Taxonomies of Digital Assets: Recursive or Progressive?
This Essay discusses the development of taxonomies that seek to map digital assets onto existing financial markets laws as a means of assisting regulatory clarity. The publication of such taxonomies has become something of a mini-industry, yet there has been little consideration given to the construction of taxonomies and their potential to develop—or constrain—thinking about how best to develop regulatory responses to the industry. This Essay suggests that taxonomies are often little more than descriptive, appearing to “solve” taxonomic problems while at the same time embedding restrictive assumptions, and accordingly can obstruct policy development.
Cryptographically secure consensus technology (henceforth “CCTech”), which forms the basis of blockchain and distributed ledger technology applications, enables qualitatively different boundaries of commercial activity than was previously possible. It provides new models of activity proximate to traditional financial services activities concerning venues, participants (such as intermediaries) and products already subject to laws governing securities, futures and commodities.
How existing laws and regulations governing highly regulated financial markets apply to digital assets (henceforth “cryptos”)
This makes policy formation leading to regulatory implementation difficult as these conditions increase the risk that regulations could be made only to see the industry change under it, or that the regulations capture the wrong family of acts—in either case, the policy objectives are missed. To these risks must be added the list of technical concerns that hover over CCTech, which potentially give rise to legal problems and requires an appreciation of how the science and technology operate and their weak points, such as how they might be gamed by bad actors. Nevertheless, it is essential for both the industry and society that consumers and the capital market are protected from abuse and that the proper allocation of risk capital to commercial activity is able to occur.
The development of CCTech presents challenges to a legal system that has evolved at a time when CCTech did not exist. The struggle is to identify whether or how to regulate cryptos, what or who should be regulated, and to what extent should regulation be applied given that this is a developing technology in its early diversification phase.
One response to this set of issues has been the development of taxonomies that seek to map cryptos onto existing securities laws as a means of assisting regulatory clarity. The development of taxonomies has become something of a mini-industry, yet there has been little consideration given to the construction of taxonomies and their potential to develop—or constrain—thinking about how best to develop regulatory responses to the industry. Taxonomies should provide information that assists the understanding of a problem; however, frequently they are little more than descriptive, appearing to “solve” the problem while at the same time embedding restrictive assumptions.
1. Taxonomies and their uses
Systems that identify, describe and classify are based on a priori constructs (i.e. ideas or theories) or purposes, which can change in response to new or corrected knowledge or new purposes. Consider, for example, the change experienced in biology following Charles Darwin’s classic work On the Origin of Species, which shifted biological taxonomy from systems based on the shared morphology of organisms to systems based on the genesis of organisms. A biologist might point out that while the former could assist with the understanding of common functions that have led to the development of recurrent structures, information concerning shared and divergent origins and histories, such as responses to changes in the ecosystem, would be lost under a taxonomy based on morphology.
Similarly, when organising cryptos into a taxonomical system, questions that must be asked of the taxonomy include: what purpose is it intended to serve; does it provide information germane to that purpose; does the a priori construct it is based on presuppose outcomes; and is it likely to be sustainable as “new species” emerge, i.e. cryptos that are based on developments in CCTech.
Consider the information that is provided by categorizing cryptos into the following categories: cryptocurrency, platform cryptos, utility tokens, security tokens, natural asset tokens, crypto-collectibles, crypto-fiat currencies and stablecoins.
Siamak Masnavi, Alex Tapscott’s Taxonomy of Cryptoassets (From Consensus 2018, CryptoGlobe (May 23, 2018), https://www.cryptoglobe.com/latest/2018/05/alex-tapscotts-taxonomy-of-cryptoassets-from-consensus-2018.
General Taxonomy for Cryptographic Assets, Brave New Coin, https://bravenewcoin.com/enterprise-solutions/taxonomy.
