Plodding Mediocrity (Part IX)

These series are from April 2018

SRO is RYP

In this section I will set myself loose and cover thoughts and possibilities that do not yet stand a legal or scientific ground. These are like puzzle pieces from different sets and that I like to put together and experiment with, so what follows is theoretical approach and not factual in nature.

I would like to discuss the possibility of Self-Regulatory Organization (SRO). There are talks about it in crypto, some notable mentions coming from Brian Quintenz (CFTC commissioner), Winklevoss twins mentioning it recently and Ryan Selkis who actively works on Messari. SRO would enable a fair framework and bring some transparency and standards that community will follow. This is helpful during the period where regulators are not able to enforce transparency due to regulatory vacuums. I consider that SRO can go even further. If we put in place right guidelines and establish right governance then decentralized economy might function without further intrusion of federal and other government agencies. Good SRO might coordinate globally with governmental agencies and as well provide network integrity and directly take into account global nature of cryptocurrencies from the beginning, rather than fragmenting network through various jurisdictions. SRO examples that we have today, among most notable ones include FINRA (Financial Industry Regulatory Authority, previously NYSE regulatory body and NASD) that was established under SEC rule and NFA (National Futures Association) that was established along with CFTC. FINRA and NFA can increase market oversight or change its policy either by posting new rules of conduct or by Congress passing new acts like Dodd-Frank (blanket for SRO). N.B: SRO is not regulation haven or sandbox, it is rather flexible industry oriented actor.

SRO was first mentioned in Securities Exchange Act of 1934 (this is some serious forward thinking in regards of market oversight and freedom 80 years ago). Today SROs are not only in financial sectors, they appear wherever there is a loose end from regulatory perspective that as well can benefit from markets self-regulation. SROs are usually established by governments or agencies and they are comprised of a diverse boards. Agency then cedes its oversight to SRO which oversees rules and conduct of SRO members.

Proper SRO can be incarnation of governance in crypto economy. Again I don’t think we’ll be able to achieve completely fair self-regulating rules, but this is not the issue that decentralized network can solve, this is governance issue that is prevalent everywhere. SRO can exert its authority over its industry members only and not on outside parties. At first SRO might seem appealing because it is distanced from regular government agencies but it has its pitfalls, some accuse the growing authority of SRO leading to corruptive behavior, while others doubt its efficient enforcement over the frauds. What is good with SROs though is that it can be more flexible for the markets and industries that are about to grow bigger, its board can consist of a wide range of stakeholders in the industry, but this still doesn’t marry well with decentralized promise, absolute ownership and freedom. I’d argue it is still most favorable form to provide framework for the market that can range from anywhere between $300 billion to $800 billion in a span of 3 months. And I believe we are not at the stage where crypto market would self-regulate in a way that would be harmful, this is a loud market with lot of participants, and will of course require offsetting risks of large actors, as well as considering voice of smaller players.

For SRO to operate efficiently we’ll need to decide and relinquish part of decision making. If we want SRO to stand a chance and have lawful enforcement, it should be structured under some government mandates, have rules and governing board composed of lawmakers, technology advocates, network and product engineers and investors among others who are necessary. I don’t think that every forked blockchain must abide to its rules, it better give a substantial freedom to developers until network usage and market capital achieves a point where enforcement should benefit honest network participants, although it might set set-up standards and provide transparency. SRO should not meddle inside separate blockchain governance and protocols, its mandate should be to legally harmonize digital asset economy with real-world regulations. I don’t think that rushed SRO will solve short-term problems, on the contrary a rushed movement to self-organize might result in government taking action first, thus it must be a synthesis between all stakeholders.

I like a lot how Ryan Selkis has described his Messari a.k.a. open source crypto EDGAR, in a proposed draft rules it will consist of: a) curated list; b) will be open to public; c) where token holders could vote to put upcoming tokens on the list; d) token holders would be hedge funds, institutions and mostly all the major stakeholders in the industry; e) token holders would be kept responsible for green lightning the projects they enlist; f) criteria would be provided to public at large. These rules are simple and manageable to start with, they provide a framework for transparency and standardization. In current market examples you can think of the power of CME and other futures exchanges that can introduce futures contacts through self-certification process - a crypto SRO must achieve something of this amplitude. As for other examples I’d suggest not to think about SRO as a legislative act, but more like the self-organization against certain events that we historically had, one example can be G10 summit on banking, story of Basel Committee or even creation of IMF as a result of Bretton-Woods system, these all are the results that came into existence because there was a need to self-organize at the first place and resolve the issue. It is questionable yet, if with cryptocurrencies we are resolving obvious, real-world issues, unless majority suffers from current systems that are in place, we won’t know, what we know though is that we are challenging current system by removing actors with concentrated powers.

