POLKADOT IS NOT A SECURITY

There are endless debates currently about which tokens are in fact ‘securities’ and therefore subject to SEC oversight. The SEC presently deems all token/coins besides Bitcoin as securities; though the status of Ethereum is uncertain, it likely leans towards not being a security, legally speaking. The definition of a security is defined and discussed on this blog in other places at length, and other tangential matters such as litigation regarding some particular token’s legal status can also be reviewed here.

To summarize: a security is an investment of money in a common enterprise, with the expectation of profit from the (essential or managerial) efforts of others. In other words, the investment is passive and requires no effort on the part of the investor with nearly full reliance on the issuer/manager of the investment. The totality of the circumstances must be reviewed, including marketing language of the issuer, expectations of the investors, and other factors such as the stage of platform development and control the issuer retains over the governance of the platform.

Why is Polkadot not a security then? Injection of investment funds is ongoing and the platform is presently being managed and upgraded by the issuing team. It appears that the investment into the token is quite passive and there is significant reliance on the manager to operate and improve the Polkadot platform. However, assessment of the nitty gritty of the transaction and holding of the actual token must be examined to determine its true status. It is argued here that DOT, the native token used on the Polkadot network should not be deemed a security for the following reasons.   

Firstly, while it is clear there is an investment of money into a common enterprise, the questions rest with the reliance element. DOT is a token that is similar to ETH in its function; it is a ‘smart contract’ token, meaning anything that may be done on the Ethereum blockchain may also be done on the Polkadot blockchain. Hence, by extension if ETH is deemed to not be a security, then DOT must also be so due to their similar development stages, which are fully operational and marketing language used by each issuer merely describing the utility inherent in the use of their respective token, but not using investment type language.

“Reliance” -a key element of the definition of a ‘security’- by a given investor for obtaining any kind of return on investment, should that be his/her goal, would most likely be upon the platform itself and on other users of the platform, and to a minimal extent on the issuer, who may continue to manage the platform, upgrade its functions and otherwise monitor its stability. In other words, the intervention of platform managers would not be ‘essential’ or sufficiently “significant’ to push it into the ‘security’ category of instruments. This analysis does not apply to other smart contract tokens, such as ADA, which requires far more development to get it to a fully operational stage. Furthermore, ADA’s staking process is entirely passive. ADA is in its infancy with very few projects using it, and it is most likely still a security.

DOT could be argued to be even less of a security than ETH because of the major staking process differences of these tokens. This factor touches on the passivity element of the security analysis. In other words, securities are passive investments, if active participation is necessary from the investor it is unlikely the instrument in question should be deemed a ‘security’. While each token may be held on its own without staking, the expectation of profit by an investor could not be conclusively demonstrated because it could just as likely be held in preparation for future utilization of one of the many available functions of either platform, and there should not be any expectation of profit by a purchaser because that is not the marketing language used by either issuer, hence an expectation of profit may be unreasonably held.

If an investor decides to really hold DOT for profit, as is the key factor in the analysis, he/she will need to go through the staking process which is highly involved and must be actively monitored and managed. First the staker must nominate ‘validators’ who actually pool funds and process Polkadot transactions. These validators must be assessed carefully using numerous factors such as number of nominators bonded to each validator, being the most important one. Only the first 246 nominators are paid rewards, therefore anyone above that number will not be paid and the staker must change validators. Other validator factors are also highly important, such as their commission for pooling staker funds, reward distribution frequency, whether they are ‘elected’ or not, any personal funds the validator has in their pool, and a few other less important metrics.

Any of these factors may change without warning, and it is up to the staker/investor to monitor the staking process to ensure that there is an actual validator that has his/her funds bonded to its pool, and the rewards are being timely calculated and paid. An investor can nominate up to 16 validators at once, and although they may switch automatically in the event one validator ceases to process transactions, the investor must monitor that they actually have a validator out of the entire list of nominations, or he/she must go to the nomination list and remove some validators and nominate others to see if they will take up the staking process, and if not, then repeat the process as many times as necessary.

As is self-evident, DOT’s revenue/reward generating model is far more active and involved than ETH, for example, where funds are staked and then no further action is needed on the part of the owner of the funds. Most staking processes are quite passive, which boosts the SEC’s contention that these digital assets are securities. DOT is a software network, more akin to Ethereum, with a far more active staking process; hence if ETH is deemed not to be a security, then chances are very good that DOT should not be deemed such either.