citizens — rom — inancial crises. But — inancial crises keep happening. The response to each crisis has traditionally been more regulation. But regulation encourages people to migrate to unregulated markets. Despite ratcheting up disclosure and compliance regimes, the — inancial world does not seem to be a sa — er place. Albert Einstein (apparently) said, “insanity is doing the same thing over and over and expecting di —
erent results.” Perhaps it is time to consider alternative approaches, especially considering that the regulatory state has huge and disparate social costs. A — ter two decades o — increasing regulation, American wealth inequal- ity is at an all-time high. According to the World Bank, America’s Gini coe —
icient, which statistically measures wealth inequality, rose — rom 0.38 in 1990 to 0.414 in 2018. Statistica reports it increased to 0.49 in 2020. This growing gap between rich and poor — uels social tensions and raises doubts about the e —
icacy o — the entire
inancial system.
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press 190 Conclusion
While correlation does not prove causation, it is notable that, as the --- ederal
government increasingly regulated the --- inancial sector in this Third Era, the rich
got richer while the poor got poorer. Across the political spectrum, many people
perceive that --- ree-market capitalism has irredeemably collapsed into bureaucratic
cronyism, where the most power --- ul one percent award --- avors to each other, while the
other ninety-nine percent --- ace a rigged system and play a game they cannot win.
In this light, the --- act that millions o --- people are abandoning the --- inancial protec-
tions o --- the regulatory state and --- locking into uncharted territory makes sense.
People appear to be attracted to emerging --- inancial technologies because this new
digital environment promises to return --- inancial power to the people. Just as people
once came to America seeking the land o --- opportunity, they are now leaving because
o --- a sentiment that America is not --- ul --- illing its promises to them.
There is a serious risk that this --- inancial --- light toward cryptocurrencies, NFTs,
digital property, and other novel assets will result in a crash. I --- history has shown us
anything about markets, it is that bubbles are inventible, as is their bursting. I --- or
when these new markets crash, there will likely be a cry --- or government to step in
with more regulations. But that may or may not be the best response. More regula-
tions might drive people even --- urther toward harder-to-regulate assets, where risk
and --- raud may be even more pervasive, making yet another crash more likely. The
result o --- such a process would be ever-increasing regulations, with increasing
ine ---
iciencies and inequalities, but not necessarily a sa — er — inancial world. Instead o — creating some new — ederal agency in response to whatever the next crisis will be, perhaps we can begin to think about alternatives to the administrative state that can protect investors without driving them away. In our Third Era, where ordinary people can easily choose to invest in unregulatable assets, too much regulation can dangerous, just as too little regulation can be. We should think creatively about alternative ways to design optimal regulations so that the — uture o —
inancial technology leads a sa — er economy with equal — inancial opportunities — or all.
https://doi.org/10.1017/9781316597736.013 Published online by Cambridge University Press Index
Abacus, 67 digital, 130, 130–131, 133, 138
Abood v. Detroit Board o --- Education case, 145 stripping, 102
Accredited investors (AIs), 10, 78–80, 94, 157, Asymmetric cryptography, 119
