Blockchain and the Birth of Web3
With the emerging businesses in Web3, the term itself has become the buzzword in the technology landscape. This article is the start of the Virecube series of Web3 educational blog posts. Before we delve into the potential use cases of Web3, as opposed to Web 2.0, let’s understand the foundation that opened all the possibilities: blockchain.
What is Blockchain?
The pioneer of blockchain technology is a product called Bitcoin, highlighted in Satoshi Nakamoto’s Bitcoin whitepaper. The advancement of transactions in the modern world requires a third party to manage and mediate disputes. This ends up increasing the overall transaction cost and creating hassles for the sellers and buyers alike, as no electrical payment over communication channels could exist without a financial institution.
Enter Bitcoin, which works in blockchain, the pioneer for nascent decentralised finance. Transactions are recorded by the nodes in the network as follows. And the global timestamp is managed by maintaining the distributed global timestamp server in the peer-to-peer network using the proof-of-work (Nakamoto, no date). Therefore, the security of the system without the financial intermediaries can still be achieved by the power of the long hashes. If the system is dominated by honest CPUs, then the system is secure.
Source: (Nakamoto, no date)
Source: (Nakamoto, no date)
This makes the record coming from every node that joins the system, rendering the presence of a central institution governing the data addition not necessary. The node itself is a network stakeholder. The nodes and their devices are authorized to keep track of the distributed ledger and serve as communication hubs for various network tasks (‘What are Blockchain nodes? Detailed Guide -’, 2022). It can be likened to communication in the network of peer-to-peer computers or devices.
Each node can either be offline or online. Offline node means the node only needs to download the updated blockchain, called synchronising with the blockchain. Online means the node’s function is tasked to update the network consistently for any new addition of the transaction to the blockchain.
As such, the functions of a node can be generalised into three:
● Determining whether the new transaction is legitimate and then accepting or rejecting it
● Saving the transaction block
● Broadcasting the updated blockchain across the network
Therefore, the name blockchain comes from the way each piece of new information is added to the ledger, as every new transaction is added to the existing block, creating a chain of the blocks.
One of the applications for blockchain itself is Ethereum, which differs from Bitcoin in the way that it is built on top of the neutral blockchain, not necessarily a payment transaction blockchain (What is Ethereum?, no date). This makes Ethereum a versatile blockchain network to develop dApp (decentralised app) on top of it. Some of the non-payment applications of blockchain are for tracking the history of agricultural foods (Marchesi et al., 2022) or public health data management (Gul et al., 2021). Moreover, blockchain is also a suitable technology for the smart city concept, leveraging their smart contract for data verification (Serrano, 2022). Multiple research projects have also been conducted to explore blockchain usability during the COVID pandemic, such as in developing the digital vaccination passport (Nabil et al., 2022).
Blockchain and Web3
The internet has evolved from the old Web 1.0, where everything was read-only, requiring minimum input from the users, to Web 2.0, which is more social-driven with user-generated content (UGC). Now, in Web 3.0, which is commonly written as Web3, the social driving force is taken up a notch. Users will be able to share their UGC and have power over their data and transactions, while Web 2.0 products still require a centralised institution (What’s the Relationship Between Blockchain and Web3?, no date).
An example of this contrast between Web 2.0 and Web 3.0 is the grant to the central authorities of how they could exploit users’ data. In Web 2.0, just like the current social media we use daily, there is an entity behind it that runs the servers, maintaining and collecting our data. Although the content is majority UGC, the communication power itself is still controlled by the platform owner. Therefore, even the financial transactions occurring on the platform are still in the centralised mode. Web3 makes the experience more community-centred because the transactions and data exchange happens without a central institution as an intermediary. P2P transfer or lending can happen in Web3 without central banks involved in the middle (more about it will be covered in the upcoming articles).
Blockchain and Smart Contract
What is, then, a smart contract and its relationship with blockchain? When we hear the term ‘contract’, our mind immediately goes to a legally-binding agreement between at least two parties, signed and maintained to be reflected in future transactions whose scope is documented in said paper.
However, with the presence of blockchain, a contract to process and finalise transactions between two parties does not need to exist in this traditional law definition. A smart contract is, in essence, a computer program that states with the ‘if/then/else’ logic whether a transaction is allowed to happen. It is a code that defines the conditions that must suffice before accepting or rejecting a transaction. Since it is a computer program that is coded to recognise and move forward based on the conditional statement above, as long as the conditions have been met, there is no need for human intervention.
