Regulatory Tribalism in Cryptocurrencies

Over five years ago, FinCEN issued guidance on the application of the Bank Secrecy Act in certain virtual currency operations. The guidance clarified that those who perform certain virtual currency activities, i.e. “administrators” and “exchangers,” will be subject to money services business (MSB) regulations. Although some users on BitcoinTalk, the main cryptocurrency discussion platform then, did acknowledge the benefits of AML protections, the majority of the community was wary of the stifling effect it could have on both adoption and innovative applications of cryptocurrencies.

By contrast, when SEC Commissioner William Hinman stated that ether is not considered a security as of June 2018, the cryptocurrency community was divided. While most investors and developers rejoiced, certain broker-dealers, investment advisers, exchanges, and financial institutions were irritated.

Why? Because a broader interpretation of “security,” one that’d include even ether, would require most cryptocurrency transactions to pass through pre-existing regulated systems. Meaning these broker-dealers, advisers, exchanges, and financial institutions would be able to boost revenue and get a headstart on competitors who had not yet obtained proper registrations and licenses.

As cryptocurrencies have begun to capture mainstream interest, the industry’s witnessed a Cambrian explosion, with more and more entities investing and building out the ecosystem. Although the cryptocurrency community may seem homogenous to the casual observer, especially in the case of Twitter and Reddit subgroups like/r/ethereum or /r/bitcoin, the truth is that the landscape is growing more diverse by the week. The “cryptocurrency community” no longer just consists of O.G. 2009 libertarian bitcoin developers: it now encompasses numerous diverse token projects, decentralized application projects, independent developers, cryptocurrency users, miners and validators, licensed and unlicensed exchanges, retail investors, hedge funds, venture funds, financial institutions, technical service providers, academic research groups, and more.

Actors in each category have different paradigms, different incentives, and, ultimately, different policy goals. Not only does each category have different priorities and incentives, subgroups within the same category can, and do, have divergent and competing policy desires. This means that some actors may promote certain policies that will help them gain adoption, while the same policies will lever collateral damage on tangential ecosystem actors.

This throws a new wrench in policymaking for cryptocurrency and blockchain: regulatory tribalism. While there may be overlap in several desired outcomes, different actors in the cryptocurrency community have been incentivized to push for completely orthogonal outcomes. It is naive to believe that there’s still a uniform voice that promotes the goals of the entire community — that is, if there even was one to begin with.

Before we can achieve efficient and unbiased policy outcomes, actors in the cryptocurrency industry must first acknowledge the discrepancy in incentives and desired policy. They must define their most critical issues, identify compatible actors who also prioritize these issues, and invest in impactful structures for collaboration.

The optimal collaborative structure would likely look very different than, for example, a hypothetical lobbying group of the top 20 token projects; such a group would likely be so divided in philosophies and goals that the group’s aggregated impact is far inferior than the sum of each individual’s efforts.

Here are some illustrations of instances where interests and priorities may diverge within categories, or “tribes,” and between them.

1. Projects that are building decentralized applications and/or are issuing a token:

• Definition of a Security: We regularly witness bitcoin maximalists argue that the SEC should consider ETH, and other cryptocurrencies, to be securities. And there’s a significant number of people who don’t believe ETH to be a security but claim that almost all 2017 and 2018 ICO tokens should be classified as such. Interpretations of the rungs of the Howey Test are manifold. <br/><br/> Furthermore, following Commissioner Hinman’s speech, coin issuers, developers, investors, and the community at large began to ask — what does it mean to be sufficiently decentralized in the eyes of the law? Does it mean a diverse and independent developer base? Diverse and independent transaction validators? A maximum Gini and Nakamoto coefficient for coin ownership? Decentralization built into specific technical features like the consensus mechanism and/or the ability for anyone to meaningfully validate and submit transactions?, Or is it some combination of the above? Different projects will advocate for higher significance and weight of different items.
• Privacy: Some cryptocurrencies, such as Zcash and Monero, offer privacy features. These projects will raise a much higher flag to promote the values of privacy than, projects such as Harbor and Ambisafe that are coding AML/KYC and compliance guides into smart contracts on the blockchain.
• Developer Liability: Developers may create platforms, cryptocurrencies, and decentralized applications that are used by criminals to facilitate unlawful transactions and operations. Should developers be held accountable if they know there’s a reasonable chance that their platform or application may be used for unlawful purposes? Different projects may have different risk levels and thus have different priorities: privacy coin developers will be at higher risk, whereas bitcoin developers may not worry as much given a wider diffusion of responsibility and liability.
• Legitimacy & Association: At time of writing, there are 1850+ coins listed on CoinMarketCap. These coins are associated with projects that vary in legitimacy. It is unlikely, for example, that Ripple will wish to lobby for policies in the same coalition as Dentacoin. Associating and collaborating with less legitimate token projects is seen as a stain on legitimacy.