161, 165 Automated quotations (AQ), 89
Activist investors, 100
Adams, John T., 16, 170 Bain Capital, 94
Adams, Samuel, 16 Baltimore and Ohio Railroad (B&O), 26
Adelphia Communication Corporation scandal pre --- erred stock proposal, 28–29
(2002),92 Band o --- Angels, 80
Advanced Research Projects Agency Network Bank o --- New York (BNY), 10, 15, 18
(ARPANET), 91 Banking corporations, 15
Agency costs, 36, 62, 64, 163 Barnett, Randy B., 94, 150
in index --- unds, 62–63 Base58, 119
and misaligned interests, 56–59 Base64, 119
Aguilar, Luis A., 171 Beauty.com, 93
Alshamrani, Mohammed Saeed, 149 Behavioral costs, 58, 62
Altcoins, 143 Benebit scandal, 135
American Research & Development Corporation Berkshire Hathaway, 27
(ARDC), 69–70, 75 Bill o --- Rights, 16
Ames, Oakes, 25 Binary digit (bit), 119
Anachronism, 99 Bitcoin, 38, 112, 115–116, 118, 119, 120, 123–124, 130,
Angel Capital Association, 80 132, 133, 142, 147, 149, 170
Angels, 74, 75, 80, 165 Genesis Block, 118
groups, 80–82 Bitcoin Cash, 130
investor, 68 Blockchain technology, 98, 112, 120, 122–123, 140,
super, 83–84 See also Cryptocurrencies
syndicates, 80, 82 hash problem, 122–123
Anonymity, 112, 116–117, 123 proo --- -o --- -work, 122
Apple, 71, 149 solving double spend problem, 121
Application (App), 1, 114 startups, 134
Applied Materials, Inc., 71 Boston Stock Exchange (BSE), 33, 34
Arab Spring, 98, 102 Bots, 91
ArtistShare, 154 Bounded rationality, 58
As You Sow (non-pro --- it --- oundation), 103 Brandeis, Louis Dembitz, 46
ASCII, 119 Brandeisian regulatory theory, 46–47
Asset(s), 16 Breakeven, 72
class, 70 Brokers, 13, 32, 33, 34, 38, 90, 107
cryptocurrency, 170 Brown v. Bullock case, 63
191 https://doi.org/10.1017/9781316597736.014 Published online by Cambridge University Press
192 Index
Brown, Duncan, 104 mistakes, 63
Brute --- orce hacking, 120 mutual --- unds, 53–54
Bry, Charles, 118 pre-regulation investment advice, 52
Bucket shops, 7, 34–37, 38, 53, 54 transaction costs, 56
Budd, Ted, 136, 138 Computational technology, 64
Bu ---
ett, Warren, 28 Computer evolution, 67 Bulldog Investors, 102 Computer power, 59, 61 Burr, Aaron, 15 ENIAC Project, 60 Bush, George W, 93 Integrated Circuits (ICs), 60 Buttonwood Agreement, 7, 14 logarithmic increase in processing power, 61 Buying on margin, 106–107 VFINX, 61 ByteDance Ltd, 88 Contractual control rights, 10 Coolest Cooler, 154 Canadian Securities Exchange (CSE), 34 Corporate Cantor Arts Center, 25–26 direct democratization o — corporate govern- Capital. See also Venture capital (VC) ance, 98 to entrepreneurs, 158 externalities, 9
ormation
—
or entrepreneurs in crowd
—
unding,
—
raud, 11–13
170–171 gad
—
lies, 103
Capitalism, 1, 3, 7–8, 19, 31 investors, 9–10
Cardano blockchain plat
—
orm, 130 limited liability, 8–9
Casey, John P., 34 risk and reward, 10–11
Chesapeake & Ohio Canal Company (C&O), Corporate America, 8
26, 27 Corporate
—
inance, 1, 3, 80, 153, See also Stock
China Banking Regulatory Commission, 140 market
China Insurance Regulatory Commission, 140 crowd
—
unding and, 169
China Securities Regulatory Commission, 140 and currency markets, 29
Churchill, Winston, 134 development, 16
Churning, 36
—
uture o
—
, 189
Cisco Systems, 71 NYSE in, 15
Citizens United v. Federal Election Commission securities regulators, 170
case, 144 technological innovation in, 26
Classic activism, 102 Corporation o
—
Georgetown, 28
Clayton, Jay, 132 Corporations, 7–9, 22, 34, 78, 79, 96, 98, 133
Clinton, George, 16 banking, 15–16
Co
—
ey v. Ripple Labs Inc. case, 132
—
or-pro
—
it, 15
CoinMarketCap data, 144 growth in America, 15–16
Comcast Corporation, 141 issues with, 9
Commodity Futures Trading Commission nature o
—
, 8
(CFTC), 130, 136, 137 payment
—
or stockholders, 27
