m Blockchain Regulation Trends
- jimm1
Key Points
- Some interesting blockchain solutions have been listed under Candidate Solutions below
- There are multiple blockchain frameworks and platforms available
- Some target enterprise, permissioned blockchain requirements like Hyperledger
References
Key Groups
Capital Markets Regulations
https://wiki.hyperledger.org/display/CMSIG/CMSIG-Projects-Regulation
Key Regulation Concepts
Dr Thomas Dunser: New article about Decentralized Finance (DeFi) and Financial Market Regulation
https://medium.com/@tduenser/defi-and-financial-market-regulation-4ec8843619b8
dunser-DeFi and Financial Market Regulation.pdf link
dunser-DeFi and Financial Market Regulation.pdf file
- Article focuses on investor perspectives: choices, risk, protection.
- Other keys are: KYC, AML, OFAC sanctions, banking and insurance regulation compliance by jurisdiction
Here are our key findings:
- Decentralised Finance (DeFi) is an important financial market development with high innovation potential.
- The fundamental conditions and mechanisms of DeFi are entirely different from Centralised Finance (CeFi), which provide a new view and a new paradigm.
- Subordinating DeFi applications to financial market regulation designed for CeFi is neither sensible nor practical. DeFi applications must be clearly distinguished from the traditional financial market and the scope of its application.
- It is not sensible to regulate the technology nor the protocol layers.
It is to be expected that even in ideal DeFi-applications, intermediaries will be present to support and service users. DeFi regulation should primarily focus on regulating those service providers.
DeFi-regulation triggers two fundamental paradigm shifts in policy:
- We must improve the education of retail-investors about DeFi — and CeFi.
- We should change the paradigm from a 100% investors protection to a system of choice for the investors, whether they want to use the services of a regulated entity, a non-regulated entity or directly use a protocol.
Notes on article
regulators or supervisors are often faced with the choice of whether an application is regulated by an extensive interpretation of the scope or is otherwise not subject to any regulation at all.
global distribution, the multitude of potential users, and the lack of organisation (software instead of people) make applying centralised financial market regulation to DeFi practically impossible. ( or global regulations and compliance services required )
DeFi applications can harbor completely different types of risks and few are subsequently well addressed.
DeFi regulation: how financial market regulation has to change in order to achieve these goals: to effectively limit the risks and at the same time not hinder innovation?
Regulation - role vs rule basis ( opposite of security trends )
an innovation-open regulation in the DeFi environment must be functionally oriented or (even more granular) “role-based” and must not regulate a specific set of functions as a business model. Business model regulation is hostile to innovation. EU-MiCAR also follows a role-based approach
Rule-based regulation has lower risk of misinterpretation
Rule-based regulation thus also creates legal certainty for all participants in a mature and established system and cannot been seen as negative per se.
Rule-based systems limit innovation because of fast obsolescence with implementation specifications
Principles-based regulation is innovation friendly but less certain leaving legal authorities large room for interpretation ( see GDPR regs etc )
Innovation-friendly regulation must therefore be principles-based and, as far as possible, technology-neutral and needs processes based on the rule of law to give the authorities and market participants sufficient orientation as to how the principles are to be seen or applied in concrete applications
TVCN - Trusted VCN using VC creds and SSI
The DeFi application could thus refer to a combination of several DeFi licence holders and thus more easily gain the trust of users. This regulatory approach could, in principle, also be applied to semi-DeFi applications
DeFi supervision: In the case of central supervision of DeFi applications, a distinction must be made between the preventive and the reactive approach
there is no possibility for users of DeFi platforms in the typical setup to reduce their risks via service providers
<<jem DeFi DAOs have varying levels of credibility, governance and compliance with related regulations
<<jem how to define criticality and related governance activities that need to apply to a given app??
Open source consortiums best for specification, compliance reviews? see OWASP etc
The verification of software code and hidden risks probably works most efficiently with open-source software through the community. Therefore, one viable approach would also be for the users of a DeFi application to pay a particular contribution to the technical experts who take over the technical review of the code and the people involved.
