RΞCAP: Progress vs Precaution

Regulation: The Inevitable Clash Of Progress vs Precaution

Given the turmoil in the crypto markets we saw throughout last year, it seems reasonable to discuss a topic that is increasingly likely to get more coverage week-on-week in 2023 and beyond. If anything was learnt from the past year, regulators and legislators need to play catch-up and are going to be scrutinising blockchain technology and its applications far more than ever before. From DeFi to DeSo, from on-chain protocols to off-chain platforms, entire new economies and ecosystems are being built, with few external rules defining how such ecosystems should operate.

For some, this is just a feature of the technology: "Code is law" - i.e. any rules or constraints are built into the system itself and are self-governing. This is not to say that code replaces any legal considerations, just that the system itself already has measures in place that define how it operates - i.e. the consensus mechanism - and that these rules are hard for any regulator to change. For others, this causes paternalistic panic and drives many to push for stricter regulation.

In light of this, given the open source nature of the technology and its global reach, there is a growing concern among regulators over the regulability of such systems, particularly given the potential impact that these systems can have on wider society and everyday life. This article will look at some of the latest stories and discussion points of the past week and how they fit into this broader regulatory narrative.

Buckle up - this is a lengthy one!

TLDR: Regulation is good...when it works.

A Game of Cat and Mouse

To begin with, back in 2017/18, I wrote my first essay on the inevitable tension that would arise between the innovation of blockchain technology and regulatory policy. Having spent a few years prior to this looking into the evolving blockchain landscape, it was clear that this technology would be something that disrupts countless industries for the better - bringing radical transparency, an incorruptible record of transactions, and the ability to break free from reliance on third party intermediaries. At the same time, by its very nature, it would be the features of this technology and what it could facilitate, that would challenge traditional power structures and controls like never before.

Over the years, whilst cryptocurrencies such as Bitcoin were initially dismissed by various authorities, these rule-makers are now having to catch-up as the genie is now well and truly out of the lamp and proving hard to control. Where legislators and regulators have acted, they have struggled to pass any productive measures, with examples including New York's stifling BitLicense being a clear failure and a bottleneck on innovation, regulators failing to prevent fraudulent ICOs, and India's regulatory uncertainty (constantly changing their policy) causing web3 startups and businesses to take flight.

Given this, it has to be asked: if we fast forward to today, has anything changed? At face value, it would appear that both legislative and regulatory measures have struggled to have any real bite, let alone have a positive impact on the industry as a whole over the past several years. Examples that highlight this include:

• In 2016, the SEC made a public statement that some ICOs (Initial Coin Offerings) could be subject to federal securities law but failed to take any meaningful action during this mania - as a consequence, many ICOs continued to operate and many retailed investors were burned by scams and ponzi schemes. A notable example of this was BitConnect, an ICO that launched in 2016 and rose to see it's marketcap rise to over $2.4bn on the promise of high yield with an aggressive marketing scheme that targeted those with little industry knowledge. As with any Ponzi, it wasn't sustainable and collapsed causing retail investors that had invested to lose their capital. Only in the past week, and just over 5 years later from its inception, have 800 or so victims been able to receive some (measly) restitution: $17m.

• Between 2017 and 2021, the People's Bank of China clamped down on crypto (predominantly Bitcoin) mining farms, banning the mining of crytpocurrency. Whilst this did have a significant impact on the share of network hashrate originating in China, latest data suggests that 21%+ of all hashrate is still provided by Chinese Bitcoin miners with other miners moving overseas to continue operations. A more recent example, in a slightly different context, is that of Tornado Cash - a crypto mixing protocol designed to help ensure on-chain privacy through the obfuscation of the origin of funds - being blacklisted by the US treasury in 2022.

• Even more recently, if we look at the collapse of FTX in 2022, as discussed in my 2022 review, it could be argued that this would not have happened if there had been more regulatory clarity that would have encouraged the exchange to operate within a jurisdiction that fostered innovation and provided regulatory certainty. Ultimately, the fact that FTX felt the need to operate offshore meant that it largely avoided any scrutiny until the exchange imploded.

So, What Are The Challenges?

The examples above are relatively unsurprising if we consider the four headline challenges that this technology presents:

• The challenge of entity resolution on-chain and identifying the "real-world" entities to be targeted with any enforcement. Whilst it may be possible to identify the bad actors are on-chain, it can be difficult to map this on to a legal entity. This criticism largely focuses on protocols and anyone operating on-chain as institutions, such as centralised exchanges or mining farms, are easier targets to identify, however, as seen above there are other challenges associated with this.

