About sense and nonsense of Blockchain regulations

Blockchain based financial systems are becoming real. In the last months a completely new stack of protocols and companies has emerged that offer an alternative to the traditional financial system. On the other side, government agencies like the SEC in the U.S. are increasing their efforts to protect investors by taking actions against companies that issue token or that operate exchanges without permission.

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The blockchain community and regulators all over the world are arguing and fighting on how to deal with regulation with regards to Distributed Ledger Technologies such as Blockchain. Sadly, the ignorance to arguments on both sides is stunning. It has become a fight of freedom against legacy players. The latter not willing to let new entrants enter their market and the blockchain community overemphasising their liberal views on politics. However, the regulation of blockchain based financial systems is not about taking a side either in the world of freedom or in the world of corporate standstill. It is about defining rules — if necessary — that are independent of the underlying technology.

The easy stuff: Regulating ICOs

Let’s talk about the easy stuff first. By this I mean the things that are made easier and safer by Blockchain technology, but which existed before. And that is what you might call Initial Coin Offerings (ICOs). ICOs are a way for companies to take a kind of compensation in exchange for a special kind of token that hasn’t been in the market before. These token are bought by investors as a way to make more money out of it. It is obvious, that these token are financial instruments. Experienced lawyers will take any advantage to claim that some of these token aren’t financial instruments but for the majority of investors the main reason for buying these token was to make money. Sadly, in most cases this was about loosing money. Every investment opportunity is associated with risks. This is why governments have set out strict rules for entities handling with financial instruments.

They want to preserve investor security and so far, I haven’t heard of a good reason why the purchase of a token is less risky for investors than the purchase of company stock. So why should we make a difference in regulating them? The consequences of this are clear: Wherever a company is offering token these token are to be regulated as securities. What is the point in giving the people dealing with blockchain based financial instruments more freedom than those handling traditional financial instruments? If you have an answer to this just post it here (It also makes me feel less ignored, by the way):

Don’t get me wrong: We should discuss if it is fair to make it difficult for companies to raise funding in favour of investor security. But that’s a question to be answered with regards to all financial products not just blockchain based token. In addition, I have to say that there are some regulations that don’t make any sense in a scenario where securities are transferred using blockchain technology. That’s due to the fact that these regulations are not defined technology agnostic and they should change.

The hard stuff: Regulating decentralised systems

Having dealt with the “easy” questions of regulating ICOs we are able to have a look at the really interesting issues — some that have rarely been targeted in the discussion: Which rules should apply for fully decentralised financial systems? Let’s dive into this with the help of a little example: Consider an escrow smart contract for trading two different token: User A and User B send their token to the escrow contract. If both token are in possession of the contract, the token are swapped. If one user fails to send the token after a defined period of time the other user is able to reclaim the token. Regarding the fact that both token are securities, the smart contract must be in the possession of several licences because it is performing a financial service.

Next, let’s have a closer look at what a smart contract really is. At first sight, it seems that a smart contract is software developed, deployed and maintained by some entity. However, a smart contract really is a piece of software that runs on User A’s computer, on User B’s computer and on an arbitrary number of other computers. It has to be that way, because this is what makes the transactions secure and temper proof. Especially, it is not run by a dedicated entity that can be charged if it deploys a contract without having a proper licence. In some way it is just there. It is software that can be used by anyone that is aware of its existence.

As of today, it is therefore impossible for any government agency to do something about it. What are the possibilities for regulations then? Here are three of my favoured solutions to that problem:

Every smart contract is born free

There are indeed some good arguments for not regulating decentralised systems at all. It becomes clear if you compare decentralised and centralised systems. Let’s get back to our escrow example and replace the smart contract with an escrow company e.g. a bank. This company is really a black box for both users. You put in the token and have to trust the bank that it will do the things you want them to do — which means waiting for the token of User B to arrive and if they don’t, you want to get your token back (minus bank fees of course!). It is hard to trust the bank, right? And that is why we need rules that regulate them. This prevents banks for making choices you wouldn’t want them to do — at least most of the time. When using smart contracts instead, the situation is different. The code execution determines what will happen. Algorithms haven’t got a choice. If User B does not send her token to the contract during a specified period of time, User A gets back her token — no strings attached. There is less benefit which could be brought in by regulation.

However, the downside is that User A and User B have to understand what the contract code does. Certainly, that means they have to be able to read code which cannot be taken for granted (To be fair, I think all of us have difficulties to read legal contracts as well). But there are other ways to assure User A and User B that the contract does what it’s supposed to do.

Personhood for smart contracts

The arguments mentioned above take advantage of the fact that we as a society haven’t figured out on how to deal with the rights and obligations of technology that has some kind of human intelligence. But things are starting to get serious. The European union has made a first draft on how to deal with these things. One of the suggestions is to give robots or any kind of artificial intelligence a personhood status. Sure, smart contracts don’t employ any kind of artificial intelligence. However, the interesting thing here is that a piece of software is able to act on its won behalf. What that means for smart contracts is that despite the fact that there is no one operating the contracts, a court could shut down the contract or they could force contracts to change and comply with the rules.

Self-regulation and certificates

Considerations on personhood for smart contracts are fascinating but we are at least five years away from this becoming real. In addition, I don’t believe that letting decentralised system run free will do the society and economy any favour. Whereas this may be an accelerator for innovation, at some point, the people need security to fully adopt new technologies. That is way I think that self-regulation and certificates are the most practical and most likely way to facilitate a proper regulation.

So let me explain what I mean by that. To do so, let’s recall the pain that User A and User B had with the smart contract. They have to be able to read the code in order to fully understand what will happen if they send their token to the contract. This is comparable to you buying organic food. You could trace down the farmer and watch her for a day or two to make sure that she doesn’t use any pesticides. You wouldn’t do that every time, would you? You rather trust a certificate that ensures that this food is indeed organic. I believe this will work for smart contracts as well. Maybe it is even a new opportunity for banks to earn money from smart contract developers. Think of an escrow contract approved by Deutsche Bank for example. It may as well be that entities that approve contracts must apply for licences. Anyone would be free to use any smart contract out there if she is able to verify its function. But, those who need trust of a third party could easily rely on approved smart contracts.

Decentralised financial systems based on blockchain may just start to gain early adoption but this is the perfect time to start a discussion on the topic as we are able to experiment. So, if you have any suggestions feel free to comment or get in touch!

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