Employing the principle that the ‘code is law’, smart contracts in blockchain have the characteristics of (Dobrauz-Saldapenna and Schrackmann, 2021):
● Self-execution: once the conditions have been met, the predefined actions will run without human intervention
● Immutability: the code does not change and is applicable to all the subsequent actions in the blockchain, varying it is not possible
● Digital performance: a smart contract exists in the digital realm, signifying whether the new transaction can be added to the blockchain, but not about the performance in real life
Combined with blockchain, smart contracts become the tool that enables the objective that Nakamoto’s white paper includes. Transactions can happen anonymously between two cryptocurrency holders that satisfy the conditions. There is no need for a central bank or a fintech product server constantly monitor the activities.
Due to the nature of blockchain, the properties of smart contracts cannot be altered by a single contractual party. This answers the cost and efficiency objectives, increasing the speed of the transaction recording and storing while lowering the risk of malicious rejection once the conditions are fulfilled. Moreover, due to the immutability of the blockchain, smart contracts can be traced afterwards. Blockchain and smart contracts provide the ecosystem for decentralised finance.
Challenges in Policymaking — The Innovation Trilemma
The plethora of new products based on blockchain has raised issues of legal surveillance and policymaking. There is a concept called the policy trilemma (Brummer and Yadav, 2019) that shows the triangle of the maximum objectives the regulators can achieve. The paper focuses on the three foundational objectives as the basic functions of all regulators. Those three objectives are maintaining market integrity, financial innovation, and rules simplicity.
Market integrity is the ultimate goal of a regulator, acting as the overseer of the market activities to protect the consumers of the services from unfair and illegal acts. Moreover, the regulators guarding the stability of the playing field encourage market confidence and public trust in the blockchain. Market integrity involves the presence of comprehensive rules and antifraud protections, being put in place to achieve stability.
This brings us to the second value, which is financial innovation. A fast-paced climate for innovation does not necessarily mean harm to the regulation. For example, a blockchain that fosters the growth of decentralised finance is a breakthrough against the data/system loopholes that could exploit consumer information. Blockchain was born because of the privacy issue as one of the driving forces. Therefore, with this innovation, market independence and public trust can be achieved, which aligns with regulatory policy. Also, smart contracts eliminate the need for a middleman, lowering transaction costs.
To achieve the previous two objectives, regulators must create rules that are clear and precise. This is the only way to reach the goals because simple and rational rulemaking will help the players and the market to focus on innovation rather than get confused about compliance. This also streamlines the product plan and standard, ensuring a uniform experience for a consumer, and promoting a sense of safety.
However, a trilemma arises from the three values. Among the three values highlighted above, regulators can achieve a maximum of two at any given time. If a regulatory body prioritises market integrity and clear rulemaking, the regulators will inevitably limit the innovations of the potential developed upon blockchains. Blockchain started by Ethereum hosts vast potentials that might go untapped if too many rules are imposed upon it. On the other hand, if the regulators want to encourage innovation and clear policy, it might endanger the market integrity because of the simple regulatory frameworks.
When the blockchain products were too-small-to-care, regulatory bodies did not focus on them. Rather, the energy was on the mass products in traditional banking. The logic behind the ‘tacit acceptance’ of blockchain products from the regulators is mainly efficiency (Arner, Barberis and Buckley, 2016).
With more products coming from the blockchain universe, including cryptocurrencies, more exposure is given to the consumers, giving raise to fraudulent transactions and illegal purchases that happen under the regulator’s radar. As such, the regulators who were still at the ‘tacit acceptance’ stage at the beginning of the popularity of the blockchain start to take a more active approach to the matter.
The revolution of smart contracts that are immutable and ‘faceless’ gives a beneficial advantage over traditional financial institutions which constantly exploit gaps and ambiguities in the regulations, called the ‘regulatory arbitrages’ (Omarova, 2019). In other words, blockchain and smart contracts are deemed worthy by market participants because they overturn the dominance of this rooted practice of circumventing the regulations, making the market not equal for all.
However, the market seems to forget the fundamental building block of smart contracts is still human. The programmer(s) or the product management team of the contracts are still prone to error in defining the logic, or the testing method is not robust enough to anticipate forthcoming issues (more on this in the following articles in the coming weeks). With no or less supervision from a central authority, it might create a situation where the problems cannot be de-escalated and create a systemic impact on the system, whether financial or in other applications. Moreover, since the system integrating the off-chain data work is similar to ‘oracles’ in ancient Greece, this poses a problem in the decentralised system: who can ensure that the oracles conform with the audit process (Silva et al., 2020)?
Closing Thoughts
Regulators should adapt to the principle-based approach given that the possibilities of blockchain technology are unlimited. This approach gives more focus to the spirit of a regulation rather than a rigid, to-the-letter rules adherence (Arner, Barberis and Buckley, 2016). Rule-based regimes are not suitable for the blockchain start-ups and established businesses that tap into this market because each process has to be identified and complied with. It does not do well for efficiency within the regulatory bodies, and it limits innovation as highlighted in the trilemma.