<<jem conclusions
- the problems with current traditional regulatory governance of DeFi solutions is well defined
- the market segmentation on DeFi solutions and related risk models not well defined
- both traditional and DeFi solutions have many losses for investors but DeFi losses are relatively higher now
- the need for KYC, AML, OFAC regs is not addressed in the DeFi market
- DAOs vary clearly in governance, risks, penalties, enforcement, definition of rules
- RTE - Real Trust engineering needed for any DLT solution ( DeFi or not )
- q>>> is community governance adequate replacement for legal governments ? probably not
Comments on Dunser article
All governments require regulatory compliance and taxation of financial assets
Biden Executive Action: "same business, same risks, same rules" focus
Governance Concepts in Finance DLT
Missing in many private market offerings -
1> lean in to regulations
2> transparency
3> accountability
does a DAO implemented in smart contracts solve all of the issues on:
- economics
- privacy
- transparency
- compliance
- information asymmetry
- accountability
- guarantees
- recovery
- resilience
- control
- consent
- communication
- operations management
- migrations
- maintenance
Utah Act on DAO support
https://cointelegraph.com/news/dao-gets-legal-recognition-in-the-us-as-the-utah-dao-act-passes
Regulation Jurisdiction Concepts for Blockchain
On Arrogance and Drunkenness - A Primer on International Jurisdiction and the Blockchain
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4234569
DLT considerations: on trust, “arrogance” and “drunkenness”.
whenever decision making power is concentrated in one or even several central entities, the latter tend to display what Cavafy called “arrogance and drunkenness”
blockchain based networks make a very interesting argument about replacing human controlled systems with code-based decentralized governance.
intermediated trust: instead of concentrating power and decision making status to one single entity, intermediated trust systems accept that this duty can be shared between governments and private stakeholders ( governments, banks, etc )
blockchain promises a new version of trust, one that will remove intermediaries from the crucial positions of power and will replace them with code based decentralised governance options
blockchain is an accurate, tamper-resistant record keeper providing higher levels of trust than traditional data solutions
Blockchain governance is designed to be resistant to power centralization and promote disintermediated architectures
Each full Node has it’s own copy of the Master ledger
Validating nodes for the transaction will decide if it is a valid transaction
Transactions may be ordered into blocks
Block is broadcast to all nodes for ledger update
Nodes reach consensus on the current ledger state using a consensus protocol ( POS, POA etc )
Legal jurisdiction of blockchain activities
the endeavor to allocate international jurisdiction according to the Brussels Ia Regulation would be futile, if the unique set of characteristics of the technology are not adequately factored in.
considered crucial for the problem of allocating jurisdiction are the following: decentralisation, immutability, transactional anonymity, enhanced peer to peer incentives and high level of automation
decentralization - decision on transaction validity and ledger consensus is done across the network, not in a single location
immutability - low risk of corruption bu not guaranteed - can the consensus code be trusted?
q>>> can a governing body set rules for the blockchain to enforce on transaction execution? yes
privacy - transaction anonymity - public keys
- sender, receiver both get wallets and related pki keys from a wallet provider service
- sender gets receiver's wallet address public key
- sender creates transaction to transfer tokens to receiver wallet address and signs with his private key
- sender sends public key to receiver
- receiver wallet receives signed tokens from sender
- receiver uses sender public key to access tokens in the wallet
issues
- keys are assigned by wallet intermediaries normally
- public keys are potentially mappable to PII data using wallet providers or other intermediaries
privacy is not an absolute right in blockchain or anywhere else legally
privacy and anonymity are not absolute rights and/or values. They are highly contextual. They must be protected when they serve widely acceptable purposes, but can be, partially and temporarily, suspended when serving malicious actions.
MICA regulation of identities
Markets in Cryptoassets Regulation 76 , is the obligation of blockchain based service providers and a number of other important key stakeholders to register and reveal their identities.
blockchain based transactions is that they incentivize peer to peer communication and exchange
Web 2.0 has the platform as the intermediary at all times ( eg Amazon etc )
Automation - blockchain transactions benefit from a high level of automation
blockchain based transactions to be safeguarded by the deterministic deployment of code
global event management across blockchains is a key for transaction automation << no accepted standards defined yet in blockchain
Escrow services enforced by HTLC - Hash time lock contracts in many cases
That means that if A wants to acquire a blockchain based asset from B, the payment of the asset price from A, usually in some form of cryptocurrency, will be withheld by the smart contract itself (instead of a human intermediary) and will only be transferred to B, after it is cleared that the promised asset from B to A is available and can be transferred to A as promised.