regulation o
—
cryptocurrencies, 137–138 reasons
—
or
—
ailure, 10
Compaq Computers, 71 and Web 2. 0, 98
Competitive regulation, 1, 3, 170 Cost(s)
Compression, 119 agency, 36, 56–59, 62–63, 64, 159, 163
Computational asymmetry, 51 behavioral, 58, 62
Computational investing in
—
ormation, 56
agency costs, 56–59, 62–63 opportunity, 12
computer power, 59–61 transaction, 56
diversi
—
ication, 54–56 Creative destruction. See Schumpeterian
index
—
und, 61, 62 entrepreneurship
in
—
ormation costs, 56 Crimean War, 21
Investment Advisers Act (IAA), 52–53 Crowd science theory, 164
Investment Company Act o
—
1940 (ICA), 52–53 Crowd
—
unding, 151, 153
misaligned interests, 56–59 avoiding crowd
—
ailures, 165
https://doi.org/10.1017/9781316597736.014 Published online by Cambridge University Press Index 193
care about, 169 asymmetric, 119
crowd-lending, 155–156 Cypherpunks, 113–114
crowdsourcing, 165 and --- reedom --- rom sel --- -incrimination, 148–149
donative, 154 and --- reedom not to speak, 144–145
equity, 156 as natural right, 150
ailure o — , 157–159 origins o — , 112
ixing, 169 regulation and — reedom o — association, 145–147
orming capital — or entrepreneurs, 170–171 symmetric, 119 gami — ication, 167–169 Cyberspace, 147 investors, 163, 164 Cypherpunks, 2, 113–114, 116 JOBS Act, 157 intentions to use cryptocurrencies, 123 lack o — resale options, 160–162 Nakamoto’s emails to, 118 limited — undraising, 159 origins in dot-com era, 153 Dark pools, 161 pre-purchase, 154–155 Data technology, 1 protecting investors, 169–170 Davidson, Warren, 138 rational apathy, 165–167 Dearie, Raymond, 135 reputational e —
ects, 167 Debt, 9, 26–27, 28 rewards-based, 154 crowd — unding model. See Crowd-lending SPVs, 162 investment, 156 wisdom o — crowd, 163–164 national, 17, 18 working strategy, 162–163 obligations, 183 Crowd-lending, 155–156 Debt Slavery, 102 Crowdsourcing, 65, 165, 168 Decacorn companies, 75, 88, 89 Crypto Wars, 113 Decentralized Autonomous Organization (Ð), Cryptocurrencies, 2, 30, 119–120, 129, 130, 137, 145, 170 See also Blockchain technology Decryption, 113, 119 Bitcoin. See Bitcoin DeepFuckingValue, 106, 108 Commodity Futures Trading Commission De — ense Advanced Research Projects Agency (CFTC) regulation, 137–138 (DARPA), 91 congressional regulation, 136–137 De — ined-bene — it plan system, 169 constitutional questions, 144 Delaware Bridge Company, 20 Ethereum. See Ethereum Demo days, 81 Federal Bureau o — Investigation (FBI) Democracy, 114 regulation, 137 shareholder, 98, 101, 103 Federal Trade Commission (FTC) Democratization regulation, 138 o — access to stock exchange in — ormation, 33
oreign governmental agencies (FGAs) direct democratization o — corporate govern- regulation, 140 ance, 98 and — reedom — rom economic slavery, 150–151 Digital assets, 138, See also Cryptocurrencies Internal Revenue Service (IRS) regulation, 138 regulation, 130, 130–131 investing in, 123–124 Digital wallet, 123 Litecoin. See Litecoin Disclosure, 48, 49, 52, 58, 64, 88, 93, 94, 100, 142, market share (2021), 115 157, 159 marketplace, 87–88 Distributed ledger, 121 markets, 112, 142–144 Distribution Act (1836), 18 mining, 139 Diversi — ication, 54–56, 68, 76 O —
ice o — the Comptroller o — the Currency Dividend, 26, 28 (OCC) regulation, 139 Dodd-Frank Act (2010), 67 private regulation, 140 Dogecoin, 143 search and seizure, 147–148 Donative crowd — unding, 154 sovereign, 140 Doriot, Georges, 69 white papers, 135 Dot Com Bubble, 52, 70, 89, 91–93 Cryptography, 112, 114, 147, 151 NASDAQ and, 89
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Dot Com Bubble (cont.) o --- pre --- erred stock, 24, 26–28, 29
penny stocks and, 89–91 Financial law, 2
