Decentralization, a Battleground in the Regulation of Crypto
Most people reading this will probably agree that Bitcoin is valuable. In theory, Bitcoin’s value derives at least partially from the fact that it doesn’t allow the state or financial institutions to easily control it or seize it. This use case for Bitcoin has gained increased attention lately in the light of recent global events including fears of another deep economic recession. However, the idea that Bitcoin, cryptocurrencies and decentralized finance protocols are beyond centralized control needs to be investigated more closely. With Governments globally taking steps towards regulation of the crypto asset class, there is more need than ever to understand what is at stake in the battleground between radical decentralization and a more centralized regulatory-compliant crypto market.
Decentralization — The Central Idea of Cryptocurrency
The central idea of Bitcoin is that it enables the act of exchanging a digital asset freely and remotely peer-to-peer on an ‘immutable’ and decentralized ledger. This very idea could arguably be seen as dangerously radical and at odds with the entire centralized state apparatus and financial system. In fact, until recently most politicians and traditional finance industry players did regularly argue exactly that.
Many early cryptocurrency ‘purists’ such as the pseudonymous creator/s Satoshi Nakamoto saw the need for this technology exactly because of these characteristics. To these pioneers, the whole idea of Bitcoin was to develop a new peer-to-peer system for payments, transactions and store of value outside of the current financial system. The idea was to avoid the concentrations of wealth and power of the traditional financial system which was seen as within the control of Governments that are not acting in the best interests of ordinary citizens.
Building on this idea, came the decentralized finance movement based at first on Ethereum, but quickly spreading to a number of other smart-contract enabled blockchains. Ethereum is an (arguably) relatively decentralized protocol, and is seen by many advocates as furthering this mission by enabling small-scale financial innovation. It does this through the decentralization of the financing of, and sharing in the benefits of, economic activity. A number of de-fi applications have been built on this base, which enable users to collectively create, fund and share revenues from real-world and digital businesses.
The latest evolution of this mission can be seen in the explosion of Decentralized Autonomous organizations or (DAOs). DAOs utilize smart contract blockchains to enable a community, collective, group, or organization which has banded together to work without barriers or bureaucracy towards the progress of a common goal. Common uses so far include co-governing a web protocol/app, creating and managing investment opportunities, performing activism or advocacy within a particular field, or producing/managing Media or creative content.
Decentralized Exchanges — the final Frontier?
A potentially explosive use of the DAO structure is as a vehicle for governing defi protocols, or even fully decentralized exchanges. This use case is emerging because despite its decentralized origins, today, statistically almost all of Bitcoin transactions happen on centralized exchanges (Coinbase, Binance etc). In such transactions, the hosting exchange acts as a third party custodian — meaning the user doesn’t actually hold the BTC on their exchange balance, but rather a credit to that amount that can be withdrawn to fiat or a suitable crypto wallet.
It wasn’t always this way, a few years ago, before regulations restricting cryptocurrency exchanges and transactions were loosened in most jurisdictions, the only way to buy bitcoin for many was through peer to peer sites which involved significant risk to users. Short of using LocalBitcoins again, in reality there are few easy ways to exchange fiat currency for cryptocurrency today or to use your crypto for real world purchases. This currently requires off and on ramps from fiat currency via the legacy banking system.
To many cryptocurrency purists this is one of Bitcoin’s few weaknesses and potential attack vectors. As we have seen recently, centralized exchanges and wallet providers can be forced by governments to comply with certain requirements, including handing over information on customers or even freezing accounts when required to do so. Most cryptocurrency advocates now accept this tradeoff of greater convenience, security and liquidity in exchange for limited ownership rights and limited privacy as a necessity and an important way to encourage new people to get into the asset class.
However, others see this tradeoff of financial privacy as contrary to the pure ‘permissionless’ and decentralized intentions of bitcoin and cryptocurrency, and many are suspicious of the intentions of crypto regulation. Decentralized exchanges such as Uniswap and OneInch running on the Ethereum blockchain have emerged as an alternative to centralized exchanges over recent years that use self-custody wallets such as metamask. It is clear this issue will emerge as a key battleground issue in the coming efforts by governments and citizens to collectively determine the best form of regulation for the industry and asset class.
Limits to Decentralization?
Crypto industry insiders have given much consideration to whether stricter centralization through regulation of the crypto sector is a good thing for the industry. Many believe that more centralized regulation will be positive, as it will provide much needed clarity and legitimacy and protect consumers. It is thought this will lead to mass adoption of the technology as people feel more secure and in that way achieve many of the impacts that blockchain offers such as increasing efficiency and innovation.
For example, StandardDAO advisor Steven Forte — an early Bitcoin investor and Managing Partner of VC fund Fresco Capital takes a pragmatic view of the regulation issue:
“As a lover of decentralization, one has to realize that we live in a centralized world. So compromises have to be made. We live in nations with centralized governments and those nations have costs and benefits of being a citizen, however, we have to adhere to their rules in order to reap the benefits. While the rules for KYC/ALM are harsh for smaller financial institutions, I understand why they exist, and would rather a more pragmatic, less restrictive regulation, vs no regulation. We benefit from the rules — since the United States and Europe have strong property laws, national security, and aligned foreign policy.”
From an analysis of crypto twitter and the media it seems that this view favoring some form of regulation is likely held by the majority in the sector. However, there is certainly some fear even within this more compliant segment of the sector regarding the exact nature of regulations and how they might impact the nascent industry.
