The Relationship Between Progress, Innovation, and Regulation
*NB None of the views expressed here are representative of New Finance Ventures or Mike Kelly. No mention of any app or protocol is an endorsement.
The past few weeks my articles have focused on regulation and UX, which overlap more than you’d think. This week is no different.
Naturally, when the conversation returns to regulation in the crypto space, things can get heated, quickly. This week on the New Finance Pod, we were lucky to have Xavier Lavayssière on the pod to discuss such topics with a cool head! For more of his insights go check out the pod here :)
An interesting point of conversation that came up a few times during the pod was how regulation affects innovation. Usually, these arguments are presented as simple- “regulation kills innovation!”.
The reality, as usual, is more complex.
The line of thinking is that people need absolute freedom and no restrictions to be able to innovate.
This is false.
People need constraints, even if they are self-imposed, otherwise, you have too many options and nothing gets done. Self-regulation or regulation can be helpful BUT it needs moderation. Too much is stifling and does restrict creativity. We need balance. Check out here from the Havard Business Review how constraints can be a positive for innovation or another great article here by Louis Shulman.
It is often assumed that regulators are inherently evil or are trying to restrict or block innovation. This is a mischaracterization and oversimplification. Are there people who seek to overreach or have nefarious motives, absolutely?
But I believe that most regulators think they are doing an important and meaningful job trying to protect consumers, control risk in financial markets and just generally make markets safer.
They do not always get it right, but this does not make them all evil.
What this does mean is we need to challenge assumptions and educate them on the technology, to help shape policy.
My view, perhaps unsurprisingly, is that balance is needed. For crypto to continue to grow and be adopted by the mainstream consumers will need to feel protected. Right now there is little that offers this feeling, I have discussed that here & here.
Whilst operations like Coinbase or FTX are regulated, outside of that you are operating in a grey area that is unrealistic to expect most of the population to feel comfortable with. The same issues apply for institutions. They have fiduciary responsibilities and regulatory uncertainty is not viewed as an opportunity but rather as a risk, especially for those who wish to stay employed. Yes, it is ass-covering, but that is the reality they are faced with.
Xavier also made a great point during the podcast, discussing a model of ‘the 4 quarters of crypto’:
- Full anarchist, alternative, opaque
- Crypto-related centralized exchanges
- Crypto as a backend like AAVE Ark, regulated version of existing defi protocols
- Private or permissioned blockchains
Whether you agree with the model or the definitions is beside the point for this discussion. Approaching this with realism, some of the sectors want regulation and the job is to try to engage with regulators so that what does inevitably come isn’t heavy-handed. MiCA is already here with implementation on the way. FATF has been issuing guidance on the space with feedback from the industry.
I read this from Yuri Kurat, he argues that regulation doesn’t hurt innovation. He also points to positive constraints unleashing creativity. He quotes from Fred Brooks’ ‘Mythical Man Month’:
There are many examples from other arts and crafts that lead one to believe that discipline is good for art. Indeed, an artist’s aphorism asserts, “Form is liberating.” The worst buildings are those whose budget was too great for the purposes to be served. Bach’s creative output hardly seems to have been squelched by the necessity of producing a limited-form cantata each week.
I agree with most of this. However, I think this misses a point about regulation that is often not discussed. It is not just the regulation that matters, but the penalties and incentives. Bach would not face jail for experimenting outside of what was considered a norm, but a CEO may face criminal penalties or bankruptcy if certain regulations aren’t followed.
A point to consider when shaping regulations or thinking about them is the penalties, allowing slack in the system for people to push boundaries with the understanding they may get a slap on the wrist but not the death penalty in cases is important. Regulations should be graded on a spectrum, the penalty for trying to create a new company structure like a DAO and arguably/accidentally issuing a security should not be the same as selling drugs yet to be approved by the FDA.
Equally on the incentives side, we have to try to avoid regulatory capture. This means that we don’t want the regulatory bodies only serving to protect the incumbents from challenges and protect the status quo. Banks, payment providers and other incumbents cannot be the only side participating in the shaping of crypto regulation or this is what we risk.
Ideally, we want lots of communication and good-faith discussions because a lot of regulations are legacy creations that are outdated. Both sides need to come to the table willing to discuss what they want to achieve and then trying to shape agreements and build towards that.
I have been thinking about power structures and regulation a lot more recently. Especially since reading the book Dominion by Tom Holland. It makes you realise how deep-rooted many beliefs are but also how outdated many things are that continue to shape our society.
Here is a great discussion with Kevin Werbach from Wharton on How to regulate innovation without killing it’. A quote I felt was especially relevant:
A lot of what we are seeing in these markets is the need for legislative change, for governments to change the structure of the rules, because the rules use terms that no longer make sense, or they have categories that no longer make sense.
With a proactive attitude and engagement, I would hope we can limit regulatory overreach not stifle innovation or creativity while still providing assurances to participants that they are covered and to government agencies that we as an industry are building and behaving in good faith.
It is clear to me that regulation is on the way in some shape or form. It is also clear to me that regulation done wrong does kill innovation, but when balanced we can create a safer place for people to create and participate. I believe this is part of our responsibility and role.
For more discussions follow Mike & I on twitter! :)
