This paper explores why we need to think differently about the oversight of cryptoassets to avoid the costs of incrementalism, and proposes how we might develop a more meaningful regulatory response that better engages with blockchain’s fundamental characteristics.
Policymakers responding to the irruption of blockchain-based cryptoassets have adopted an incrementalist approach based on the single supporting column of interaction with public capital. This paper explores why we need to think differently about the oversight of cryptoassets to avoid the costs of incrementalism, and proposes how we might develop a more meaningful regulatory response that better engages with blockchain’s fundamental characteristics.
The irruption of blockchain, initially Bitcoin with its limited capabilities and subsequently Ethereum and all that came after it, has not been matched by any real development in how to think about it in regulatory terms. There is widespread institutional acceptance of financial regulators applying financial regulations to cryptoassets (the “standard narrative”). This paradigm is usually touted as having brought benefits relating to consumer protection, systemic risk issues, and to protecting the industry from reputational damage by actors who might abusively seek to profit illicitly from the buzz around blockchain. The initial application of financial regulation did help to tame a Wild West environment. This was, and largely continues to be, enforcement-based. However, the specific and limited mandate of financial regulators stands in high contrast to possibilities presented by blockchain capable of reaching well beyond the purposes for which such a mandate was established.
Too little thought has gone into interrogating the appropriateness of the standard narrative paradigm, its impact on the shape of the industry’s development, and the possibility that opportunities presented by blockchain, and chances to experiment with it, are being unnecessarily delayed, obstructed, or pre-empted. How did we reach this point, and how might we move forward?
When faced with a new policy problem, the approach of policy makers is often informed, and constrained, by both tacit and explicit knowledge about the nature and scope of the problem.1 This can facilitate initial responses by finding an analogy based on existing practices, then seeking to apply a pre-existing solution—financial regulations in the case of cryptoassets. This can be called regulatory incrementalism and it is not, per se, a bad thing. It builds on experience, allows for a gradualistic evolution of standards that minimizes disruption, and tends to preserve the status quo.2
Let us back up a little: incrementalism understandably performs well where change is gradualistic, but blockchain is widely understood as an innovative, disruptive and disintermediating technology wholly different from what was possible in the 20th century. For the technologist, the application of financial regulation was drastic, a tectonic shift not at all incrementalist in nature.
Where the predicate of an incrementally changing fact pattern is absent, regulatory incrementalism encourages a conservative attitude that tends to work against developing improved responses to new fact patterns. This results in limited policy alternatives being adopted and a greater preoccupation with risk reduction than with facilitation of goals3—both of which characterize the standard narrative.
The experience in Europe provides an example. In a 2018 resolution, the European Parliament acknowledged the broader social benefits of blockchain to reshape value chains outside of any financial sector considerations.4 However, Europe has in recent years pursued a primarily financial regulatory agenda in its proposed Markets in Crypto-assets (“MiCA”) regulation.5 MiCA remains premised on a mindset preoccupied with the systemic impact of cryptoassets on payments and monetary policy.
The tendency to think of regulation only from the perspectives of risk control and market failure and to regard innovation as something that occurs spontaneously is an incomplete picture.6 Supporting legal conditions are precursors that can enable innovation to flourish.7 However, the standard narrative constrains blockchain innovation because it embodies assumptions about the architecture of commercial endeavour that may be inconsistent with possibilities offered by blockchain. Moreover, finding solutions from within the extant regulatory framework diverts effort from the development of other tools that are possibly more effective.
Institutional preferences and mantras
The application of securities laws is conceptually and empirically adequate within its own explanation of reality. Flexible functional tests of what should be regarded as a security, such as the Howey test in the United States or the definition of collective investment scheme under other legal systems, provide ample latitude. It also suits institutional preferences for familiar investment structures. One of the important elements of the shift from the ICO (initial coin offering) to the STO (securities token offering) was that investors were able to obtain the legal opinions they were familiar with, namely, that securities were being offered pursuant to an applicable exemption from securities laws. It also suited professionals connected to the finance industry looking to redirect their experience in traditional markets to new business opportunities. This was a win-win for regulatory agencies that could to an extent rely on those professionals as control gateways and as centres of learning and experimentation. But it also meant that capital in search of legal certainty may be less forthcoming for new public blockchain proposals that did not fit neatly into that framework.
Two frequently heard mantras in this regard are: “same business, same risks, same rules”; and, normally heard in regulatory circles, the need for regulation to be “technology neutral.”
