Digital Assets

Squaring Regulation with Decentralization

You’ll find a lot of views on regulation in the digital assets space, but on the whole it’s welcome.

Karen Tang   Karen Tang · Published on 20 October 2022

The challenge is how we match up a regulatory model built for traditional businesses, with the decentralized ‘network of networks’ that is the current web3. What hope is there for real decentralization — and how real does it need to be? We’ll give these questions a look, hopefully without getting too far into the long grass on any of them.

Regulations and networks: a missed high five

Digital assets, and the blockchains that host them, are decentralized. They’re immune to the manipulations of central banks and the plans of governments. They’re transnational (or more accurately, nation-agnostic) and transparent.

All of this is true, but they also have to function inside a web of regulations imposed by national governments. This isn’t always a bad thing, but it does raise questions. How decentralized is a web3 network when crucial decisions can be imposed by those outside the network? What are the effects of regulation on decentralization?

We can start with the second question. The decentralized web is now over a decade old, if you date it to the Satoshi white paper, and governments have been actively seeking to regulate it since around 2017. So we should be able to look at web3 projects from the last couple of years and ask, have they become more centralized and top-heavy? If so, it looks like regulation and centralization go together.

That’s what you’d expect to find, because governments would ideally prefer centralization. You can see the confusion in legislative chambers as lawmakers try to get their heads around the idea of a multibillion dollar organization with no staff, headquarters, executives, assets, or org chart. Well… where is it, then? There’s nothing to levy the power of governmental regulation against. If web3 can be compelled to reshape itself along more conventional lines it will sit easier in the minds of legislators — and make it easier for them to impose further regulation down the line.

In fact, though, this doesn’t seem to be the case. While answering this question is a little tricky because there are multiple competing, and sometimes contradictory, definitions of decentralization, it does look like genuine decentralization is still a key concern for web3 projects.

Ethereum: responding to technical pressures, not regulatory ones

Ethereum is one of the most-used blockchains on the planet, serving as the base for a slew of NFT, token and web3 projects through the ERC-20 and ERC-721 smart contracts, running as programs on the Ethereum Virtual Machine. This year, Ethereum switched over from Proof-of-Work to Proof-of-Stake as its consensus algorithm, because “it is more secure, less energy-intensive, and better for implementing new scaling solutions”. All of which is true, but what have been the effects on decentralization?

This is unsurprisingly a debate close to the heart of the web3 community. We’ll keep this brief, but touch the main points. Some say PoS is less decentralized, because “it requires more computers and participants across the network to review and approve of transactions”. Others argue that “staking is more decentralized”, because “economies of scale do not apply in the same way that they do for PoW mining”.

In either case, regulators haven’t directly chosen one over the other. There are merits to both arguments: how decentralized is a network where only a minority actually validate blocks, however democratically they may ostensibly be chosen? (How democratic is a network where opening more shares wins you more votes? We’ll get to that further down.) But how decentralized is a network where just one company is ultimately responsible for half of all mining activity (as was briefly the case with Bitcoin before mining was banned in China)?

Securities law and web3: regulating centralization into existence

These are technical and ethical debates within the community, intended to reconcile decentralization with security and efficiency. Insofar as there is a trend toward reducing the number of validators, it has more to do with pressure on the machinery of web3 itself than with regulatory pressure from outside. And as providers of general-purpose blockchains proliferate, the operating mechanism of individual networks matters less — in the same way that a restrictive menu at a restaurant matters less if it’s on a street of other restaurants. If you’re allergic to half the menu, you have other places to eat.

However, there are cases where regulation has actually acted to force a degree of centralization on some projects, even as it has displaced or shut down others. The SEC has sought to apply the “Howey test” to the digital assets space. This presents some legal issues, but more importantly for us it leaves some digital assets projects with nowhere to go. If they launch the way Bitcoin did, simply publishing their white paper, publishing the source code and mining the genesis block, they won’t contravene regulations — but what are their chances of success? Look at Bitcoin’s adoption curve, and ask whether a new blockchain network entering a crowded and competitive marketplace can afford to wait years to reach commercial viability.

The SEC has tended to focus on commercial activity outside blockchain environments, and on identifying digital assets that behave as securities. Major waves of regulation in Europe and the USA have been promised but have not yet materialized — perhaps when they do we will see web3 change under their influence, but so far that hasn’t happened.

How decentralized are web3 projects, and does having government regulation inherently mean they aren’t decentralized? This isn’t about internal consensus mechanics, but about whether it matters what the majority of users want when the state has already effectively decided what’s permitted.

The SEC’s efforts to pull many taken offerings under their regulatory aegis has had two clear results. One is a chilling effect on ICOs; the other is the creation of a de-anonymized, de-decentralized ‘access layer’ which exists to fulfill the SEC’s requirements that securities be offered only on an accredited basis. Since no decentralized institution can be accredited, this amounts to a requirement that institutions and individuals deal directly with named brokers. It has typically also meant that tokens have been offered only to accredited investors, with obvious effects on decentralization — and predictable effects on project scope and structure. That’s had some upsides, but it’s undeniably reduced the amount of effective decentralization in the digital assets space.

The debate within regulatory agencies

Support for the SEC’s position isn’t universal even inside the SEC. in 2020, Commissioner Hester M. Peirce published the transcript of a recent speech on the SEC’s own site, entitled ‘Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization.’ While making it clear that the views presented were hers rather than the SEC’s as a whole, Commissioner Peirce noted that the current legislative environment was bad both for the digital assets space and for the United States’ economy, arguing that ‘our securities laws stand in the way of innovation’ and saying that ‘projects have sought to sever any ties with the United States to avoid the reach of our securities laws.’

Commissioner Peirce went on to argue for specialized forms of regulatory relief. These may yet be coming, but what’s more interesting about her speech is the heterogeneity of viewpoints on digital assets even among regulators that it illustrates.

Why decentralization? Web3 governance

Beyond the direct effect of regulation on decentralization, and beyond the debates on digital assets networks’ consensus mechanisms — debates which are now years old and show no signs of abating — there’s also the broader question of democracy within digital assets networks. What does it mean to have a democratic network? Should networks seek to balance the excess voting power of large shareholders, and if so, how? Like many issues encountered by the digital assets space as it grows to maturity, these questions have been encountered before in conventional businesses (in many cases, long enough ago that they were then unconventional).

One solution is simply to allow the largest shareholders to have the largest say. That this might allow a handful of companies or even a single individual to effectively own the whole company (read: network) is held to be no bad thing. This washed better when the organization under discussion was the Ford motor company and makes less sense when we’re talking about a blockchain project for something like DeFi. But blockchain and digital assets — web3 — projects come in shapes and sizes. Broadly, a network that exists to track items in shipping containers will excite less debate around on-network democracy than a network designed for some highly participatory use, with the real furore reserved for the most public, general-purpose parts of the we3 ecosystem.

A question for the ecosystem

These debates are only beginning. As web3 projects mine historical corporate governance structures for inspiration, and others invent novel ones to coincide with their consensus algorithms, we’ll see the technical debate (‘how do we make sure our network is decentralized?’) and the ethical debate (‘how do we make sure everyone is treated fairly on our network?’) continue alongside the philosophical debate: what do you mean, exactly, by democratic and fair? The best indicator of the success of our industry will be not whether we arrive at the answer, but how many people are participating meaningfully in the conversation.


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