Regulation: the one word that strikes palpable fear into the heart of the crypto community, hanging over its head like the Sword of Damocles. Since the early Bitcoin days of crypto-anarchism and libertarianism, regulators have often been seen as the bad guys trying to clamp down on a technology and currency that is a threat to their very way of existence. A recent essay in The Defiant showcases the indignation and worry in the crypto community, making the claim that the ‘crypto industry is facing an existential threat’ with Western governments accelerating their regulation of crypto. Gary Gensler, the Chair of the SEC, has been referred to multiple times as a ‘formidable adversary’. On the other side of the aisle, regulators have long been concerned about the potentially nefarious powers of cryptocurrencies, right from the days of Silk Road all the way to the present, when innovation in the crypto space has evolved so rapidly as to leave current regulations and frameworks in the dust. This article in the New York Times perfectly highlights these fears, with the entry of crypto into traditional finance (TradFi) causing alarm bells to ring across DC. The potential status of many digital assets and DeFi products as securities is the elephant in the room, with regulators keen to act quickly in the name of consumer protection and financial stability. The crypto industry seems to have taken this well:
The debate, though, is a lot more nuanced. On the one hand, regulators do have a point. Many tokens, under current laws, can be classified as securities. A number of DeFi projects have been subject to scams and ‘rug pulls’ – i.e., projects that, on the face of it, seem exciting and revolutionary, attract a lot of money and liquidity from users, the price of the underlying token increases, and then the developers pull all the liquidity they can and run away, leaving the users / liquidity providers with nothing. Moreover, there are DeFi projects that can be extremely risky for consumers, such as DeFi lending for new altcoins that can be extremely volatile in nature and have wild price swings that can cause the value of the coins to fall much below that of their collateral. Lastly, there are numerous questions around decentralisation – what actually is considered to be decentralised? What is the holy grail of ‘sufficient decentralisation’, as espoused in 2018 by the SEC’s William Hinman, and do many ‘decentralised’ crypto projects actually meet this standard? What is the actual influence of whales on the governance of crypto projects? A lot of these questions remain unanswered, but looking at the statistics of actual community participation in governance decisions for DAOs (for example, this report on governance in Uniswap), it seems as if a high number of proposals and governance decisions are made by a comparatively low number of participants. With all of these potential red flags, is it any surprise that regulators have begun to scrutinise the crypto space like hawks?
On the other hand, it is clear that current regulations are not fit-for-purpose for an industry in which new innovations are occurring at breakneck pace. Summer 2020 turned the spotlight squarely onto DeFi, with the Total Value Locked or TVL (representing the number of assets staked in a specific DeFi protocol) in all of DeFi increasing by 1,245% between June 2020 and September 2021, from $7.27 billion to a peak of $97.81 billion.
Innovations like Decentralised Exchanges (DEXs), yield farming, stablecoins (algorithmic and non-algorithmic), derivatives, lending, wrapped tokens (allowing tokens from one network to be used in another network), and liquidity mining, among others, have all taken off in the space of a year. This has made it challenging for regulators to even come to grips with how they work, let alone devise comprehensive frameworks to effectively regulate them. Further, regulators commonly use the Howey Test to judge whether an asset is a security – is a test created in the 1930s really the best tool for regulation available in the 2020s? Technological innovations build on top of one another, like a single snowball rolling down a mountain can turn into an avalanche. One of my favourite articles is Packy McCormick’s Compounding Crazy, which puts all the technological upheaval we’re seeing today into perspective. In it, he says ‘every new invention is an output of centuries’ worth of innovations, and then voila, it becomes a simple, cleanly-packaged input for the next invention.’ Today’s snowball is on its way to turning into tomorrow’s avalanche – but overly aggressive regulation (that perhaps says that most cryptos are securities) has the potential to severely dampen paradigm-shifting innovation.
In today’s article, we’ll cover why regulation is not always negative and indeed, may be necessary for the crypto industry to grow and succeed. We’ll also dive into the perspective of the crypto industry and why excessive regulation and outdated laws could hamper innovation, and brainstorm some solutions on how to potentially find a balance between regulation and innovation.