2. Cryptocurrency exchanges:

• Response to Government Data Requests: Different exchanges possess different philosophies on how and whether to cooperate with government. For example, some custodial exchanges hand over data readily to the IRS, whereas some exchanges choose to fight the scope of the request. Some, like Kraken, challenge the necessity of specific information disclosures, whereas others will readily disclose all requested information without contest. A self-regulatory organization of exchanges is bound to have members with drastically different philosophies on government interaction.
• Decentralized Exchanges: It’s unclear how decentralized exchanges should be optimally treated in money transmitter, securities, derivatives, and tax frameworks. While decentralized exchanges currently lack the speed and user experience of centralized exchanges, once technology improves and a meaningful percentage of traders convert to DEXs, could we see centralized exchanges respond by challenging the compliance requirements for order book maintainers and broadcasters?
• Risk Tolerance: Different exchanges have different risk tolerances for potential securities and money transmitter penalties, and this is reflected in the variety of tokens they offer, where they operate, and whether they already possess the proper licenses to operate in the jurisdictions where they have clients. Exchanges that have proper licenses (and are shouldering the burden of compliance) may push regulators to investigate emergent exchanges who are more risk tolerant and may not have mature compliance infrastructure.
• ATS & Stock Exchanges: Some exchanges, such as Coinbase, Poloniex, and TZero, are becoming, or have become, ATS’s (alternative trading systems) that can trade securities legally, thereby subscribing to the securities token thesis and hedging the existential risk that cryptocurrency transactions will be labeled as securities transactions. Now that the designation of cryptocurrencies as securities will no longer devastate the business, and could even boost business activity, it is possible that some ATS exchanges could lobby for a broader interpretation of security in the cryptocurrency context. <br/> <br/> The same is true for incumbents like Intercontinental Exchange (“ICE”), which is building a new trading ecosystem for security tokens. ICE, an institution with significant lobbying and regulatory experience, would have much to gain in a world where all new cryptocurrencies are considered securities (since they’d likely drive revenue to its product and service offerings).

3. Cryptocurrency users and retail investors:

• Risk of Loss: Cryptocurrency users and investors want to reduce the risk of their cryptocurrencies losing value. Those who have lost money may submit complaints to agencies and legislators for greater regulatory scrutiny of various projects, greater enforcement activity, and the passing of consumer-friendly legislation. Greater scrutiny, enforcement, and requirements would lead to heightened burdens for projects that may be honest and legitimate. For example, one consumer-friendly measure could be increased disclosure requirements for issuers of publicly held cryptocurrency. While this could benefit users and investors, this would potentially impose heavy administrative costs on the issuer and offer less leeway for a project to transition into more “decentralized” control structures.
• Fraud: Cryptocurrency users and investors may push for greater enforcement and penalties on fraudulent actors in this space. It’s indisputable that this is directionally positive. However, there is ambiguity around what, exactly, constitutes fraud — could it include an overly optimistic tweet or an honest Reddit post that is actually rooted in a miscommunication with the partnerships team? A trigger-happy enforcement regime could scare developers and projects away from candid communication and impose complex communication guidelines akin to those of public corporations.

4. Technical service providers & SaaS companies

Permissioned Chains vs. Public Chains: Companies, such as IBM and R3, that sell products and services related to permissioned chain technologies, may choose to underplay the importance of public networks and cryptocurrencies. Understanding the legislators are wary of potential misuses of cryptocurrency, some permissioned chain companies could shape the narrative to emphasize the possibility of blockchain innovation detached from the existence of cryptocurrency. This style of narrative may lead policymakers to undervalue open networks and freely transferable cryptocurrencies, leading to less informed and biased policymaking.

5. Financial industry incumbents: Broker-dealers & money transmitters

• Incumbent Advantage:As the allure of cryptocurrency and blockchain attracts established players into the space, it is natural for these players to try and leverage their preexisting compliance operations and processes. Entities may wish to offer, for example, securities related token products and services under the purview of a broker-dealer, or offer custodial cryptocurrency payment services under the authority of money transmission licenses. <br/> <br/> As incumbents understand the potential for profit, they may wish to advocate for stricter regulatory interpretations, regulations, and compliance requirements of cryptocurrency related transactions to reduce competition and drive the need for their products. Moreover, these financial industry incumbents may have significantly more experience and better networks in policy advocacy and lobbying, amplifying their perspectives.

These examples are not comprehensive; there are additional instances where actors in the space can possess competing incentives. None of these incentives or perspectives are objectively malicious or wrong, per se — they are rational reactions to an entity’s initial conditions, philosophies, and goals.

If you were an SEC commissioner visiting San Francisco for a week to hold meetings with developers, entrepreneurs, funds, users, financial institutions, professors, and technical service providers in the cryptocurrency ecosystem, you’d hear these the “cryptocurrency community”’s narratives, philosophies, fears, and desires sliced a thousand different ways.

While some may marvel at the meta-decentralization of incentives in the industry, a distracted motley of messaging will likely lead to ineffective, biased policy outcomes that are primarily shaped by incumbents who have already substantial clout and experience working with legislators and regulators. In the worst scenario for freedom of grassroot innovation, large financial institutions and technical service providers will end up framing cryptocurrency and blockchain policy.

So, what can we do? First, we must abandon the naive notion that members of the “cryptocurrency community” want, and would benefit from, the same policies. Second, we need to put substantial thought into how, as actors in the space, we may need to group and regroup flexibly based on various policy issues, identifying allies and opponents potentially on a per-issue basis. Third, we need to reconsider the structure and decision-making processes of trade associations and self-regulatory organizations who claim to represent the “voice of the community,” and potentially discover new structures for coordination. In a future post, I will explore the second and third steps in greater detail.

The process of identifying shared policy outcomes and coordinating policy efforts in cryptocurrency and blockchain is becoming a critical governance question that may prove substantially more complex than protocol governance.