On regulating the web3 future and Onchain vs Decentralisation.

Allow me to paint a picture of how different the conversation about crypto regulation would be if the predominant use of crypto assets was driven by utility rather than speculation. Although I fully understand this is a hypothetical scenario, for now, I strongly believe that the future of web3 is utilitarian for society as a whole. Therefore, we should consider decisions, rules and frameworks that catalyse this utilitarian web3 future instead of hamper its development.

Role of Regulators

Blockchain technology enables regulators to execute their mandate more efficiently, with productive approaches aiming to safeguard economic stability and consumer confidence, while not obstructing innovation. Due to the unprecedented transparency and integrity brought by the data generated by the blockchain, regulators can now gain oversight through real-time data showing the state of the web3 economy. Furthermore, this oversight also offers deep insight into the way in which the economic actors behave, meaning that regulators are able to target bad actors at scale and with high degrees of accuracy. As long as regulators know the identity of the economic agents, I believe that additional regulation on top of the standard consumer non-financial regulation is unnecessary to achieve economic stability as a whole. In addition, the term risk must be properly defined in order for regulation to achieve its objectives. The risk I believe regulators should focus on is that of systemic institutional risk and that large numbers of retail consumers hold a high weight of a specific crypto asset in their portfolios. Note that is true for all volatile assets, not just crypto. I do not believe that the market cap of a specific crypto asset should be the main variable measuring the potential of this risk. Rather, a measure that describes the way in which the crypto asset is being adopted by the wider economy is more important.

To be clear, I do not believe that licensing is necessary, unless the crypto asset is a financial product or security as defined below. I think that oversight of crypto assets and wallets that are owned by consumers within specific jurisdictions is enough and anything else has a strong potential to impede innovation.

Definitions

Regulators and traditional policy makes readily uses terms like centralisation, decentralisation, custody and exchange without explicit definition. I contend that the execution of the outcome of any decisions made with regards to regulation strongly depends on the definition of these terms or the use of alternative terms that are more relevant. As with the design of any complex system, the devil is in the detail.

Furthermore, I would like to propose that crypto assets are financial products or securities if and only if:

• The crypto asset is a token, whether fungible or non-fungible, that is linked to a smart contract or a set of smart contracts where the balance of these smart contracts is not fully controlled by owners of the crypto asset through an on-chain voting mechanism but instead is controlled by another person or distinct group of people to which the crypto asset owner is not part of;
• Or the crypto asset is linked to an off-chain financial product or off-chain security.

On the one hand, the certain regulators loosely define custody of a crypto asset as an entity having control of private keys while at the same time they aim for a technology agnostic approach. All blockchains are not dependent on private keys due to recent technological advances, therefore, as stated above, the concept of custody should refer to the technological ability of another person other than the owner of the crypto asset to execute transactions that transfer the asset to a digital location outside of the control of the original owner.

Classifications

Regarding the classification of crypto assets, my view is that this is not a constructive exercise during the pursuit of regulating the web3 space apart from the categorisation of the crypto asset either being a financial product / security, as defined above, or not. Part of the reasoning for this view is that I do not believe that additional regulation of activities related to non-financial products / securities is required, therefore the classification is unnecessary. Furthermore, the web3 space is too nascent in terms of utility for anyone to create a classification system that can withstand the rapid advancement of this space.

Although much of the general conversation about regulation focuses on “centralised” businesses that also provide certain crypto related services, all businesses can be configured as combinations of centralised and decentralised workflows therefore, trying to categorise any business as “centralised / decentralised” is both misleading and counterproductive. The concepts of centralisation / decentralisation are ambiguous at best and I propose that the discriminator should be the concept of on-chain v.s. off-chain. The reason for the use of on/off-chain vs de/centralisation is that the former is clearly defined while the latter is not. Additionally, on-chain processes are transparent, immutable, unambiguously defined and trustless while off-chain processes are not. Trustless processes do not require the same type of regulation as actions or products that rely on the trust in human action.

I would like to point out that certain regulators references the concept of a centralised crypto exchange and define them as entities that hold custody of crypto assets, have order books and make markets on these crypto assets. My view is that this definition is incorrect. Apart from the use of the word centralised, an exchange of any nature only offers the ability to settle transactions and in some cases offer orderbook functionality. Market makers use exchanges to offer bid and offer spreads, i.e. making markets on selected assets which offers liquidity to the market. I believe that instead of using the term centralised crypto exchanges to describe the umbrella term of exchange / custody / market maker, a more suitable term would be Off-chain Crypto Markets where the term “off-chain” is applied if the marketplace has any workflow that executes off-chain. If an Off-chain Crypto Market for example offers non-self custodial services, I do believe that regulatory requirements should apply.

Finally, I feel the need to highlight the importance in understanding that centralised and decentralised notions of a business, as previously mentioned, are ambiguous and multi-faceted concepts that relate to various aspects of a business. This is due to the fact that businesses are aggregations of workflows, either automated on-chain, automated off-chain or executed by humans. Therefore, I strongly believe that any regulatory oversight should not focus on entire businesses but instead on the off-chain workflows within a business when dealing with crypto assets that are financial products / securities or offer custody services.