Sarbanes-Oxley Act (2002) and, 93–94 Financial markets, 1, 2, 157, See also Stock market
Double spend problem o --- digital currency, 121–123 evolution o --- , 67, 84, 129
Dow Jones Industrial Average (DJIA), 43, 54, 62 --- raud in, 12
Dr. Suess, 93 social media impact in, 100
Due diligence, 81 technological innovation in, 61
Financial pre --- erences, 28–29
Early-stage --- inancing, 71–72 Financial regulation, 1, 14, 131
E-commerce, 67, 92 Financial revolution, 1, 100
Economic slavery, --- reedom --- rom, 150–151 Financial Services Agency o --- Japan, 140
Economics, 11, 38 Financial Services Regulatory Authority
Keynesian, 45 (FSRA), 140
trickle-down, 51 Financial technology (FinTech), 70, 143
Edison, Thomas A., 32 Financing
Electric Boat Company, 54 early-stage and seed-stage, 71–72
Electron tunneling, 61 expansion stage, 72–73
Electronic Arts, 71 later stage, 73
Electronic Numerical Integrator and Computer First Amendment o --- U.S. Constitution, 129, 145
(ENIAC), 60 Fix Crowd --- unding Act, 159
Encryption, 113, 114, 119, 129, 147, 149, See also Flash Crash, 63, 64
Cryptography Foreign governmental agencies (FGAs), 130, 136
patents, 118 regulation o --- cryptocurrencies, 140
via cryptography, 146 Foreign Intelligence Surveillance Act (FISA), 146
Enhanced Surveillance Procedures, 146 Fourteenth Amendment o --- U.S. Constitution,
Enron Corporation, 10, 92, 93, 162 150–151
Entrepreneur(ship), 68, 69, 151, 162–163, 170 Fourth Amendment o --- U.S. Constitution, 147–148
positive impact in social wel --- are, 171 Franklin Delano Roosevelt (FDR). See Roosevelt,
Equity crowd --- unding, 156, 157–159, 164–165 Franklin Delano
Ether, 133 Fraud, 11, 48
Ethereum, 38, 130, 132, 142, 143, 170, 185 bucket shop, 36
E*Trade Financial Corporation, 87, 142 consequences o --- , 12
Expansion stage --- inancing, 72–73 corporate, 11–13
External cost. See Negative externality in --- inancial markets, 12
ExxonMobil, 101 ICO, 135–136
risk o --- , 11
Facebook, 80, 97, 99, 100, 102, 123, 171, 187 Free banking era in American banking, 19–20
Farook, Syed Rizwan, 149 Free incorporation, 16–17, 19
Federal Bureau o --- Investigation (FBI), 136, 141, 146 Free riding, 100
regulation o --- cryptocurrencies, 137 Freedom o --- association, 145–147
Federal laws, 2 Freenet, 153
Federal Reserve, 169 Friends, --- amily, and --- ools (FFF), 71
Regulation T, 107 Funding portals, 157, 158
Federal Trade Commission (FTC), 130, 136
regulation o --- cryptocurrencies, 138 Gabbard, Tulsi, 138
Female computer at Langley, 59 Gambling on stock markets, 35, 38, 54
Fi --- th Amendment o --- U. S. Constitution, 147–149 GameStock Short Squeeze, 108
Financial Crimes En --- orcement Network GameStop Episode (GME), 105–106, 108
(FinCEN), 138 Gami --- ication, 167–169
Financial ecosystem, 51, 67 Gekko, Gordon, 51
Financial Industry Regulatory Authority General Electric Corporation (GE), 32
(FINRA), 158 General Theory o --- Employment, Interest, and
Financial innovation, 14, 26, 53 Money, The (Keynes), 45
penny stocks, 89 Genesis Block, 118, See also Bitcoin
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Genesis Investments Limited, 79 In --- ormation, 7, 36, 99
Gilmore, John, 113 accessibility, 147
Gnutella, 153 asymmetry, 162
GoFundMe, 154 asymptotic, 164
Gold standard, 29–30, 73, 88 cascade, 164
Gold Standard Act (1900), 29 costs, 56
Golden Spike, 24–26, 67 cryptography, 149
inancial pre — erences, 28–29 decryption, 120
inancing railroads, 26 democratic, 33
gold standard, 29–30 digital, 122
pre
—
erred stock, 26–28 encryption, 113, 120, 147, 148
replica o
—
, 25 exchange in bucket shops, 34–36
Goldstein, Phil, 102
—
inancial, 31, 32, 33, 47, 97, 168
Google, 71 limitations on dissemination o
—
, 166
Goose Chase, 167 networks, 171
Gottheimer, Josh, 138 overload, 49