The first mantra is firmly grounded in institutional presumptions: a vertical hierarchy based around investors as providers of financial capital, a company that uses financial capital, and the consumers of products or services subsequently produced or provided. While blockchain can sometimes service such institutional arrangements more efficiently, to stop there misses the point that blockchain creates new prospects for the formation of commercial relationships, institutional arrangements and community interactions that were not previously possible. This includes enabling possibilities for corporate structures that are flatter and more networked than hierarchical,8 an overall shift to markets rather than hierarchies as coordinators of economic activity,9 and consequently new models for economic governance and coordination.
The second mantra glosses over the reality that the new prospects offered by blockchain are fundamentally about the technology and that meaningful policy development likely requires engagement with the technology at a more primary level. Technology neutrality does not imply technology agnosia.
These mantras are decoys that inhibit more probing enquiry and tend to direct regulatory thinking to the extant ways of doing things that preserves an institutional status quo. For example, centralized cryptoexchanges can attain the reputational badge of becoming subject to regulatory oversight because they are modelled on extant exchange structures; however, decentralized exchanges cannot, despite undertaking the same exchange functions.10
It is difficult to ignore the considerable telescoping of blockchain’s possibilities for institutional reform that has caused its evolution in various ways to become pinioned by the standard narrative and painted into a corner to provide financial products. Capital allocation decisions have been affected and consequently the ability to experiment and innovate has been inhibited. This has resulted in a slanted environment for ecosystem development that may represent an exclusion mechanism blocking institutional innovation. The effect of this on the industry cannot be disregarded and questions must be asked about the consequences.
Positioning blockchain under financial regulation may also have inadvertently bolstered an interest in cryptoassets as speculative investments. Consequently, the business proposition of disintermediated commerce that might be effected via a digital medium now competes with a crypto-finance market that continues to be volatile, and subject to abusive practices with limited pockets of effective oversight. What makes this more problematic, despite the safeguards implied by the application of financial regulation, is the deficiency of effective laws that define and control market abuse in cryptoassets.
The stumbling block
The particular property of blockchain to encode anything of value as a tradeable information object—information and value thus becoming interchangeable—is barely an afterthought in the standard narrative, as are the governance aspects of such remarkable consensus-based metamorphoses. Yet this feature of information/value interchangeability may be the perfect expression of economies being based around the value of information.
Phil Salin’s American Information Exchange (1984) was premised on such a valuation-of-information concept, as was Timothy May’s experimental information market, BlackNet (1993). However, at the time, blockchain technology was yet to emerge from the discussions that preceded its advent, leaving only more approximate approaches to the transformation of information/value into a discrete, tradeable object. In the post-Ethereum era, this has been referred to as the tokenization of everything—anything of perceived value, whether tangible or intangible, may in principle be represented by a cryptoasset.
Cryptoassets that represent the nexus of information and value can properly be called the currency of an information economy. This is not currency in the restricted sense of money—as Aristotle or central banks conceive it. Rather, it is currency in the sense of information objects—cryptoassets—being generally accepted or prevalent because they are expressed in a common form that renders them exchangeable. Hence, “cryptocurrency.” A cryptoasset can be created, owned, stored, assessed, valued, used, exchanged, transacted, sold and so on irrespective of what it represents. This could be as diverse as a right to do or obtain something, a proof of ownership such as a vehicle registration certificate or an artwork, carbon footprint data observable by anyone but changeable by no-one, or a dynamic NFT (non-fungible token) that allows sustainability-related knowledge to be valued and traded.
The property of interchangeability has presented a fundamental conundrum for policymakers and regulatory agencies who have sought to fit cryptoassets into the triarchy of preexisting regulatory silos: money (or store of value), securities (whether by design or function) and commodities. That approach has been problematic from the outset because, inter alia, there is a sense in which all cryptoassets qua information objects are merely a representation (or store) of value. This is quite unlike the singular inflexibility of money, securities and commodities as traditionally understood which are, by and large, dependent on and distinguishable by their form and function.
Policymaking for ecosystem development
The standard narrative, initially a successful stopgap, has not evolved in any significant regard. It hardly seems within the purposes of a financial regulator to explore alternative solutions that might reside outside its ambit and require a departure from statutory origins premised on centralized modes of action. If you ask a securities regulator a question you are going to get a securities regulation answer, and within that limited frame of reference, it may be entirely plausible to construct a regulatory response based on the single supporting column of interaction with public capital. Policymakers have had little cause to disrupt an incumbent paradigm that protects the status quo. However, that structure starts to look like a precarious legal contrivance the more one prods around the boundaries of blockchain as a general purpose technology (rather than any specific product). Instead of witnessing the emergence of a polymorphic ecosystem, the standard narrative has facilitated a vortex of activity around financial products and decentralized finance. As SEC Commissioner Hester Peirce put it, actions taken to date offer no clear path for a functioning cryptoasset network to emerge.11
The ex post facts-and-circumstances enforcement approach arising out of the standard narrative creates considerable uncertainty when developing and launching a cryptoasset that might not conform to a traditional financial regulation framework. Arguably, it creates unreasonable costs for developers by demanding compliance from many persons, as opposed to an ex ante approach that may be more cost effective where, in complex scenarios such as the blockchain landscape, policymakers have less information about participants that are quite diverse.12
To facilitate ecosystem development, it will be more productive if policymakers recognize and respond to the characteristics of blockchain that are qualitatively different from those provided for within the standard narrative. Doing so may promote the evolution of regulatory oversight mechanisms that are better aligned with society’s interests in the fuller exploration of blockchain. The question is how to go about doing so.