• The question of jurisdiction due to the global reach of blockchain networks and their distributed nature - who enforces and where? It has to be asked whether regulation has any real impact if it is so easy for on-chain entities to move jurisdiction with little friction. Again, whilst it may be harder for more centralised institutions such as centralised exchanges to move operations it is still something that is possible, as seen with the likes of Binance with such exchanges pursuing a course of regulatory arbitrage - exploiting the difference in regulations and laws between different jurisdictions.

• The problem of collaboration naturally leads on from this as any enforcement mechanism would likely need international cooperation given this cross-border nature of the technology and the potential for regulatory arbitrage and skirting regulations. This is challenging given the game theory at play and the opportunities that can be capitalised on.

• The education barrier for regulators and the challenge of technical complexity for policy-makers to be able to stay informed on a fast-evolving technology - understanding what is possible to regulate, what is not, and what mechanism this would be through has proven to be difficult for those looking to put constraints on the industry.

So Has Regulation Made Any Meaningful Impact?

Some steps have been taken, but we are still to see any significant positive impact for the industry. If we consider that regulation is designed to achieve government policy objectives - and at the heart of these, the motivation for such is to protect economic growth and public interest - then the regulation we have seen implemented to-date has missed the mark:

• CEX's can still operate in the grey
• Shitcoins and rug-pulls are still created on the daily
• Lending platforms have failed to uphold their fiduciary duties
• Scams are still promoted across the industry, with little consequence
• Businesses are afraid to adopt such technology due to fear of prosecution

The list of examples could go on...

If we start with Binance, as a case study, it is clear that they have been able to nimbly avoid regulators and this has allowed its explosive growth since 2017 and clear dominance over the CEX market, which rose to over 66% of all CEX volume by December 2022.

During this time Binance has launched a number of different offerings beyond spot and derivatives trading, including a Liquidity Farming offering, Crypto Loans, Institutional Asset Management and Custody Services, DeFi Staking, among many others. Whilst these services are not necessarily "innovative" per se, these offerings have allowed the CEX to compete with similar DeFi products but through an "easier" user experience. Even more so, despite the undefined status of Binance, this week it's growth has continued unfettered as it Voyager Digital received an initial approval from a court in New York that would allow the sale of $1bn of assets to Binance, further extending its market dominance. For all intents and purposes, regulation has had little impact on the exchange.

Despite this, regulators are playing catchup with these centralised entities as it becomes harder to elude the hawkish eye of regulators around the globe. Whilst exchanges such as Binance has effectively played for time by bolstering their policy teams with hires from regulatory bodies, they have caught the attention of many regulators that have started to impose restrictions on Binance and its products. For this reason, it is unsurprising that Binance has started to change tack:

Focusing on more on-chain activities, regulation has also struggled to find a target, albeit with a few caveats. Whilst, last year, Tornado Cash was targeted by the US Treasury's Office of Foreign Asset Controls (OFAC), as mentioned by Chainalysis - a leading crypto data platform - "no person or organization can “pull the plug” as easily on Tornado Cash as they could with a centralized service" due to the fact that it's decentralised and non-custodial design, facilitated by smart-contracts. Whilst the front-end to the site can be blocked, this does not stop the underlying smart contracts from continuing to operate as, due to the distributed and decentralised nature of a blockchain, it is extremely hard to regulate on the protocol level. Although a middle-ground for regulators is targeting Web3 infrastructure providers (Infura and Alchemy), allowing the Ethereum API for Tornado Cash to be blocked, this is contingent on these providers being within a jurisdiction over which these regulators have control.

If we look at the percentage of OFAC compliant blocks (where validators have censored specific transactions that are not compliant with OFAC) that have been processed since the Merge, we can see that an analogy with the state of Bitcoin mining in China - initially a vast majority of miners comply with regulators, before this begins to wane. Whilst 66% of blocks may enforce OFAC compliance as of today, this is will likely decrease as the Ethereum mainnet continues to grow beyond the reach of American regulators and it becomes easier to setup validators. As long as there are non-OFAC compliant validators, then it will be possible to still freely use DApps such as Tornado Cash.

So Where Does The Industry Stand?

Although regulators have struggled with certain crypto and blockchain-related entities, they have been successful in targeting most centralised entities - whether their approach has been as effective as it could have been, is a separate question. Looking at the past week, there's evidence that this activity will likely increase as well, with:

• Gemini and Genesis being charged by US regulators for illegally selling crypto to investors
• The EU becoming more vocal about providing clarity over what is regulated and what is not, as well as how this balances with jurisdictional challenges.
• Banks beginning to take crypto loans through crypto lending platforms
• Members of the Upper House of the UK Parliament looking to incorporate crypto regulations into current financial regulations
• Russia and Iran floating the idea of a gold-backed stablecoin

Yet, regulators will have to learn from past cases and potentially modify their approaches if they are to be successful in their aims in the long run.

