Robin Capital

When Technology Outpaces Regulation

The development of blockchain technology can be divided into three eras, each presenting their own challenges with current regulation. The peer-to-peer era (with Bitcoin), the programmability era (with Ethereum) and the decentralised organisation era (with DAOs).

P2P Payment Era

A new digital peer-to-peer (p2p) payment system was introduced in 2008 with the launch of Bitcoin. This allowed people anywhere in the world to send, receive, and trade value instantly over the internet without using a third party.

The key regulatory issue with p2p payment systems is that it enables pseudonymous value transfer by circumventing the use of financial middlemen who, traditionally, are the parties subject to regulation. Financial middlemen, such as banks, are responsible for identifying their customers (KYC), in order to combat money laundering and the financing of illicit activities (AML).

Regulators globally have addressed this problem by enforcing KYC & AML standards on exchanges that serve as fiat on- and off-ramps into cryptocurrencies.

In the US, the Financial Crimes Enforcement Network (FinCEN) is the primary federal regulator responsible for enforcing the Bank Secrecy Act (BSA)[1]. FinCENinterpretscertain cryptocurrency businesses as money transmitters. Money transmitters are required to comply with the BSA and are obliged to assist the government by implementing anti-money laundering programs.

In the EU, the primary regulation concerning digital value transfer is the fifth Anti-Money Laundering Directive (AMLD5) that sets minimum KYC&AMLrequirementsfor wallet providers and cryptocurrency exchanges. EU member states are obliged to implement the revised directive into their national laws by January 20th, 2020. In June this year, The Financial Action Task Force (FATF) published itsfinal guidance, posing similar requirements to cryptocurrency service providers.

The Silk Road marketplace is still considered ahallmark casein illicit peer-to-peer payment activity. Silk Road enabled the buying and selling of illegal drugs (and other items) using Bitcoin. Bitcoin’s blockchain, which is a publicly verifiable ledger of transactions, allowed federal investigators to tie transaction activity to the operators of the marketplace. Interestingly, this also led to the indictment of two federal agents working on the case, who attempted to steal bitcoins from the marketplace during their investigation.

Programmability Era

Ethereum’s launch in 2015 made blockchains programmable, thus enabling more complex financial transactions than simple peer-to-peer payments. One consequence of programmability was that projects could easily launch their own cryptoasset and utilise it for fundraising purposes.

By launching cryptoassets to the public, anyone could participate in a non-regulated offering of an unclassified asset (ICO). Public investors bought into these offerings with the intent to benefit from future value increase of the cryptoasset - causing a potential clash with securities regulation.

The key question for regulators is to assess whether a given cryptoasset is classified as a security or not. The legal framework for this assessment varies depending on the jurisdiction.

US regulators interpret the term ”security” broadly by applying a framework called the “Howey Test”, which originates from a Supreme Court’s decision in 1946 (SEC v. W. J. Howey Co). The Howey Test focuses on whether the asset has been bought with the intention of making profit, and to what extent the eventual profit derives from someone else’s efforts. Using the Howey test, the Securities and Exchange Commission (SEC) has broughtlawsuitsand reachedsettlementswith several industry participants, and issuedstatementsabout illegal securities offerings.

The approach in the EU is more restrained and based on interpreting the term “transferable security” under the amended Markets in Financial Industry Directive (MiFID II). This assessment examines the aspect of “negotiability” and “transferability” of the token on secondary markets. The classification as a security under MiFID II triggers a full array of other EU financial markets regulation. In January this year, the European Securities and Markets Authority (ESMA) released itsadviceon the offering of cryptoassets.

As a blockchain project scales, it shifts from being operated by a corporation or an entity, to being operated by a global online-community. This shift, from local to global, means that the ties to any identifiable jurisdiction (or person/entity) disappear. This is a major challenge for enforcing any kind of regulation.

Decentralised Organisation Era

Cryptoassets represent ownership rights in blockchain projects. These rights can include voting, working, dividends etc. In many cases, they share many characteristics with shares and/options of traditional companies. Blockchain projects are Internet-native companies, run by online-communities, where the rules of operating the company are programmed into the blockchain. These software-based “companies” are often referred to asdecentralised autonomous organisations(DAOs).

DAOs are maintained by participants around the world and are capable of facilitating financial activity. Businesses can be created on the internet without any foothold or jurisdiction in the “physical world” (e.g. Delaware or Finland). Traditional means of regulation are unlikely to be effective due to challenges in enforceability[2], as participants are globally distributed and possibly unidentifiable.

Self-regulation and “whitelisting”[3] are likely the best solutions for bringing safety to market participants within the blockchain industry. TheVirtual Commodity Association(VCA) andGlobal Digital Finance(GDF) are examples of self-regulatory organisations that have taken concrete steps to industry-wide standards and best practices. Companies likeMessariprovide public databases for sharing information that is often disclosed by traditional companies, with the aim to create disclosure standards. Globally enforceable rules can be encoded directly into the blockchain — from anywhere and by anyone — which means that traditional means of top-down regulation will eventually need to adjust for the bottom-up-based rules of the digital world.

Corporate governance can be automatically enforced in DAOs as the rules are programmed into a blockchain. This means that participants, who are stakeholders of the DAO, do not need to know or trust each other. An example of a blockchain-based tool for building DAOs isAragon, which has been used to create hundreds of Internet-native organisations to date. DAOs allow for experimentation in how to organise human activity on a global scale.

On the Aragon platform businesses can be incorporated without friction (time & cost) from anywhere in the world.

Companies can set up their corporate governance policies and manage day-to-day business operations.