Self-organization that has to provide sustainable environment for fair market execution and behavior is subject to micro-governance and results in self-regulating organization. If self-organization is an effort, SRO is its sustainable result. It comes with issues and inefficiencies, depending on the industry and the final product. It is inefficient in case the object of self-regulation is not covered under the government law, this environment then creates free-riders (those who benefit of the industry regulation, but are not members and thus do not pay fees), breach of SRO rules that might not be adequately punitive, SRO that is not a blanket regulator for the industry and if not under direct mandate of a government agency, SRO might operate in shadow and be corrupt. Thus for self-regulatory organization to be efficient it must first operate in a regulated environment, where it has oversight, authority to certain market movements and enforcement and membership of which must be compulsory by law. What SRO creates is an enclosed environment, facilitated by speed, adaptability and ethics enforcement. With SRO we avoid risk of spiteful lawmakers, biased by political agenda to regulate or stall the market, these lawmakers being accountable not only to the market players but to population at large, in SRO we are given certain freedom, price and oversight board that is accountable to the market participants only, it has more flexible structure to detect and remove parasites, because its board do not hold elected offices and is not accountable towards thousands of populist topics. At the end of the day rules that regulate anything are burden to the absolute freedom, these rules have a goal to create fair and equal environment, which are human made notions, it doesn’t mean that this is bad, just not what ideal free market is. SRO is not the remedy to regulatory trilemma of effectiveness, responsiveness and coherence, it embraces first two with ease, coherence comes unfortunately with more state regulations.

SRO is a cultural phenomenon as well. A specific culture must be present to make it possible. Apart from culture it has ethics requirement as well. It is a system that encourages (regulates) certain social behavior by a collective (self) in order to avoid direct state intervention (regulation). Self-regulation starts from within and reaches the outer, while making the initiator liable for non-obedience. The goal of SRO is not to impose chaos and to be governed by a free-market, but to chip in for the good behavior, reject the bad one by castrating bad actors from the collective interest (with possibility to impose penalties).

This kind of Self-Regulating Organization will be defined by solidarity levels and ethics. Emile Durkheim has described well such connections between solidarity, law and division of labor in his book “division of labor in society”, later with his legal opinions analyzed in “Durkheim and law” by Steven Lukes and Andrew Scull. According to Durkheim there are following correlations: mechanical solidarity resulting from dominance in criminal law that brings low division of labor and organic solidarity resulting from dominance in civil law that brings high division of labor. Through this angle SRO can be formed reflective of crypto economy itself. It will require us to look into community of investors, developers and other stakeholders and by setting standards and rules of SRO (civil leaning or criminal leaning) we’ll move the course of SRO to the level of division of labor that decentralize infrastructure strives to achieve. This will put potentially bigger importance on the board but this will make Self-Regulatory organization as well more flexible. Now this is a nicely lit hypothesis but all three components (law, solidarity, division of labor) seem to be necessary for a long-term SRO that will ignite the industry towards harmonization, where white and blue collars could merge.

Durkheim might have been looking at how law affects and is reflective of collective behavior in mechanical solidarity, but what is interesting is that organic solidarity and high division of labor were discretely the fruits of enlightenment. The society organizing through high efficiency increases division of labor, it is more interconnected, but this linkage is only possible if majority of efficient actors are vested with full trust towards the others and while others are responsible for their honest behavior. This is a description of high individuality, of faith in other for the common good, this is what democratic states have build their constitutions on. Durkheim has a point where he determines the two solidarities as pre-modern and modern, the further in evolution we have gone the higher the division of labor we have. This is as well why more advanced societies, democratic states with organic solidarity implement taxation based on fundamentals of equal opportunity. Measuring the division of labor through regulations (civil and criminal) leads us to the concept where the more advanced we are the more organic solidarity we have and the more forgiving. We are moving away from incriminating others and reducing division of labor, ideally this leads to higher contribution (employment) and this propels to the economic progress.

This tool helps when I need to think about all the promises that decentralized infrastructure is about to bring. Promise of disrupting economy through decentralization by giving power back to the people is a very loud statement, this process of formation a new economy is where this tool helps to understand the fundamentals of it. Any such new formation will be challenged by law, solidarity and division of labor. I will lean towards adopting a better division of labor and organic solidarity, I think most of the actors in this community are also hopeful towards efficiency of these two possible outcomes, where opinions get divided is the size of regulatory intrusion. Lot of actors in crypto space are free market preachers, but they are not the only ones, others such as young liberals enjoy the decentralized promise but would prefer higher role of regulation in the market. To address this I will resort to the theory of 3-tier law, where 3 very general types of law concepts are put into hierarchy.