Decentralizing Sensitive Infrastructure
Some radical decentralization advocates, on the other hand, believe that a more decentralized crypto sector can avoid such limitations on privacy and ownership rights by hosting decentralized exchanges and other sensitive De-fi protocols as decentralized digital public goods. One way to achieve this is through fully decentralized DAOs (as opposed to legally constituted DAOs via the laws of a jurisdiction).
For example, Erik Voorhees, a self-described libertarian and founder of the Shapeshift exchange, announced in 2021 that the company owning the exchange would be closed immediately and the exchange placed in the control of a DAO owned by all users of the protocol (but without any formal legal incorporation as a DAO). The company did this by announcing it would “Open source all ShapeShift code and infrastructure” and airdropping a DAO governance token to all existing users.
There is no way Bitcoin would have been able to do what it does if it was centralized. It would have been shut down in 2010. It is providing a service which is essentially illegal: the transmission of money without following the rules of money transmission. Why is it still in existence? Because it’s decentralized. It’s not immune to regulation, it’s not immune to coercion.. but it is such a better defensive mechanism that governments as powerful as they are have not been able to shut it down. This is the path. This path of decentralizing sensitive systems is the primary lesson to learn from bitcoin and that’s what we are trying to humbly apply into Shapeshift…
Voorhees, also points out that even if governments did seek to shut down decentralized protocols, their distributed and decentralized nature means this may be difficult to achieve:
..One of the ramifications of Ethereum and the Ethereum smart contracting language is people have built decentralized exchanges and these things work at scale. These things work on the billions-of-dollars-per-day scale. Open source, immutable and no one can stop them. You can’t turn them off. If someone tries to fork the code, someone could take the code and make another one, the switch is turned back on again. These are machines that people have no conception of how powerful they are. These are financial tools that are immutable…
..Uniswap as a protocol exists on Ethereum. It’s a set of smart contracts and then there’s a Uniswap company, Uniswap Labs.. with an office in Brooklyn like right in the heart of Mordor. So what would happen in an adversarial situation which we all know is coming right … The government against Uniswap? They can absolutely shut down, imprison, fine, make life horrible for people at Uniswap company — close their office, raid all their assets, sure they could shut down Uniswap labs 100%. So even if some government entities figured out how to stop the Uniswap contracts and I don’t know if that’s even technically doable, they can be forked into 10 or 100 others by copying and pasting. So the function of decentralized exchange cannot be turned off.”
In most cases, DAOs are compliant with all laws and are in fact legally incorporated in either the USA, or another jurisdiction as a Limited Liability company or as a foundation (or some combination of the two). However, in the case of a fully decentralized Defi DAO structure (like Shapeshift) things may get murkier. There is no corporation to sue, no address to mail a letter to, and no founder to threaten with criminal proceedings. Such decentralized DAOs operating in the Defi space can be entirely anonymous or at least pseudo-anonymous which effectively disables any known tool the government has to regulate them, as the law in the USA currently stands. Any change to the law to enable prosecution of a fully decentralized protocol without a clear legal persona behind it would potentially take an immense amount of effort on behalf of the government agencies involved, as well as technological intervention.
As Voorhees points out, there are likely other ways for the Government to make life difficult for decentralized protocols, (or the people behind them). Measures could include blocking consumers from accessing them at the third-party-level by making orders requiring Internet Service Providers to block their users from certain websites. It could also be by order requiring third parties to identify the people involved in the protocol. Another avenue through which governments are likely to attempt to block such defi activity would be in preventing funds from being transferred from ‘unlawful’ accounts into fiat currency at a banking system level.
It is unclear how such decentralized exchanges such as Shapeshift believe they will avoid restrictions placed on their activities at the banking or ISP level if regulators target them. Without fiat onramps, it seems likely they will struggle to provide a useful service to most customers.
File Sharing: A Case Study in Regulating Decentralized Protocols
Decentralized P2P file-sharing protocols are a possibly useful case to look at for guidance. These have been regulation-resistant for quite some time despite many laws and court rulings against the technology globally. Leading protocol The Pirate Bay was launched September 15th 2003, (even before YouTube) and it still functions in an open-sourced and very abstract way. Endless proxies of it exist to this day. As many proxies as it has, there are even more copycats and copies of copycats of varying efficiency and niche. We now see this peer-to-peer tech adopted into blockchain technology.
Although it may be difficult to shut down open-source code, it does not mean that governments will let non-compliant defi protocols and the people involved in them slide. Many past cases show that prosecutors will go to great lengths in order to make an example to others in the space and to chill activity of a certain undesirable nature. In fact The Pirate Bay founders were sentenced to prison in Sweden in 2014 for copyright violation. The strategy of ordering ISPs to block sites or identify The Pirate Bay’s users has also been attempted to limited success.
The Bottom Line:
Leaving aside the moral judgment issues on radical decentralization, legally and technologically, it may be an energy and time-consuming battle for governments to actually shut decentralized protocols down. Many in the web 3 space strongly believe the technology being pioneered by Defi increases efficiency, and enables the inclusion of ordinary citizens in the benefits of the economy previously denied to them. However, it is yet to be seen if the Government and courts will take this view, or will begin targeting decentralized protocols given their lack of ability to control and surveil market activity. These debates, and competing forces will likely play a big part in the future course of crypto regulation.
Part 2 of this series will discuss the legal arguments for and against decentralized protocols in more detail.
[THIS IS NOT LEGAL OR FINANCIAL ADVICE]
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