The Regulators
Securities Laws
In the US, the Howey Test determines whether a transaction qualifies as an ‘investment contract’ and would therefore be considered as a security and subject to the disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. An investment contract is defined as:
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others
Many tokens currently classified as utility tokens meet these conditions. The issuance of utility tokens definitely meets Points 1 and 2 – issuers are obtaining an investment of money in their ‘common enterprise’. Point 3 is contentious. If a token has been pre-mined (like Ripple or Ethereum) or burned to reduce its supply and maintain or increase its price, a case can be made that both the issuers and investors expect a profit to be derived from the enterprise. Point 4 is met because on many occasions, investors buy a project’s tokens because they ‘believe in the team’ and predicate its success on the involvement of the project’s backers / issuers. Moreover, only some token holders will be actively involved in the project’s operation – signaling that most holders will derive a profit from the efforts of others. In this case, on the evidence of the Howey Test alone, many utility tokens can legitimately be considered as securities by the SEC, and therefore subject to stringent requirements to ostensibly protect consumers and the stability of the financial system.
Moreover, many DeFi products could also be considered as securities. Let’s consider lending – i.e., interest accounts like those provided by BlockFi. In a crypto lending program, a group of people pool together their crypto, a smart contract lends the crypto to borrowers who pay interest, and part of the interest is paid back to the lenders. For all accounts and purposes, for the lenders, this is an investment of money (their crypto, which has monetary value), in a common enterprise (the lending pool), with the expectation of profit (from the interest), to be derived from the efforts of others (the common enterprise like BlockFi that brings together lenders and borrowers through their platform). Indeed, Matt Levine goes so far as to say that rather than being a security, this arrangement could even represent a bank account and could be subject to banking regulation, which is even stricter than securities regulation.
The Dangers of DeFi
Smart Contract Code
The primary attraction of DeFi is the speed and transparency it achieves. However, without careful audits of the smart contract code that powers the DeFi application, these applications are in danger of being hacked. Poly Network is a high-profile example, with the platform having over $600 million stolen in August 2021 and the hacker being able to exploit an issue with the coding of the network. Currently, because any developer can create and market a DeFi platform without any required audits, the risk of smart contract code being vulnerable is significant.
Rug Pulls
During H2 2020, it was reported that rug pulls and exit scams accounted for 99% of all blockchain fraud, highlighting how pernicious the issue actually is. Without a clear registration process that verifies the credibility of the team backing the project and code audits that ensure the sanctity of the application, DeFi protocols will continue to be vulnerable to scams.
Collateralisation
Even though many DeFi lending protocols require overcollateralisation (i.e., if you want to borrow $100 of USDC, you must deposit $200 of ETH as collateral) to mitigate against the volatility of the token deposited as collateral, there are many protocols aiming to offer undercollateralised loans now, which are loans that are not fully collateralised and the value of the collateral is not enough to cover the value of the loan in case of a default. In such cases, the protocol would rely on the creditworthiness of borrowers to determine the collateral and interest rate requirements. However, if the protocol misjudges the borrower’s creditworthiness, it could lead to significant impairments – and currently, lenders offering undercollateralised loans are not regulated, and the ways they determine creditworthiness are not assessed.
Decentralisation (or the lack of it)
One of the most vaunted benefits of the entire crypto movement is the power it aims to offer individuals. While it is important to remember that the crypto movement is only at the start of its journey, and many concepts still have to be fully fleshed out, the truth is that there are still significant problems with the governance of blockchain protocols. To the average user, governance structures are still inaccessible and disjointed. In Uniswap, for example, governance decisions take place across a number of public and private channels, making it difficult for users to submit proposals, participate in discussions, or vote. This has the effect of benefiting better-organised entities like whales, giving them structural power to make decisions in the community – indeed, for Uniswap, you’d need 2.5 million UNI tokens to even submit proposals.
In 2018, the SEC’s William Hinman suggested a regulatory framework for tokens based on the ‘level of decentralisation’ of the token network. There are questions hanging over what the standard for ‘sufficient decentralisation’ actually is. According to the Blockchain Association, the standard asks whether ‘a token network has some basic level of functionality, whether its governance is more open and distributed than a single centrally-organized team, and whether at least some purchasers are users rather than speculators.’ Even this definition is difficult to pin down. Moreover, according to a paper published by DappRadar and Monday Capital, the standard for decentralisation takes into account token holders rather than actual voters, leading to systems where a majority of decisions are made by a small number of token holders. Clearly, these issues outline a pressing need for a clear definition of what sufficient decentralisation actually entails.
All of these problems highlight why regulation is necessary to resolve some of the core issues at the heart of the crypto economy today.
The Crypto Industry
As we’ve established above, many utility tokens could very well fall under the definition of securities and meet the requirements of the Howey Test. The flip side of this is judging whether the Howey Test is actually fit for purpose. The Supreme Court, in its landmark SEC v. W.J. Howey Co. ruling in 1946, could not have imagined the impact of decentralised digital assets on the financial system.
