Financial Innovation

Updated with video. I gave my talk earlier today at Reboot 11 about refactoring the banking system:

Anyway I’m interested in any comments.

Read my 5 part blog series based on this presenation here

Due to the SEC’s closing of Prosper I do think that it is time to address the SEC rules, which were created by FDR during the New Deal. It was a very different world then. Not that I think they did a lot of good at that time either.

We need the ability to innovate, even in the world of securities and investments. We need to lower the barriers to entry as the larger players who can cross them do not have real incentive to innovate.

The cost of creating a startup is lower now than ever. Often the cost of following existing security regulation is more than the amount sought.

Personal loans on an exchange are even less likely to ever pass existing securities law unless you happen to be David Bowie.

Here are my 3 basic ideas for innovation in securities and investments.

1. Warning labels

I know, I know. I hate warning labels as well. But I’d rather have warning labels and allow anyone to invest than the obnoxious innovation killing rule about Accredited Investors.

2. Special registration rules for micro securities

A $1000 loan should not have to follow the same rules as a $500,000 angel funding round. Why not just require them to be offered through a regulated exchange service instead. I think special rules should be in place for sub $100k securities. I’d be willing to accept sub $25k if it would allow it to be passed.

While I don’t think any kind of registration with the SEC really is needed, I could be persuaded to accept the idea of a very simple free REST based web service for registration of the security with the SEC.

Think tax id, amount, offer date, description and a url to more information on the exchanges web site. The SEC could publicize this information and allow queries of the data. Of course I really think this service should be offered to be run by a private industry organization and not the SEC or we would likely have to wait for 5-10 years for it to be implemented.

3. Regulate the exchanges and not the securities

While I personally don’t think we need any form of regulation. The realities of the day are not really about less regulation. An innovative approach would be for the SEC or congress to regulate a new form of exchange. This exchange would be regulated and have to follow certain rules, but would allow smaller micro securities to be exchanged.

I was working on a project with a couple of really smart people nearly 8 years ago for creating an equities market for micro financing in the 3rd world. The project never came out of prototype stage, but one idea that fascinated me was to tax and regulate the exchange rather than the startups offered within. This would allow developing world governments to achieve revenue and regulation, while keeping a low enough barrier of entry that even very small micro businesses (like these ones in Panama ) could utilize the exchange.

This was our solution to the problems that Hernando de Soto the brilliant Peruvian economist believes for the basis for most of the economic troubles in the developing world. I have written before in A global virtual shanty town about how similar issues stop innovation and growth even outside the developing world. The SEC/Prosper debacle is evidence of as much.

Prosper were just sent a cease and decist by the SEC for offering investments without registration. Prosper is/was one of a small handful of P2P lending markets offering an innovative approach to lending, allowing normal people to lend money to each other.

Not that I am a lawyer, but from reading the ruling, it appears that for Prosper to be allowed they would need to register each and every loan with the SEC as well as every investor would need to be an Accredited Investor. Either of these 2 would be impossible to do for them or anyone else trying to offer a similar service.

Using existing rules, I think the SEC were following clear rules. That does not stop them from being evil of course. Personally I can’t see either how the constitution even permits them to shut down Prosper without a trial. They are somehow allowed to both make the rules, execute them and judge them.

Reves ruling

The SEC metions the Reves ruling and lists the following rules from it:

(i) the motivations of the buyer and seller; (ii) the plan of distribution; (iii) the reasonable expectations of the investing public; and (iv) the existence of an alternate regulatory regime.

They argue that (i) is breached as:

… Prosper lenders are motivated by the desire to obtain a better return on their money than they otherwise could in another venue. While some Prosper lenders may be motivated, in part, by altruism, altruistic and profit motives are not mutually exclusive.

Oh, horror that someone would like better returns than in the bank.

(ii) is breached because as they say:

With respect to the plan of distribution, the Prosper notes are offered and sold on the internet to the public at large. There is no special level of financial sophistication or expertise that Prosper lenders must have.

Those are the rules, I know but just look at the current financial mess and read anything by Nassim Taleb to see what happens when “sophisticated” investors are let loose.