Gottlieb, Mark, 102 sharing, 90, 96, 116, 121, 163
Grassroots shareholder activism, 101–102, 103 stock exchange, 33
Great Depression, 1, 2, 31, 44, 51, 53, 54, 64, 69 in stock markets, 34
Great Recession (2008), 184 Initial Coin O
—
erings (ICOs), 132–135
Greenbacks, 21, 29
—
raud, 135–136
Greylock Ventures, 70 Initial public o
—
erings (IPOs), 67, 73, 88, 133
Griswold v. Connecticut case, 148 Instantaneous multilateral worldwide communi-
Gut instinct, 62 cation networks, 171
Integrated circuits (ICs), 60
Hamilton, Alexander, 10, 15, 16 Internal Revenue Service (IRS), 136, 148
Harrison, William Henry, 18 regulation o
—
cryptocurrencies, 138
Hash
—
unction, 119 International government agencies (IGAs), 130
Hashing, 122 Internet, 1, 2, 67
Hastings, Reed, 99 bubble. See Dot com Bubble
Hayes, Nick, 104 development, 91
Hectocorn companies, 75, 88 shareholder voting, 98–99
Hells Fargo protests, 101–102 shopping. See E-commerce
Henry, Patrick, 16 Internet service provider (ISP), 91
Herding, 164 Investment, 2, 17, 21, 36, 76
Hewlett, William, 68 advising, 52
Hewlett-Packard (HP), 68–69 angel, 80
garage in Palo Alto, 69 automated, 53
Hexadecimal digits, 119 contract, 47, 143
Hitler, Adolph, 44 in cryptocurrency, 123–124
Hoover, Herbert, 44, 106 early-stage, 72
Howey Test, 131, 136, 143–144 equity, 156
Hughes Telegraph, 32 in expansion phase, 73
Hughes, Eric, 113
—
ever, 37–38
Human analysis, 62 later stage, 72
in mutual
—
unds, 62
Icahn, Carl, 100 opportunities, 2
Idiosyncratic risks, 54–55 as pre
—
erred stock, 82
Illiquidity discount asymmetry, 160, 161 pools, 53, 62
Index
—
unds, 51, 53, 62, 64, See also Mutual
—
unds relatively sa
—
e, 169
agency costs in, 62–63 syndicate, 165
regulation o
—
, 63–64 Venture Capital, 70, 73, 75, 82–84
IndieGoGo, 154 Investment Advisers Act (IAA), 43, 48, 52–53
Individual risks. See Idiosyncratic risks attempt to reduce agency, 58
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Investment Advisers Act (IAA) (cont.) LimeWire plat --- orm, 153
designed to resolve agency problems, 63 Limited --- undraising, 159
Investment Company Act (ICA), 43, 48, 52–53, 79 Limited liability, 8–9
attempt to reduce agency, 58 Limited liability companies (LLCs), 166
designed to resolve agency problems, 63 Liquidity events, 71, 73–75
Investors, 34, 35, 142, See also Accredited invest- Litecoin, 38, 130, 133, 142, 143
ors (AIs) Lobbying, 12
activist, 100 Local regulation o --- cryptocurrencies,
angels. See Angels 139
corporate, 9–10
crowd --- unding, 163, 164, 169–170 Mac OS, 91
exotic and risky investments, 170 Madison, James, 16
long, 107 Main Street investor, 34, 36
margin, 43, 106, 107 Malik, Tashkent, 149
non-accredited, 75, 94, 158 Maloney, Carolyn, 157
opportunities --- or, 87 Margin
ordinary, 109, 163, 169, 170 call, 17, 18, 107, 108
pro --- essional, 163 investing, 17
share o --- , 10 investors, 43, 106, 107
short, 107, 108 Massachusetts Investors Trust, 53
startup, 162 May, Timothy, 113
McFarland, Billy, 104
Jackson, Andrew, 16, 17, 19, 29 McKenry, Patrick, 157
Jay, John, 16 Median market capitalization, 88
Jiaozi, 20 Mega rounds, 76
JPM Coin, 139 Melvin Capital, 108
JPMorgan Chase, 15 Meme investing, 108–109
Jumpstart Our Business Startups Act (JOBS Act), Meme stock, 108
153, 157–159, 165, 171 Merger and acquisition event (M&A event),
JUUL Labs, 88 73
Michigan’s Act to Organize and Regulate Banking
Karpeles, Mark, 137 (1837), 19
Keynes, John Maynard, 45, 46 Micro-celebrities. See Social media – in --- luencers
Keynesian economic theory, 45–46 Microso --- t Corp. (MSFT), 143, 160
Kickstarter, 154 Miniaturized Electronic Circuits technology,
Kilby, Jack St. Clair, 60 60
King, Brayden, 103 Mini-IPO, 157
King, Neal, 118 Mint Act (1792, 1873), 29