The not-fit-for-purpose nature of regulations made for another time is exemplified by the way antitrust legislation in the US (and globally) has been approached. A 400+ page report by Democratic congressional lawmakers reached the conclusion that ‘Amazon, Apple, Facebook, and Google engage in a range of anti-competitive behavior, and US antitrust laws need an overhaul to allow for more competition in the US internet economy.’ A paper on antitrust also makes the point that ‘information technology monopolies have radically different initial growth incentives compared to their non-information technology counterparts, where they are motivated by user growth instead of profits.’ This clearly highlights how, over time, the incentives for technology firms have changed but the rules governing them have stayed frozen in place. In the same vein, the laws that govern crypto and blockchain firms need to evolve as well to meet the unique dynamics of the industry.
Imposing every single token to securities laws would be extremely onerous, with the likelihood of dampening innovation in the industry by significantly increasing the amount of time a project takes to go to market. In the digital age, it is more possible than ever for investors to rapidly raise money, build products, and bring them to market. This has reduced the length of innovation cycles and plays into the theory espoused in Compounding Crazy – of technology building on top of each other and growing. The opportunity to fail fast and learn from mistakes is not a wart of innovation, but rather a core feature, and it is necessary to balance this with appropriate consumer and investor protection.
Moreover, the breadth and depth of the crypto space is staggering. Tokenisation and decentralisation have allowed for the creation of tokens of all types, from payment tokens backed by collateral, algorithmic stablecoins, tokens representing real-world assets, NFTs representing intangible digital assets, etc. The Howey Test is too broad to effectively capture the nuance of the space, given that it only boils an asset down to whether it is a security or not.
The haste with which regulators are rushing to regulate crypto without holistically considering its effects on the space is exemplified by the provision entitled ‘Information Reporting for Brokers and Digital Assets’ in the US’ $1 trillion infrastructure bill. Its definition of a ‘digital asset broker’ makes the same mistake as the Howey Test in being too broad, potentially capturing crypto miners, validators, and software developers under its purview. This could pose significant roadblocks to innovation since these organisations, in many cases, do not have the information to file paperwork with the relevant agencies and may be barred from operating. While the intent behind the bill is to bring transparency to the space, its hurried inclusion highlights how regulation that does not adequately address the nuances of the crypto economy is likely to harm rather than help. Other proposed guidelines like that by the Financial Action Task Force (FATF) could even seem to suggest prohibiting peer-to-peer cryptocurrencies and privacy coins, potentially further dampening innovation.
With both the regulators and the crypto industry having legitimate causes of concern, a balance needs to be reached in order to both, protect consumers and the financial system and continue fostering true innovation.
The Path Forward
At its heart, any potential solution for the effective regulation of the crypto economy needs to bear a few key principles in mind:
A clear understanding of the nuances of each type of digital asset. Algorithmic stablecoins are different from asset-backed stablecoins, which are both completely different from a coin backed by gold. It is vital to appreciate the differences between these groups of digital assets in order to craft regulation that fully accounts for the unique characteristics of each asset class.
Regulation needs to be neither too narrow nor too broad. In the former case, extremely narrow regulation has the potential to crowd out innovation in a specific area while leaving the rest of the ecosystem to run rampant. In the latter case, excessively broad regulation, as we’ve seen above, can lead to too much of the ecosystem being regulated unnecessarily, again dampening innovation. Therefore, regulation needs to be pinpointed and be built from the clear understanding of the asset / asset class being regulated.
Flexibility is key. As we have seen above, a ruling or regulation that must be adhered to even if it is not suitable for the asset or technology it is regulating, can substantially lose its effectiveness. Regulation should be willing to adapt – hypothetically, in a world where digital assets are well regulated, new types of digital assets that do not cleanly fit those regulations should be subject to updated or new regulations that are fit for purpose.
Taking these principles into account, some solutions could include:
Blockchain and Crypto Commission
Since the regulatory status of many tokens is unclear, with, for example, the SEC asserting that a lot of them are securities and the CFTC claiming that they are commodities, a separate commission or group could be created that is dedicated towards blockchain and crypto topics. Such a body would be staffed with experts in the field who grasp the nuances of the crypto space and are able to holistically determine the regulatory status of specific tokens. This commission would also have oversight of all the measures implemented to monitor and supervise the crypto economy, such as registration processes for token offerings, audits of tokenomics, optional licensing schemes, etc.