(iii) is breached because:

bla. bla. bla. … Prosper lenders reasonably expect a valuable return on loaned funds and would reasonably believe that the Prosper loans are investments.

Again they are right according to the rules. Obviously lenders believed they were making an investment.

(iv) is breached because there is no alternative regulatory scheme:

Finally, with regard to whether an alternate regulatory scheme exists to reduce risk to potential investors, there are currently no appropriate regulatory safeguards for Prosper lenders, such as those against misleading statements by a borrower about the purpose of a loan, the borrower’s employment and income, or even the borrower’s identity, or against misleading statements by Prosper.

This is where I believe they are wrong. Granted there is office anywhere in Washington DC called the “Person 2 Person Lending Exchange Regulatory Commision”. However in the US we do have these 3 great regulatory schemes called the free press, contract law and the judicial system.

Prospers.org and apparently a whole host of blogs are busy auditing and criticizing Prosper all the time. There is plenty of information available to anyone, which should make you think twice about investing in Prosper if they are risk averse.

E-Gold were under similar constant crowd sourced regulation via their mailing lists and online tools. Read more about E-Gold’s innovations.

While Prosper may claim they weren’t a bank or under the SEC, they were always under contract law (Both Common Law and UCC). The same can be said for their borrowers and lenders. They have apparently been pursuing law suits in the courts for some time. I have no idea if they have done enough here, but then it is the job of a crafty lawyer to come up with a class action lawsuit to keep them on the right path.

Innovation is needed, new rules are needed. The SEC followed their rules and protected the existing financial industry who have done such a bang up job in recent years protecting our wealth.

Updated: Just posted 3 ideas for innovating securities law where I talk about how the SEC could allow innovation.

Updated: Thanks to David for pointing out that they aren’t actually closed, but just not able to post new loans until they get registered

I am glad to hear that Douglas Jackson and associates manage to avoid jail and get probation, community service and a fine instead.

I still think it’s extremely unfair that a service as innovative as e-gold were punished like this. Apparently so does the US District Judge Rosemary Collyer:

According to cnet:

U.S. District Judge Rosemary Collyer said the men deserved lenient sentences because they did not intend to engage in illegal activity. Even though, Collyer said, the U.S. Justice Department wanted to use the cases to show “this new day of Internet crime is going to be…vigorously prosecuted,” that alone was not enough reason to incarcerate the defendants.

While the courts don’t always do the right thing in this country, I am glad to see that they still serve their function as a safety valve against over zealous government.

Look at the situation the financial system is in right now. It is based on ancient technology and an ancient operating system. The government is throwing trillions of dollars against an unsound system and sending the Patriot Act against innovators.

E-Gold were one of the players, who truly attempted innovation in the financial space. Douglas Jackson’s genius and insight in his quest for sound money is seen in that even after all of this has happened to them, they core value of e-gold still hasn’t changed much.

For more read this article I wrote earlier e-gold innovated and were finally brought down. Also read the DGC Magazine interview with Douglass Jackson here.

update Several people have mistakenly thought my slightly tongue in cheek title to mean that I’m one of the part of the fringe paranoia groups here. While the USDOJ did bring down e-gold. The term “The Man” as well as the use of references to Black Helicopters were an attempt to caricaturize those paranoia groups. Now where did I put my tin foil hat.

e-gold is an 100% gold backed electronic currency. It revolutionized the electronic currency world using pretty simple double entry book keeping technology backed by currently 2.54 metric tons of gold and innovative legal structures to keep it safe. They are in the news today and there are lots of things startups can learn from their story about trust, innovation, legal structures, transparency and how not to deal with regulators.

It is with sadness I today read Douglas Jackson’s blog post outlining the final blow to e-gold by the US government. It felt like this wasn’t written by Doug, but by Doug with the NSA’s secret alien mind control device implanted. In reality the mind control device used was the threat of 20 years of jail and a half million dollar fine.

Also as I write in the Agree2 User Agreement:

We are men of principles, but stronger men than us have changed principles with 3 hovering black helicopters over them. If you know what I mean.

This is a case where probably a bit more than 3 hovering black helicopters were hovering over them. So I guess we can only feel sad and hope the best for Doug and his family.