Automation distinct advantages: they make transactions quicker, simpler, and more efficient, while they provide less incentive for non compliance with contractual terms
Automation can produce bad results based on incorrect logic in smart contracts, fraud risks or data quality problems - issues need to be addressed and effective remediation processes put in place
Arbitration and mediation processes need real legal standards, effective oversight - not automated chat bots
One could, of course, argue that smart contracts will lose in attractiveness if their execution either depends or is conditioned by the interference of state courts. The truth here, though, might lie in the approach: the interference of state courts in blockchain based transactions can be measured, in order to be effective
Decentralization can be a challenge for jurisdiction
While it has been argued above that blockchains are not as decentralised as they are usually considered to be, the implementation of court decisions might still be undermined by the existing levels of decentralisation. The question is which node or organization initiated the transaction in question - that can be determined.
Establishing real identity of blockchain transactions
strong pseudonymisation of blockchain based transactions can make the identification of the counterparty difficult and expensive, despite the existence of capable blockchain forensics tools.
What is impact of P2P on B2C transactions?
a digital economy that is focused on platform to consumer litigation and vice versa, but not on peer to peer, i.e. consumer to consumer, transactions.
NFTs
Web3 - management of digital value ( vs Web2 management of information )
focus is on n the creation, management and exchange of digital value. To put it in other words, blockchain based applications put an emphasis on the creation of proprietary rights over digital assets, something that is clearly different than the current digital ecosystem.
Tokens can represent real or virtual assets, fungible or non-fungible assets
NFTs identify unique non-fungible assets ( painting, a signed baseball, share of a house etc )
ERC-721 and ERC-1155 allow an NFT to link to the specific underlying asset
utility tokens - eg ptokens, reward tokens etc
NFTs - investment or utility tokens?
If NFTs are deemed to be investment vehicles, then their issuers shall comply with the relevant EU legal regime, most importantly the prospectus regulation 84 , while the acquirers of NFTs will be deemed to be investors from a legal point of view. In that case, the jurisdictional issues will be identical to those inherent in securities tokens, for which there is already a growing number of academic contributions 85 . On the contrary, if NFTs are classified as utility tokens, then they will be regulated by existing EU Internet law
NFT links to the real asset using an IPFS or other link
variety of marketplace models for selling, trading NFTs sold by the NFT creators
q>> what trusts are in place for NFT creators, marketplaces, platforms and buyers?
NFTs defined by the terms and conditions of NFT marketplaces reveals that many of them employ either arbitration or jurisdictional agreements.
Absent any such jurisdictional agreements, the dispute shall be adjudicated at the domicile of the defendant
Evaluating P2P NFT transactions
In order to assess the legal situation on peer to peer NFT transactions, one will have to look into the original relationship and rights granted between the NFT creator/provider and the first acquirer
NFT copyright infringement and NFT hacks
Despite the undeniable importance of NFT related copyright violations, this paper will only explore the problems associated with NFT hacks.
Victims of NFT hacks shall be offered the ability to challenge the outcome of the hacking before a court and negate its consequences. But this is something easier said than done.
What kind of remedy shall be made available for the persons acquiring NFTs when their digital assets are getting hacked?
UK courts: NFT hacks can be granted procedural remedies that are usually available for the protection property rights
Blockchains are not free of regulation
claims of blockchain ecosystems being some kind of self sovereign environments, that are completely free from any state regulatory and state court intervention must be rejected as utopian, especially with regard to the protection of EU fundamental rights in these new digital spaces.
EU concepts on jurisdiction for disputes, transactions
The general principle of the Regulation is that individuals should only be sued in their member state of domicile. Domicile under the Regulation is not equivalent to the common law doctrine of domicile, but rather refers to a person's habitual or ordinary residence.
Article 2(2) of the Regulation embodies the "principle of equality of treatment"[3] by stating that 'persons who are not nationals of the Member State in which they are domiciled shall be governed by the rules of jurisdiction applicable to nationals of that State'.