Kirzner, Israel, 171 Miranda v. Arizona case, 148
Kirznerian entrepreneurship, 171 Miranda warning, 148
Kleiner Perkins Cau --- ield & Byers, 71, 84 Misaligned interests, 56–59
Kleiner-Sequoia model o --- staged investment, 73 Mochizuki, Shinichi, 118
Kodak (KODK), 96 Modern startup li --- ecycle, 83
price spike, 97 Modern telegraph, 31
Modern venture capital, 75–77, See also Venture
Langley Memorial Aeronautical Laboratory, 59 capital (VC)
Large private companies (LPCs), 87, 88 Money Trust, 47
Later stage --- inancing, 73 Moore, Gordon, 60
Layering, 63–64 Moore’s law, 61, 64
Ledger, 121 Morse code, 31
Lee, Robert E., 22 Morse, Samuel, 31
Legal Tender Act (1862), 21–22 Mosaic web browser, 91
LendingClub company, 155–156 Mt. Gox, 137, 141
Leveraged investing, 17 Multiplier --- actor, 45
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Munition, 113 O ---
ice o — Inspector General (OIG), 137 Mutual — unds, 53–54, 56, 58, 70, See also Index — unds Ohio Li — e Insurance and Trust Company, 20–21 Oksman, Vladimir, 118 Nakamoto, Satoshi, 113, 115, 116, 118, 121, See also Open-source code, 114 Bitcoin Oppenheimer, Robert, 60 emails, 118 Opportunity cost, 12–13 Napster, 153 Oracle, 71 NASDAQ, 9, 89, 90, 133 Ordinary investors, 89, 90, 163 capital market, 90 Other People’s Money and How the Bankers Use digital — eatures, 90 It (Brandeis), 47 National Association — or Advancement o — Colored Over the counter (OTC), 89 People (NAACP), 145 National Association o — Securities Dealers Packard, David, 68 (NASD), 89 Palo Alto, 163 National Bank Act (1864), 21 Panic o — 1837 in US, 17–19, 22, 24 National Banking Act (1863), 21–22 Patents, 7 National Labor Relations Acts (1935), 43 Penny Stock Re — orm Act (1990), 90 National Quotation Bureau (NQB). See Pink Penny stocks, 89–91 OTC Markets People’s Bank o — China, 140 National Science Foundation (NSF), 91 Perkins, Frances, 46 National Security Agency (NSA), 141, 146 Perry, Scott, 138 National Security Association. See National Petro (₽) (sovereign cryptocurrency o —
Security Agency (NSA) Venezuela), 140
Nat’l Ass’n --- or Advancement o --- Colored People Pets.com, 92, 93
v. State o --- Ala. ex rel. Patterson case, 145 Petscore.com, 92
Negative externality, 11 Philadelphia Stock Exchange (PHLX), 33, 34
Nelson, Willie, 154 Physical stock certi --- icate, 160
Net --- lix, 99, 100 Pink OTC Markets, 90
Network e ---
ects in stock market, 33–34 pink sheets, 89–90 New Deal, 43 Pink Sheets LLC. See Pink OTC Markets disclosure rules, 48–49 Pitch, 81 Securities Exchange Act (1934), 47–48 Planned Parenthood o — Se. Pennsylvania v. Casey securities regulations, 47 case, 151 New York and Mississippi Valley Printing PlexCoin, 135 Telegraph Company. See Western Union Ponzi schemes, 57 New York Stock Exchange (NYSE), 2, 9, 15, 32, 33, Porsche SE company, 107 34, 51, 90, 133 Pre — erred stock, 24, 26–28, 29, 80, 82, 162 increasing membership, 43 Pre-purchase crowd — unding, 154–155 initial listing — ee, 90 Pre-regulation investment advice, 52 loss o — DIJA, 43 Principal, 27, 28, 57, 62 origins o — , 13–15 Privacy, 114, 115, 146, 148, 151 purchasing seat on, 38 Private Financing’s Sa — e Harbor. See Regulation regulations, 37 D (Reg D) Ninth Amendment o — U.S. Constitution, 150 Private keys, 119–120, 147, 149 Node(s), 118, 123, 163 Private regulation o — cryptocurrencies, 140 Non-accredited investors, 75, 94, 158 PRNET, 91 Non-governmental organizations (NGOs), 103, 130 Pro — essional investors, 163 Nonymity, 116, 117 Proo — -o — -work, 121–123 NSFNET, 91 Pseudonymity, 116, 117 Public Company Accounting Oversight Board, 94 Obama, Barrack, 157, 158, 171 Public corporation, 96, 98, 183 Occupy Wall Street movement, 98, 101 Public keys, 119–120 O —