First is: code is law, which had its meaning distorted by many in crypto space. They try to remedy bad behavior and to provide animalistic spirit as the reasons behind it, anarchy as the order, their motive is to show off that “(computer) code is superior to regulations”. They have distorted understanding of the statement, which actually tries to translate how computer code can be instrumental to social interactions, behavior and control. Lessig has provided these two quotes to counter anarchistic free market, “So obsessed are we with the idea that liberty means "freedom from government" that we don't even see the regulation in this new space” and then “My claim is that we should focus on the values of liberty. If there is not government to insist on those values, then who?”. This points to our immaturity, it is a fact that we’re still very excited by computer code and this excitement has to recede first, once the excitement has receded it can be implemented and the regulation can become a code. For its original meaning (Code is law) we still have a long road to go, for its arrogant current application in crypto it’s just wrong.

Second is: law is law. Now this statement is countered in crypto community by those who want to shut down the arrogance of “code is law” tribe. If “code is law” is a futuristic statement, then “law is law” is that of a current times. Simply put we live in a society where if you break the law you are going to be punished by these very laws and not by a computer code. I’d avoid providing further context to the statement law is law, because rule of law traces back to ancient times. I’d rather introduce other two notions that I’d use in further analysis. First is that rule of law and its enforcement is a testament to the intellect that is privy to humans and which results in self organization. Second is the variations of common law and civil law. In Durkheim’s solidarity model one might argue that his proposed model is a better fit for the civil law structure rather than common law, because it provides more coherent framework to distribute fair rule of law, but I’d argue that common law structure will enhance the progression and evolution of organic solidarity, if law is unbiasedly self-amending. Maybe civil law provides precision, but common law provides more moral understanding that is favorably required in high division of labor, a compassion, sort of.

Third is: nature is law (such as laws of physics, thermodynamics etc). As we’ve moved further into the layers, we’ve have also moved deeper. We started from future and we arrived to the most basic layer of law. Nature is governed by these laws, laws of physics and thermodynamics which on their part govern biological processes. Although these laws do evolve and we perfect our understanding of them over the time, they still provide basic evidence as to how observable universe works. We do not exert power on these laws, quite the contrary, this is why their function is not only important for universe to sustain life, but to understand how their function helps us to understand the fundamental human inclination towards self-organization and survival.

Humans are not ants or mice, we have intellect and compassion (tier 2) and we have survival mechanism (tier 3). In a free market at some point we’d tend to organize eventually, because in an unobserved environment natural selection (tier 3) will produce vulnerable actors, vulnerability will trigger survival mechanism, which will trigger compassion towards other vulnerables in order to organize and grow to achieve higher fitness. Collectively they will impose rules and demand justice - a result of intellect. This process naturally elevates market nature from tier 3 to tier 2. At first we see solidarity as a result of a survival instinct at the very primitive level, the more we advance, the more organic the solidarity becomes. To understand that self-organization is result of tier 3 we look at ants, who might lack organic solidarity (tier 2) but who would organize for efficiency and survival (tier 3), what they don’t have though is intellect which they could use for the execution of rule of law. All free market is organized and will eventually organize, because self-organization is embed in law of nature, which with the help of intellect translates into rule of law. What cryptocurrencies do is they test current systems to reboot and see the level of organization, this might be a free market test and exclusion of alternative currencies does not propel us forward. Inclusion of alternative currencies does not mean that free market will prevail, it means that it will factor in how we’ll further self-organize.

Self-organization is the characteristic of tier 3, especially in thermodynamic systems. I’ll bring myself a joy of making links to few of the hypothesis here. In thermodynamics we have three types of systems: isolated, closed and open. The nature of these system governs the exchange of matter and energy. In isolated system the entropy of that system only increases that is second law of thermodynamics, meaning that energy and matter does not enter or leave the system. Entropy in that system is the measure of disorder (non-useful energy). Observed universe is an isolated system. Our biosphere is not an isolated system though. In biosphere we have living organisms (a.k.a life) Schrödinger in his “What is life” tried to decipher how life came to exist, because life is a sustained order. Difference between matter and living organism is the metabolism process, but this is not what makes order sustained. Schrödinger tried to explain that how the living organism sustains order in biosphere was through the negative entropy, which is reverse entropy (increasing the entropy output to the outer universe, by preserving order in our system). This is called Schrödinger’s paradox and it does not contradict to the second law of thermodynamics because entropy increase does not happen in an isolated system. Following Schrödinger’s "What is life", James Lovelock has built upon the Gaia theory, which was further explaining that Earth was self-regulating organism that enabled matter and living organisms to co-exist and decrease entropy. This theory of self-regulating earth appealed to some and is still appealing, but was further countered with Gibbs Free energy to explain further how we sustain order in our biosphere and still conform to the second law of thermodynamics, Gaia theory also does not conform to the thermodynamic systems. Gibbs free energy provides availability of the energy through observation that the conditions in these systems are constant (temperature and pressure), presence of these constants provides reversal for energy to organize. Earth is biosphere that is open because it takes the energy emit from the sun and outputs infrared waves into space- high entropy is exported to keep our entropy low. To increase complexity on earth, sustain order, we take energy from the sun and our net disorder output to the universe is greater than the order we gain on earth. Now where does the maximum entropy leads the isolate system? It leads to the thermodynamic equilibrium which results in heat death of universe. This is when all energy is converted, randomized, spread out and useless. In an isolated system, thermodynamic equilibrium is maximum entropy and entropy tends to increase. In biosphere this is when metabolic processes stop.