Registration and Licensing
Currently, any project can list its token on a DEX without any sort of registration or licensing process. While this grants a lot of flexibility and pace, it can also lead to vulnerable smart contract code, rug pulls, and other types of fraud. An automated, streamlined registration process run by the Blockchain and Crypto Commission has the potential to resolve many of these issues. An offering would be subject to human approval only if it throws up any red flags, and investors / token buyers would gain more confidence in the offering if it is clear that it has been through an approval process. The process would also build upon past data, needing less human intervention and improving over time. The approval process should also avoid the necessity for the organisation to have a legal wrapper or entity in the real world – rather, each project can appoint legal representatives for any interaction with the off-chain world. This would help in streamlining the process even more.
There could also be an option provided for a longer, more comprehensive optional licensing process that can grant more credibility to projects that choose to go through the process. This license could include comprehensive and peer reviewed smart contract and token audits, and could be made mandatory for lending or liquidity provision projects that are riskier for consumers.
Token and Smart Contract Audits
The Blockchain and Crypto Commission could include a board of experts that peer reviews the smart contract code and tokenomics for every token offering application. To avoid too much time lag, the peer reviews could be done in ‘levels’ – i.e., Level 1 would be a rudimentary, cursory check of the code and tokenomics to make sure no red flags are thrown up, Level 2 would be more comprehensive, and so on. Depending on the potential riskiness of the project for consumers, the minimum review requirements for each project could be different. For example, a project like Axie Infinity that offers in-game tokens like AXS and SLP would be subject to a Level 1 review, while a DeFi project that offers undercollateralised loans would be subject to a Level 3 review, with the registration process potentially including an automated review of the data points and model used to ascertain a borrower’s credit.
A time limit could be set up to limit time lag as well – if a project has not been peer reviewed in ‘X’ number of days, then it immediately gains approval, placing the onus on the Blockchain and Crypto Commission to conduct its reviews on time. A project could also choose to go through more than the minimum level of reviews before listing its token on a DEX in order to engender more trust in the project.
Definition of a Security
The definition of what a security constitutes in the crypto world needs to be overhauled. It is easier than ever for projects to raise capital and go to market today, and regulation should not reduce this flexibility. However, certain stipulations could be included to make the issuance fair for consumers and incentivise project backers to continue working on the project and not conduct rug pulls. For example, there could be conditions around token vesting schedules if tokens are pre-mined, both for VC investors and the project team.
Definition of Decentralisation
The exact definition of ‘decentralisation’ needs to be determined. Specific guidelines for what ‘good governance’ is should be published, such as clear channels for proposals to be discussed or not having extremely high limits on the number of tokens that users need to have in order to submit or vote on proposals.
Moreover, as Vitalik Buterin outlined in Moving Beyond Coin Voting Governance, it is unnervingly easy to unbundle the two rights that a protocol with coin voting offers: economic interest in the protocol’s revenue and the right to participate in governance. The guidelines for good governance (or even some form of regulation) could prohibit holders that do not explicitly own the tokens they have in their possession (e.g., a centralised exchange where users deposit their tokens, or a borrower in a DeFi lending protocol) from participating in governance decisions with those tokens.
In order to ensure that a project and its governance is actually decentralised, the Blockchain and Crypto Commission could set up a supervisory committee that monitors proposal submissions and votes. For example, the committee could judge whether only a subset of individuals is submitting proposals or whether whales are exerting undue influence on votes. Decentralisation could be defined not by token holdings but rather than by actual voters, which would make it a lot clearer if a project is decentralised or not. Best practices could also include governance that allows for something like ‘one vote per wallet’ or quadratic voting, which makes the power of a single voter proportional to the square root of the economic resources that they commit to a decision.
The guidelines and provisions would make it easier to clarify what decentralisation actually is and make the regulation of entities that are not ‘decentralised’ a lot more transparent.
Scratching the Surface
Regulation is not ‘bad’ if it is implemented correctly – it can give more credibility to the crypto industry and projects while simultaneously protecting consumers and financial stability. Some of the solutions we’ve brainstormed here are aligned with the general direction the crypto industry seems to be moving in. Brian Armstrong, CEO of Coinbase, outlined as much in his article published in the Wall Street Journal last week, calling for a new, fit-for-purpose regulatory framework and bespoke regulator to specifically regulate digital assets, all underpinned by the key principles of transparency, efficiency, and innovation. This article is only the first step in a long journey towards achieving the balance of regulation that is fair, protects consumers, and does not act as an impediment to innovation, a level of equilibrium that is necessary for the crypto space to grow and thrive.
I realise I haven’t sent any articles out the last couple of weeks - mainly because I was concentrating on researching and writing this piece - but I did come across a lot of brilliant stuff. Here’s 5 of the best:
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