The construction of modern securities regulation in common law countries has been significantly influenced by the approach in the United States, whose fundamental triumvirate of investment laws
SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
Other taxonomies do use the language of law based on use-case, quantitative or risk-based scenarios. For example, the approach taken by the Monetary Authority of Singapore is to put cryptos into three categories: utility tokens, payment tokens and securities. This basic taxonomy has been recast in a similar approach that seeks to understand and develop governance frameworks and codes of conduct with a view to mitigating risk:
Global Digital Finance, Taxonomy for Cryptographic Assets (Oct. 10, 2018), available at https://www.gdf.io/wp-content/uploads/2018/10/0003_GDF_Taxonomy-for-Cryptographic-Assets_Web-151018.pdf.
Sometimes called utility tokens or consumable tokens, although these terms have been contaminated by issuers who have used them in misleading ways.
2. Interrogating taxonomy use cases
In the context of the regulatory question, each of these types of approaches may be interrogated on the basis of its value to policy-making, or whether they are rooted in a need for clarity based on existing laws only. In this regard there are three essential concerns.
First, while a particular taxonomy might seek to describe something intrinsic to a crypto, intended use and actual use may diverge, causing the taxonomy to break down. For example, given the high degree of transferability of cryptos, one that is classified according to its design as a voucher or utility token may in fact function entirely differently once issued, whether or not intentionally,
Syren Johnstone, ICO Utility Tokens and the Relevance of Securities Law, Hong Kong Lawyer (Mar. 2018), http://www.hk-lawyer.org/content/ico-utility-tokens-and-relevance-securities-law.
Second, the convenience of piggybacking on existing legal and regulatory concepts may constrain the ability to find the best regulatory approach to cryptos because it is essentially based on pre-existing conditions. To that extent it may also constrain the options for the development of commerce—piggybacking is subject to limitations in relation to decentralized commercial activity. Proposals to leverage off of the crowdfunding experience may be potentially useful as regards establishing familiarity, but to the extent the characteristics of ICOs of cryptos and crowdfunding differ—and they do in significant regards—misdirection may occur. Regulation that is imposed too early or misses its target can hamper the prospect of creating new models for the undertaking of commerce and the development of new asset classes that support it.
Third, while there may nevertheless be some benefit in legally-themed taxonomies because of their ready recognition by regulators, care needs to be taken that the taxonomy is not merely “solving” the problem without changing the underlying assumptions about how existing securities laws apply, or should be developed to apply, to cryptos. Taxonomies that do so are essentially recursive and in reality achieve very little. It is of course somewhat paradoxical to address something new by treating it as though it were something old. This raises a fundamental jurisprudential question, of whether the purpose of the law is to impose a framework that commercial developments must adhere to, or whether it should reflect commercial developments subject to overarching safeguards.
Taxonomies establish systems that facilitate dialogue and common understanding based around it. It is not sufficient that a taxonomy can be said to be “correct” insofar as it is consistent with a set of observable facts—aeroplanes, birds, Icarus and angels all belong to a category of winged things. The relevant test is the usefulness of the taxonomy, or what information it provides to develop an understanding of a problem. If the taxonomical question is how to determine which cryptos should be considered the subjects of which form of regulation, taxonomies that service legal solutions based on existing constructs of law and regulation may amount to an exercise of arbitrary power inconsistent with the rule of law.
I.e., what is constructed as law services the power of the authority that is able to apply the construction, as opposed to applying impartial and clearly defined principles of law. See, e.g., Jacques Derrida, Force of Law: The 'Mystical Foundations of Authority’, in Deconstruction and the Possibility of Justice (Drucilla Cornell et al. eds., 1992).