ice o — Comptroller o — Currency (OCC), 136 Public o —
ering, 77 regulation o — cryptocurrencies, 139 Public/private dichotomy, 87
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Pullman Sleeping Car, 24 SEC regulation o --- crypto-securities, 131, See also
Pullman, George, 24 Cryptocurrencies; Securities and Exchange
Commission (SEC)
Quali --- ied Institutional Buyers (QIBs), 161 Co ---
ey v. Ripple Labs Inc. case, 132 Quali — ied purchases (QP), 78–79, 161 ICO — raud, 135–136 Quantum computers, 61, 120 initial coin o —
erings, 132–135 Quantum Corporation, 71 SEC v. Howey case, 131–132 Qume company, 71 Second-order e —
ects, 37 Securities Act (1933), 43, 47, 52, 156, 158 Railroad Era, The, 24 registration requirements, 77 Rational apathy, 80, 100, 165–167 Securities and Exchange Commission (SEC), 2, Rational ignorance, 100 43, 47, 48, 77, 130, See also SEC regulation o —
Ravikant, Naval, 80 crypto-securities
Reddit, 97, 168 Regulation D Rule 501, 78
Regulation, 1, 14, 130, See also SEC regulation o ---
Regulation D Rule 506(b), 78
crypto-securities Regulation D Rule 506(c), 77, 157, 159, 165–166
competitive, 1, 3, 170 Rule 14a, 99
o --- cryptocurrencies, 136–142 SEC-mandated disclosure, 100
o --- digital assets, 130, 130–131 Securities Exchange Act (1934), 43, 47–48, 138
NMS, 63 Security Tokens, 135
regulatory standards, 77 Seed valley o --- death, 72, 84
T call, 107 Seed --- unding. See Seed-stage --- inancing
Regulation Crowd --- unding (Reg CF), 157, 158, Seed-stage --- inancing, 71–72
159, 165 Sel --- -incrimination, --- reedom --- rom, 148–149
Regulation D (Reg D), 83, See also Securities and Sel --- -regulation, 34
Exchange Commission (SEC) sel --- -regulated stock markets, 13
Regulation Fair Disclosure (Reg FD), 77–78, 96, Sel --- -regulatory organizations (SROs), 14, 34
99–103 Sellers/selling, short, 106
Relevance assessment, 168 Sequoia Capital, 71, 84
Rent-seeking theory, 12, 13 Sequoia Fund X, 79
Reputational e ---
ects, 57 Series A — undraising round, 83 in crowd — unding, 163 Series AA. See Early-stage — inancing Resale options, lack o — , 160–162 Series Seed. See Early-stage — inancing Rewards-based crowd — unding, 154 Shareholder(s), 11, See also Social media share- Ripple, 88, 130, 132 holder activism Roaring Twenties, 43, 53, 68 collective action, 99–103 RobinHood ( — ree stock trading app), 88, 108, 142, communication rules in SEC, 99 167, 168 democracy, 103 Roe v. Wade case, 151 direct democracy, 98 Roosevelt, Franklin Delano, 2, 43, 44, 93 Shark Tank, 76, 171 Roulette game, 54 Shelly, Mary, 116 Rule, Ja, 104 Shirking, 57, 93 Ryan, Harris, 68 Short squeeze, 106–108 Ryzen 7 3700X chip, 61 Silicon Valley, 2, 51, 87, 158, 170, 171 AIs, 78–79 San Bernardino County Department o — Public angel groups, 80–82 Health, 149 angels, 80 Sapien, Brendan, 38 early-stage — inancing, 71–72 Sarao, Navinder Singh, 63 expansion stage — inancing, 72–73 Sarbanes-Oxley Act (2002), 67, 93–94, later stage — inancing, 73 182 liquidity events, 73–75 SATNET, 91 QP, 78–79 Schumpeterian entrepreneurship, 171 Reg D, 77–78 Scytale, 112 seed-stage — inancing, 71–72
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startup model, 68–69 BSE, 33, 34
venture capital, 69–71, 75–77 bubbles, 89
venture capitalists, 82–84 bucket shops, 34–37
Silk Road, 116, 137 crash, 44–45
Smith, Adam, 13 doldrums, 105
Social media, 96–8 investment --- ever, 37–38
impact in --- inancial landscape, 97 modern telegraph use, 31
in --- luencers, 2, 104–105, 108 network e ---