One approach has been to create taxonomies of cryptoassets. However, these frequently range from being a restatement of the triarchy mentioned earlier to being descriptive and reactive to the latest market or regulatory trend. A more promising, bottom-up, approach is Tasca and Tessone’s taxonomy tree,13 albeit it remains essentially a descriptive approach.
Another approach is to look under the hood of the technology itself to ascertain what might be relevant to regulate. This is analogous to shifting the conceptual level of enquiry from molecules to examining the underlying atomic elements that form them. If one can identify such elements, it may be possible to deliver a more sustainable regulatory framework as novel ways of configuring the “atomic elements” are found and put to new use cases. Such an approach would instantiate a point made earlier, namely, the need for any regulation of blockchain to be cognizant of, and responsive to, how the technology actually works.
An interesting piece of technical work in this regard is that undertaken by Bonneau et al.14 who identify three axes around which blockchain technology commonly turns. Namely: public-key cryptography that enables secure transactions, a consensus mechanism that enables the state of data maintained by the network to be agreed, and decentralization in the form of an ad hoc peer-to-peer network of participants.
I have proposed a Determined-By-Architecture (“DBA”) framework (see Figure 1) which suggests that, if regulatory oversight were directed to issues arising across these three axes, questions that are more relevant to ecosystem development could be asked.15 For example, whether the design of cryptography facilitates interoperability, or how the consensus mechanism influences decentralization. An important overlay to this technical layer of governance is to recognize that how a blockchain performs in the field depends not only on the technical aspects of the implementation (design elements, absence of bugs, unexpected properties, etc.) but also on social behavior.16 It may be difficult to anticipate how actors might seek to game a particular blockchain iteration, or come to engage in self-organizing behaviours. Stigmergy might emerge as a consequence of information exchange in the blockchain environment. Consequently, the interaction of the technical infrastructure of the code (the “internal dimension”) with social behavior (the “external dimension”) may cause intent and outcome to diverge.
The interaction of the internal and external dimensions gives rise to issues around code governance, namely, the arrangements that infuse or impose order and lure (or do not lure) the undertaking of activities regarded as desirable (either within the defined objectives of that chain or, more generally, socially). Governance mechanisms can be created poorly, gamed, abused or simply provide inadequate means of resolving issues moving forward. Recognizing issues arising out of such interactions also gives rise to more germane regulatory questions, such as how types of powers given to different nodes in a network influence network behaviour, or how a consensus mechanism distributes power and may benefit some token holders ahead of others.17
Figure 1: The DBA framework. A blockchain iteration can be characterized by three axes and its internal and external dimensions.
The DBA framework enables different types of questions to be posed and focus to be placed on items of concern to consumers and the industry. Importantly, it can avoid an outcome-dependant formulation of regulatory taxonomy based around fitting a cryptoasset on an ex post basis into the historical triarchy of money, securities, and commodities, thus addressing the risk of a cryptoasset being treated differently at different times.
Policymakers need to start thinking about blockchain in terms other than the “investment purpose” implicit in the standard narrative paradigm and start anticipating what new regulation might look like. To pursue a more informed regulatory approach, there inevitably must be a discussion around the purposes for which current regulatory bodies were established, the ambit of their operations and whether they are suitable for regulating blockchain-based activity. Financial regulators are poorly suited to regulate blockchain beyond specific interactions with financial capital as traditionally understood. It will be necessary to explore what type of agency needs to be created and what powers it would have to ascertain and limit the boundary lines of where financial regulation might apply.
The conundrum is that the ability of a polymorphic ecosystem to develop depends on the availability of a more fit-for-purpose regulatory paradigm. Progress requires taking a prodigious step out of the extant regulatory framework, and the mindset and immediate preoccupations of today’s regulators, to consider the larger frameworks of concern. This ranges from the proper role of regulation in response to the pressing needs of society, to the possibilities created by blockchain, to the dynamics governing regulatory policymaking, to the ramifications of the standard narrative on the development arc of the technology.
This paper is based on Rethinking the Regulation of Cryptoassets: Cryptographic Consensus Technology and the New Prospect by Syren Johnstone (Edward Elgar Publishing, 2021).