Moreover, the rule-based approach does not foster creativity and agility for the regulators because the rules are deemed sufficiently comprehensive. In the realm of blockchain technology, regulators that are complacent because of the easiness of the set of placed rules will find difficulties in maintaining market integrity. The feeling that everything is put in place will cause them to be slow to match the speed emerging products are launched.
Blockchain technology and everything developed upon it should be viewed as problems to solve and revolutionise how the regulators work. The regulatory framework must be evaluated over time, and it must equip the regulators with the following (Grier, 2022):
● Sufficient knowledge fused between the industry, academia, and regulators, making everyone on the same page about the scope of the products
● Cross-border working groups to exchange knowledge globally, since blockchain’s objective is to ensure frictionless transactions. Cross-border receives massive transformation with this innovation
● Compliance is incorporated in the product design, not later in the rollout stage. This is to avoid costly waste in the development while the end result does not comply with the framework
● Best practices in existing financial or corporate compliance and ethics to follow. This aligns with the ‘principle-based’ rules as written by Arner, Barberis and Buckley above
With the exciting development for the market, regulators and market participants can formulate a synergy for the regulatory framework that promotes innovation growth while protecting its integrity.
References
Arner, D.W., Barberis, J. and Buckley, R.P. (2016) ‘The evolution of fintech: a new post-crisis paradigm?’, Georgetown Journal of International Law, p. 1271+.
Brummer, C. and Yadav, Y. (2019) ‘Fintech and the Innovation Trilemma’, Georgetown Law Journal, January, p. 235+.
Dobrauz-Saldapenna, G. and Schrackmann, M.A. (2021) ‘Economics of Smart Contracts: Efficiency and Legal Challenges’, in E. Kaili and D. Psarrakis (eds) Disintermediation Economics: The Impact of Blockchain on Markets and Policies. Cham: Springer International Publishing, pp. 33–46. Available at: https://doi.org/10.1007/978-3-030-65781-9_3.
Grier, J. (2022) Council Post: Legal Compliance Is Crucial For Web3 Mass Adoption, Forbes. Available at: https://www.forbes.com/sites/forbestechcouncil/2022/12/21/legal-compliance-is-crucial-for-web3-mass-adoption/ (Accessed: 29 December 2022).
Gul, M.J. et al. (2021) ‘Blockchain for public health care in smart society’, Microprocessors and microsystems, 80, pp. 103524-. Available at: https://doi.org/10.1016/j.micpro.2020.103524.
Marchesi, L. et al. (2022) ‘A blockchain architecture for industrial applications’, Blockchain: Research and Applications, 3(4), p. 100088. Available at: https://doi.org/10.1016/j.bcra.2022.100088.
Nabil, S.S. et al. (2022) ‘Blockchain-based COVID vaccination registration and monitoring’, Blockchain: Research and Applications, 3(4), p. 100092. Available at: https://doi.org/10.1016/j.bcra.2022.100092.
Nakamoto, S. (no date) ‘Bitcoin: A Peer-to-Peer Electronic Cash System’.
Omarova, S.T. (2019) ‘New Tech v. New Deal: Fintech as a Systemic Phenomenon’, Yale Journal on Regulation, 36(2), pp. 735–793.
Serrano, W. (2022) ‘Verification and Validation for data marketplaces via a blockchain and smart contracts’, Blockchain: Research and Applications, 3(4), p. 100100. Available at: https://doi.org/10.1016/j.bcra.2022.100100.
Silva, T.B. da et al. (2020) ‘Blockchain and Industry 4.0: Overview, Convergence, and Analysis’, in R. da Rosa Righi, A.M. Alberti, and M. Singh (eds) Blockchain Technology for Industry 4.0: Secure, Decentralized, Distributed and Trusted Industry Environment. Singapore: Springer Singapore, pp. 27–58. Available at: https://doi.org/10.1007/978-981-15-1137-0_2.
‘What are Blockchain nodes? Detailed Guide -’ (2022), 22 February. Available at: https://www.blockchain-council.org/blockchain/blockchain-nodes/ (Accessed: 29 December 2022).
What is Ethereum? (no date) ethereum.org. Available at: https://ethereum.org (Accessed: 27 December 2022).
What’s the Relationship Between Blockchain and Web3? (no date) Binance Academy. Available at: https://academy.binance.com/en/articles/what-s-the-relationship-between-blockchain-and-web3 (Accessed: 27 December 2022).