ects, 33–34 investing, 109 NYSE, 32, 33, 34 lending plat — orm, 156 PHLX, 33, 34 Social media shareholder activism. See also SRO, 34 Shareholder(s) ticker technology, 31–33 corporate gad — lies, 103 wash sale technique, 37 direct democratization o — corporate governance, Stockholders, 10, 27–28, 161 98–99 securities regulations, 156 GameStock Short Squeeze, 108 SPV, 162 GameStop Episode, 105–106 traditional, 36 internet shareholder voting, 98–99 Stop Wells Fargo, 102 meme investing, 108–109 Stump — , John, 102 Reg FD, 99–103 Sub-prime mortgage crisis, 67 shareholder collective action, 99–103 Sun Microsystems, 71 short squeeze, 106–108 Super angels, 83–84 Social utility, 11–12 Supply-and-demand graph, 37 Solicitation Symmetric cipher system, 113
or sale o — stock, 156 Symmetric cryptography, 119 general, 78, 79 Song Dynasty o — China, 20 Tandem Computers, 71 Soto, Darren, 136, 138 Terman, Frederick, 68 Soulseek, 153 Thiel, Peter, 80 Sovereign cryptocurrency, 140 Ticker technology, 31–33 SOX. See Sarbanes-Oxley Act (2002) TikTok app, 114 Special purpose entities (SPEs), 167 Token Taxonomy Act (2019), 138 Special Purpose Vehicles (SPVs), 159, 162, 166 Tokens Speculation, 52 digital, 121, 138 Spoo — ing, 63–64 Security, 135 Stan — ord University, 67 Tali, 121 Startup(s), 71, 72, 74, 88 Utility, 135 blockchain, 134 XRP, 132 Coolest Cooler, 155 Tor network, 116
inancing li
—
ecycle, 83, 84, 88 Trading, 17
investing in, 81, 162 algorithmic, 53, 59, 65, 67
Kickstarter, 154 crypto-currency trading plat
—
orms, 38
LendingClub, 155–156 discretionary, 62
model, 68–69 electronic, 89, See also E-commerce
policy goal o
—
democratization, 158
—
ees, 36
Statis Group, 135 technology-driven trading schemes, 64
Stellar, 130 volume, 33
Stock, 10 Traditional Startup Financing Timeline, 74
earnings, 27 Traditional startup li
—
ecycle, 88
manipulation schemes, 109 Transaction costs, 56
port
—
olio, 53 Transcontinental Railroad, 24, 25, 27
pre
—
erred, 26–29, 82 Transmission Control Protocol and Internet
Stock market, 54, See also Corporate
—
inance; Protocol (TCP/IP), 91
Financial markets Trevithick, Richard, 24
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Trustless systems, 117 Venture capitalists (VCs), 75, 82–84, 163
Twitter, 96, 100, 102 Ver, Roger, 123
Two and Twenty --- ormula (2 and 20 --- ormula), Virtual Asset Commission (VAC), 141
166, 167 Virtual Currency Consumer Protection Act
(VCCPA), 136, 137, 140
U.S. Virtual Currency Market and Regulatory Voluminous prospectus, 134
Competitiveness Act (VCMRCA), 136,
138, 140 Wall Street, 14, 34, 100
Ultimate bene --- icial owners (UBOs), 79 investment opportunities, 36
Ultra-sa --- e investments, 169 investors, 106
Unicorn companies, 75, 84, 88, 89 stockbroker, 34
Union Paci --- ic line, 25 Wall Street Crash (1929), 44
United Stated Congress, 136 Wash sale technique, 37
United States o --- America (USA), 7 Washington v. Gluckberg case, 151
impact o --- Great Depression, 44–45 Web 2.0 technologies, 65, 97, 98
panic o --- 1837, 17–19 Webvan company, 71, 93
return to national banking, 20–22 Wells Fargo annual shareholders meeting, 101
rise o --- corporations in, 15–16 Western Union, 31
United States v. Gratkowski case, 148 Ticker Model, 32
University o --- Pennsylvania, 60 White papers, 116, 134–135
Unlocking shareholder value, 103 Whitney, Richard, 43
USA Patriot Act, 146 Wikileaks, 96
Utility Tokens, 135 Wildcat banks, 20
Wilson, Woodrow, 47
Van Buren, Martin, 18 Windows, 91
Vanguard, 142 Winklevoss twins, 123
Vanguard 500 Index Fund (VFINX), 61 WorldCom, 92, 93
Venture, 68 WorldCom scandal (2002), 92
Venture capital (VC)
evolution, 70–71 XRP tokens, 132, 143
irms, 69–72, 73–74, 75–77, 78–79, 82, 83
undraising, 135 YouTube, 106, 108, 164 investment, 70, 75, 82–83 modern, 75–77 Zero-sum game, 13, 55 origins o — , 69–70 Zietzke v. United States case, 148 transactions, 77 Zillow (Z), 89
https://doi.org/10.1017/9781316597736.014 Published online by Cambridge University Press