Effective Crypto Regulation Starts At Layer 1
February 9, 2023
Take a moment to empathize with cryptocurrency regulators. We’ve tasked them with managing a constantly morphing ecosystem that is both plagued by lawlessness and built atop blockchain technology that thwarts outside control. The effort required to identify and apprehend pseudonymous criminals makes enforcement impracticable for most blockchain crimes, and no amount of effort can stop an automated decentralized autonomous organization like Tornado Cash.
As a result, regulators are relegated primarily to know-your-customer processes via fiat on-/offramps to accomplish enforcement. In a decentralized, permissionless environment, relying on KYC alone is like attempting to tame the ocean by damming a few rivers. Effective regulation requires the full capabilities of law enforcement to protect property rights, remedy breaches of contract, and intervene to stop crimes in progress.
Such capabilities are available through layer 1 protocols that enforce the law on-chain. Such protocols obviate the need to seize private keys from pseudonymous criminals by enabling direct action on wallets and smart contracts. Officials invoke these protocols by obtaining a court order, just as they would for off-chain enforcement. For example, the US Treasury could shut down Tornado Cash by demonstrating cause to enjoin its smart contracts, or could seize assets by obtaining a warrant.
On-chain enforcement was unthinkable to most even a year ago but, having endured weekly hacks for hundreds of millions of dollars and frauds for tens of billions more, the blockchain community is ready to embrace it. Most market participants not only acknowledge the need for effective law enforcement but are demanding it. Many see on-chain enforcement as the best hope to thaw the crypto winter and establish blockchain as the backbone of mainstream commerce and the decentralized internet.
Adoption is already underway. Bitcoin SV (a top-50 blockchain proclaiming dedication to ‘Satoshi’s vision’) recently implemented a protocol for blockchain authorities to enforce court-ordered transfers of BSV coins. The community hopes this development ingratiates it with regulators and diverts users from legacy bitcoin. Similarly, Jurat’s layer 1 protocol enables consensus about the meaning of court orders so that nodes can execute them autonomously. The premise for on-chain enforcement is strong. More blockchains will follow.
There are several objections to on-chain enforcement, but none should give regulators pause.
First is the fear that tyrannical officials will seize digital assets. It is worth noting that those expressing this concern also own houses, cars, and bank accounts, all of which the government leaves alone. Due process is an excellent protector of property rights, so limiting on-chain enforcement to valid court orders will keep digital property as sacrosanct as physical.
Potential for abuse by intermediaries is a second objection, but an exaggerated one. Bitcoin SV chooses trusted ‘notaries’ (assumedly solicitors) to interpret and publish court orders to the network. Jurat, by contrast, eliminates intermediaries by generating machine-readable hashes for judges to include in their docketed orders.
Third is concerns about ledger immutability. These misunderstand the on-chain enforcement process. Courts do not rewrite ledgers. Rather, they enforce the law through a new remedial transaction that changes the effect of a prior (illegal) one. They do not alter the ledger itself.
Regulators have multiple paths forward. Mandating minimum enforcement standards is one, but the multijurisdictional nature of public blockchains makes this impracticable. A second option is to do nothing. Self interest should drive adoption given that property becomes more valuable as legal protections are strengthened. A third is for influential agencies like the US Treasury and the Securities Exchange Commission to offer a regulatory sandbox when providers use blockchains with on-chain enforcement. The move is justified because oversight is reduced when private actors can enforce legal rights (think of shareholder suits for fraud). This approach will also hasten legal protections on-chain – the ultimate goal for any regulatory scheme.