Now back to markets. U.S. markets are considered open markets in two ways. One is that they enable retail investors to participate in them (open system) and the second is that market input and output produces results in other markets and in economy overall (metabolism). These two statements enable me to assume that market behaves like a biosphere (living organism). But market alone is not a global economy. Market is one participating system, thus it is an open system that is part of one global economy that can be considered as an isolated system. Activity on the market is metabolic, it encloses itself (becomes isolated) on global economic level that is sum of all activities, thus its entropy is increasing resulting in productivity growth. Biosphere that self-regulates (pressure and temperature) is tier 3 law that keeps life sustainable in open system. Market looks like a living organism, it does not have set expiration date, it is a system and it is growing through inputs and outputs making it an open system, making it metabolic and a living system. Because it is a living organism it has a room for negentropy, which in economy is represented as business cycles, resulting in contractions and expansions. But as biosphere has its isolated system, so does markets have it and it is represented in ever-growing productivity growth that is overall global economic output.

We described the market as open system, global economy as an isolated system and observed their behaviors, now let’s see reasons for market to self-regulate. Because we have a system of living organism in an isolated system it results in the presence of intellect, compassion and survival. Survival (result of living organism) leads to self-regulation. Survival (“what is life?” by E. Schrödinger) explained through thermodynamics leads to sustained order tendency. This tendency is possible through Gibbs Free energy that provides controlled environment that of constant temperature and pressure, these rules are needed for survival. Now we try to maintain these controlled environment parameters to sustain orderly life in our open system, we do this through adding more complexity to our open system. Eventually to preserve survival we need to expand the observable isolated system to the larger isolated system, by doing this we preserve open nature of our system, we preserve the complexity of outputting disorder, by preserving order in the system we operate. We self-regulate to preserve survivability in the system, because in case we find ourselves in an isolated system the disorder that we will output to the exterior system, to sustain order (life) in ours will only increase until it achieves thermodynamic equilibrium - state of non-activity. Think about subprime mortgage crisis with deleveraging of toxic assets. To say it bluntly entropy in isolated system is the irreversible process of increase in disorder resulting in thermodynamic equilibrium.

Crypto market looks more like isolated system in that it is not yet complex, it doesn’t output disorder to the neighboring systems to sustain order in itself and it needs to do so to survive, otherwise if it stays isolated, the disorder in it will result in useless energy being fully spread out within the system itself. As loud as it might sound, yes SRO is a mechanism to introduce survival mechanisms to the system..

So no matter if we say “code is law”, or “law is law”, or “laisser-faire” is the law, we are humans with intellect, compassion and survival mechanism and in order to survive, we’d resort to self-regulation either through natural selection or through thermodynamics. This is our human nature with bad actors both in free market and in government. Survival rules imposed by government are the result of our self-regulation, be it free market we’d arrive to the same system.

“Code is law” can happen in SRO with solidarity model of civil law (contrary to criminal law), structured through common law system that self-amends depending on inputs, that have basis of our natural behavior. This is valid because as part of natural law we eventually tend to self-organize and enact rules.

To understand that how monetary governance, purchasing power of a currency is important in structuring our societal behavior and self-organization I’ll bring Alan Greenspan’s quote “At root, money - serving as a store of value and medium of exchange - is the lubricant that enables a society to organize itself to achieve economic progress”. This is why acknowledgment of bitcoin as either currency or commodity is important, it challenges decentralized promise at its very core level, if we are able to pass this bar, then we are able to proceed further with decentralized promise.

If core fundamentals of decentralized promise are based on the currency/commodity issues and exchange issues (because decentralized promise provides economic incentives at its very basic level) then the further development of this promise is based on decentralized internet thesis. Both of these movements intend to organize us better, to move us towards more efficient economy and society. Bitcoin itself is a result of a collective thirst to bring order and solidarity. Challenge is upon us - are we ready to expand our system or not.

Remove Yourself from Power.

law, finance, technologyGiorgi Gurgenidze