ICMA Finech Roadmap - 2023 5 years
US SEC Approves Crypto first 11 Spot ETFs for trading
https://finance.yahoo.com/video/sec-approves-11-spot-bitcoin-225728340.html
The US Securities and Exchange commission approved eleven spot bitcoin ETFs after the market close on Wednesday. Coinbase (COIN) will serve as the custodian for a majority of the issuers that were approved.
Key Takeaways on SEC approval of crypto ETFs
- regulated crypto investments will have greater adoption since they meet stricter investment policy requirements for many funds
- regulated 3rd party qualified custodians will become the primary store for digital assets just as they are for existing financial assets
- personal digital wallets will always exist, need great security, backup and recovery capabilities but will not be the primary store for digital assets
Key Concepts
How blockchain can impact Financial Services
"Any financial operation that has low transparency and limited traceability is vulnerable to disruption by blockchain applications.” –Bruce Weber and Andrew Novocin
https://knowledge.wharton.upenn.edu/article/blockchain-will-impact-financial-sector/
Centralized solutions may migrate to decentralized given trust, compliance
Hosanagar expects the first wave of applications to be rolled out in “private” blockchains where a central authority such as a financial institution and its partners are the only ones with the permission to participate (as opposed to public, permissionless blockchains where participants are anonymous and there is no central authority). Applications in the private blockchains, he said, will be more secure and will offer some of the benefits of decentralized ledgers but will not be radically different from the way things work at present. However, over time, he expects smart contracts (self-executing contracts when requirements are met) to be offered on public blockchain networks like Ethereum. “When securities are traded, intermediaries provide trust, and they charge commissions. Blockchains can help provide such trust in a low-cost manner. But trade of securities is governed by securities laws. Smart contracts offer a way to ensure compliance with the laws. They have great potential because of their ability to reduce costs while being compliant,” says Hosanagar.
Werbach - Important technologies, he said, are far more likely to be integrated into the system than replace it. According to Werbach, while some firms will fail to make the transition and some new ones will take hold, “over the long-run, virtually every historic innovation that eliminated some forms of intermediation also created new forms.
Reduces friction and improves efficiency in financial systems
when a syndicate of lenders participates in a loan, having one shared ledger means they don’t all need to keep track of it independently. International payments and corporate stock records are other examples where there are huge inefficiencies due to duplicate record-keeping and intermediaries. “End users won’t see the changes in the deep plumbing of financial services, but it will allow new service providers to emerge and new products to be offered,” said Werbach.
Sharing governance strategies in new ecosystems first
“Distributed organizations serving an open community need to take care to design their governance systems, incentive structures and decision-making processes to create consensus without unduly slowing down the decision-making,” said Weber and Novocin. “Scenario planning or war gaming are worth exploring at the beginning of blockchain projects. Forward planning enables organizations to swiftly respond in a predictable way that is supportive of stakeholders. Publicizing these plans in advance can also build trust and user confidence.”
Cryptocurrency Risks to date exist
Bitcoin has shown that the fundamental security of its proof-of-work system is sound, but it has major limitations such as limited scalability, massive energy usage and concentration of mining pools. There has been massive theft of cryptocurrencies from the centralized intermediaries that most people use to hold it, and massive fraud by promoters of initial coin offerings and other schemes. Manipulation is widespread on lightly-regulated cryptocurrency exchanges.
Currency regulation and governance
There must be recognition among cryptocurrency proponents that maturation of the industry will require cooperation in many cases with incumbents and regulators,” added Werbach.
It's clear, cryptocurrencies ( where they are legal ) need to comply with KYC, AML and other financial regulations. Blockchain should make that governance simpler and lower cost.
Blockchain continues to evolve
Weber and Novocin expect that in the next few years, many more businesses will implement private blockchains to improve the transparency and traceability of their financial operations, supply chains, inventory management systems and other internal business systems. Clearer standards will be adopted and a few high-profile projects will emerge. Meanwhile, they said, R&D will continue among the many decentralized blockchain projects to invent more scalable public ledgers
Potential Value Opportunities
Potential Challenges
Candidate Solutions
Step-by-step guide for Example
sample code block