3. Morphology versus genetics
It is feasible to argue that basing taxonomy around cryptos is not the only focal point to consider given it is the CCTech that drives, and limits, the possibilities inherent in any crypto iteration. One might analogize this to, for example, asking whether an endemic problem is best solved by focusing on animal morphology or genetic heredity. Or to the interconnecting laws and regulations that govern the corporate machinery enabling the creation of corporate securities, as compared to those that govern the issuance of securities into the market. It's a question of level. A taxonomy that brings within its consideration the CCTech itself could potentially assist to resolve some of the current legal uncertainties. This would require taking as its direct concern the core elements of the CCTech itself, much as regulation in parts of the financial services industry has had to move away from simply regulating human behaviour occurring in relation to financial products and services to regulating the behaviour of computer codes,
Shifting the subject of taxonomy away from solely cryptos, which are built on the “genetics” provided by the underlying CCTech, is a subtle one that brings focus to key elements of the technology relevant to questions of whether a crypto might be regarded as having an investment purpose, or whether a common enterprise is (or is capable of being) formed. This does not derogate from the point that a digital asset is itself “simply code” and that the way it is sold can evidence an investment contract subject to securities laws.
Appreciating that taxonomies serve different constructs and purposes, with differing potential implications, is relevant when seeking to meld the differing perspectives of the crypto community and the regulatory agencies. Taxonomies are not always transferable from one construct or purpose to another. The fact is that the range of relations that CCTech can possibly create, and the behaviours in the market once they are created, are at once simulacra of human commerce and a potential further development of it.
4. Looking backwards, looking forward
Past knowledge and experience so frequently informs—and constrains—the way future development is conceived. One sometimes hears the question, to what extent is 20th century thinking holding back the regulatory oversight of cryptos?
The flexibility and constraints of established regulatory categories require an appreciation of what taxonomies constructively as well as possibly destructively do, the difference between function and form, and between intent and outcome. However, one needs to be careful in answering the question posed above, for answers can go both ways in terms of consequences.
History is replete with examples of political and legal frameworks based on a priori assumptions, often protective and prescriptive in nature, hampering the development of technology. This sometimes takes the form of partitioning commercial activities into separate silos along business or product lines—while doing so promotes the development of specialized rules, it also inhibits (or prohibits) inter-silo activity. Partitioning can be done based on principles that are worthy of considered debate: the Glass-Steagall Act
See, e.g., David Isenberg, Rise of the stupid network, Computer Telephony, Aug. 1997, at 16-26.
The traditional question of what might be the best point to impose regulation in the financial markets—on promoter, platform, exchange or product—may no longer be relevant given the ability of CCTech to collapse venue, act and product into the operation of computer code via distributed networks, decentralized and disintermediated arrangements, and smart contracts. There is a venue, but it may only exist in a code supported on a network of participants. There is an act, but that may take place without intermediation other than the non-sentient operation of a code operated over a network in which the creator no longer has a role. There is a product, but there is a recognized lack of clarity as to how to characterize a crypto for the purposes of regulation-by-silo. At some point, adaptability may be challenged to the extent that fundamental questions arise as to the continued viability of existing legal silos and traditional choke points, thus giving rise to policy concerns.
It is necessary to keep a clear distinction between scientific development, the commercial application of scientific discovery and the funding of the foregoing. The distinction is important to make as many of the concerns that have been expressed by governments, regulatory agencies and others, should not be confused with the validity or otherwise of the underlying science and its technological implications. Whereas CCTech, and the cryptos built on it, give rise to policy questions concerning access to the public capital market, applications of scientific discovery in human society frequently give rise to a fundamentally different set of questions concerning the use case of the application and whether the technology has been properly developed and safely applied. How these two different concerns—about access to funding and the application of science—intersect is dependent on whether the public capital market is being accessed by technology that is or is not fit for purpose.
If there is a simple, overarching conclusion to draw, it would be this question: to what extent does the formation of taxonomies promote or hinder regulatory thought and action on CCTech cum cryptos toward supporting the efficient allocation of risk capital? If the flow of capital is unduly restricted (or made excessively costly), industry development will suffer. If transparency and accountability in capital flow is not fostered, capital may be diverted to projects doomed to fail.