A useful tool for them to consider in this process is Lessig's Pathetic Dot Theory of regulation, and the differences between regulation in "cyberspace" and the "real world". In this thesis, Lessig hypothesised that despite its decentralised nature, the regulation of the internet - and extending this theory to blockchain - would be inevitable. This theory, that is comprised of four modalities, recognises that when used effectively, the pathetic dot can ultimately be controlled - i.e. the action of an individual:

• Law - this threatens with sanctions if not obeyed
• Social Norms - these are enforced through the community (how one should behave)
• Market - this is achieved through economic forces
• Architecture - this regulates through the design of the technology itself

If we consider the approaches that regulators have taken so far, they have focused heavily on legislative measures, but as seen above there have been significant challenges with this - it has often forced entities overseas into more "friendly" or less regulated jurisdictions. Whilst this is a concern in traditional finance, given the nature of the Web3 space and the distributed nature of many teams, this is arguably even easier in this industry. If regulators wish to support the innovation that is blossoming around this technology and potential leverage this innovation to foster economic growth, then being too heavy-handed with such regulation will likely be a detractor and counter-intuitive - i.e. as mentioned earlier, causing a brain-drain in India due to the uncertainty and strict penalties that surround its crypto industry.

Similarly, looking at the architecture modality, it is unforeseeable that this would be productive given that writing code is free speech and it would likely be unproductive for a government to regulate through such means. Taking the Tornado Cash example to highlight this, the protocol is still live on the blockchain today - arresting the developer for writing open source code and publishing it on-chain does not solve the problem. It may deter some but it doesn't solve the alleged problem: money laundering.

How Should Regulators Approach This Problem?

Moving forwards, it would interesting to see regulators engage with the industry more meaningfully and they can do this by pulling on the levers of Lessig's other modalities, particularly market and social norms. As things stand, regulators are on the outside and looking in. Many are sceptical of the technology and fear the potential impact it can have on the wider economy, such as the opportunity it could present to nefarious enterprises - although, with improving entity resolution, chain analytics, and the sheer number of people able to trace the on-chain activity, this is a misplaced concern.

Instead, what they should be doing is embracing the innovation and adopting it as a solution to some of the problems they fear. Regulation in this space can and should be light touch, given the current state of the technology being open-source means that it is one of the most transparent technologies on the planet. No black boxes (if we save ZK tech for another discussion), no secret algorithms - the chain doesn't lie, given its open source nature. Authorities just need to invest in its adoption and improving their literacy, as well as proactively working with different entities across industry to develop industry standards that are fair and reasonable. There is no need to place additional regulatory measures in place beyond those already available in fintech today - i.e. to prevent fraud, deception, market manipulation, and other kinds of abuse.

An high-level example of this that touches on a different undesirable problem seen in the industry, could be with the problem of scammy crypto ads. Whilst such ads deal with a crypto-related topic - such as promoting a shitcoin that will likely rug - a regulator could use awareness campaigns to help educate the wider market or making it prohibitively expensive (through fines) to make such representations as such representations would be made in an environment where regulatory oversight would be possible - i.e. not on-chain. As seen in the UK, steps have already been taken to work towards this end.

Concluding Thoughts

Regulation is a good thing...when it works.

Without regulation, the world would be a chaotic place. It brings certainty and clarity. But in the case of blockchain and crypto, it needs to be reasoned and in moderation. Lessig's modalities show that there are different options that can be used to achieve this and that a nuanced approach should be taken when deciding which to use.

A considerable amount of the regulation we have seen applied to the crypto space has been very reactionary and, as highlighted above, that does not always achieve its aims. By its nature it is a difficult technology to control and so it makes sense to work with those that are building it rather than be overly-hostile to it - as with any industry, there are going to be bad actors but this should not be an excuse to be overbearing with regulation. The technology has been in the wild for the past decade or so and it's seeing a faster adoption rate than the internet - this is expected to continue, but only if regulation can help it achieve its potential. Ultimately, it will be challenging to regulate a significant amount of on-chain activity, as has already been seen, but by working with the industry, regulators can hope to use soft power to ensure a healthier ecosystem.

As things stand, there is international game theory at play and the nation(s) that best supports this industry will likely reap the rewards. It's all to play for still, but I expect the race to get hotter this year as regulators take it more seriously given the headline grabbing news and the impact on consumers that arose from last year's turmoil.

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