DIGITAL ASSET REGULATION: PEERING INTO THE PAST, PEERING INTO THE FUTURE.

• Author: Werbach, Kevin

TABLE OF CONTENTS

Introduction 1254 I. Risks of Digital Asset Markets 1256 II. Digital Asset Regulation 1268 A. The Regulatory Landscape 1268 B. U.S. Regulatory Activity 1271 C. Global Regulatory Environment 1274 D. The DeFi Challenge 1278 III. Learning from the Past 1281 A. The Clinton-Gore E-Commerce Framework 1281 B. Peer-to-Peer File Sharing 1285 IV. Recommendations 1290 A. Capacity Building 1291 B. Short Term: Low-Hanging Fruit 1293 C. Rethinking Financial Regulation 1296 D. DeFi and Regulating Decentralized Systems 1297 1. Stablecoins 1298 2. Application Interfaces 1301 3. Token Issuers 1305 Conclusion 1306 INTRODUCTION

In the year 2000, President Bill Clinton argued that admission to the World Trade Organization would promote openness and freedom in China, thanks in large part to the liberating force of the internet. (1) To those who claimed that China would muzzle the internet locally, Clinton had a witty rejoinder: "That's sort of like trying to nail Jello to the wall." (2) The belief that the internet was inherently too decentralized and global for national regulators to control was widespread at the time. It turned out to be grossly inaccurate. China built a "Great Firewall" to filter data passing within its borders and implemented other measures to impose its policy mandates on internet services operating locally. (3) In democratic nations as well, the idea that the internet was, or even should be, an "unregulable" space became a quaint legacy of a time before the full potential of interconnected digital networks was well appreciated. (4)

Today, the notion of unregulability is back in connection with a new wave of decentralized technology. Blockchain networks facilitate services and applications based on cryptographically secured digital assets. (5) Advocates argue that these systems cannot be regulated because they are resolutely decentralized and "censorship resistant." (6) The claim is as false today as it was for the internet twenty years ago. Blockchains can be subject to regulatory oversight, and they should. While government intervention may slow innovation, well-designed regulation can actually promote sustainable innovation and market development. In the context of digital assets, in which rapid growth of activities in regulatory grey areas has produced a great deal of fraud and other illicit activity, (7) the adoption of effective regulatory frameworks is essential. Nowhere is this more true than for the burgeoning sector of decentralized finance (DeFi). (8)

Blockchain-based activity poses four major challenges for would-be regulators. First, digital assets are protean. They can be adapted to any use, (9) which makes it difficult to apply rules, such as in the U.S. financial regulation model, which rely on sharp distinction between activities. (10) Second, decentralized arrangements can make assigning legal responsibility to particular actors challenging. (11) Third, blockchains are global, which makes the application of national or subnational legal rules challenging. (12) Finally, even when the rules are clear, enforcement can be difficult when market participants are pseudonymous and geographically dispersed. (13)

Fortunately, the problem turns out not to be as difficult as it appears at first glance. One reason is that despite the talk of decentralization and censorship resistance, most blockchain and DeFi systems retain significant points of intermediation and central control. (14) A second is that defining regulatory regimes that balance the desire for decentralized innovation with the need to address harmful conduct is possible. (15) The history of internet regulatory development in the 1990s and early 2000s provides valuable lessons. (16) Policymakers and regulators can adapt the concepts developed then to the new world of digital assets and blockchains.

1. RISKS OF DIGITAL ASSET MARKETS

   The digital asset sector has seen extraordinary growth over the last decade, coupled with tremendous volatility. Daily trading volume far exceeded $100 billion in late 2021. (17) There is now a thriving industry of decentralized applications (DApps), enabled through blockchains in a plethora of industries, from financial services to supply chains to fine art. (18) DApps are created using smart contracts, which are a form of software code that executes immutably according to its specified parameters on a blockchain network. (19)

   The benefits and potential of digital assets are real. Unfortunately, so are the abuses in the digital asset market. The scope of fraud, attacks, and other harmful activity is worrisome. (20) The fact that so many parts of this market are opaque, despite the transparency of the underlying blockchain ledgers, increases that worry. And the fact that market participants so quickly brush off hacks and losses in the tens or hundreds of millions of dollars is perhaps the most worrisome fact of all. (21)

   Major financial bubbles have occurred repeatedly over the past four centuries, ever since finance and trade were sufficiently well-developed to allow for modern markets. (22) These bubbles are often associated with scams and other abuses, especially in times of enthusiasm about new technology or market opportunities. (23) This is only to be expected. Times of transformation can create major profit opportunities. They also open the door for bad actors capitalizing on the general exuberance when the normal informational and legal counterweights are not in place. (24)

   The famed economist John Kenneth Galbraith coined the term "bezzle" for the gap between the perceived and real value of assets due to undiscovered theft or irrational exuberance. (25) This gap is particularly large during periods of market enthusiasm and innovation. (26) It creates what Galbraith called "a net increase in psychic wealth." (27) People are, for a time, effectively wealthier, but this wealth is an illusion that collapses in a crash. (28) When the illusion is revealed, it can undermine trust and have negative long-term effects on markets. (29)

   According to Chainalysis, cryptocurrency crime reached an all-time high in value in 2021, with $14 billion sent to illicit addresses. (30) Because of huge growth in digital asset trading activity, this represented only 0.15 percent of transaction volume. (31) Those who allege that fraud and illicit activity are the only, or the predominant, function of cryptocurrencies are wrong. However, $14 billion is not a small number, and it represents only transactions involving addresses known to be engaged in criminal activity, not the full range of scams, attacks, and manipulative activity likely occurring in the market. (32) One recent survey identified twenty-nine different kinds of cryptocurrency fraud in the academic literature. (33) Researchers have identified over 47,000 scam Bitcoin and Ethereum addresses and over 8,000 cryptocurrency scam URLs. (34) And nearly 7,000 people filed complaints with the Federal Trade Commission reporting cryptocurrency scams between October 2020 and May 2021, losing a median of $1,900 each. (35) The $80 million in reported losses was a 1,000 percent increase from the year before. (36)

   In January 2022, a hack of Wormhole, a cross-blockchain bridge for DeFi, led to the theft of over $300 million of ether. (37) The funds were replenished by Jump Trading, a high-frequency trading firm that is a significant investor in related projects, which raises as many questions as it answers. (38) Around the same time, the anonymous cofounder of the significant DeFi protocol Wonderland was discovered to be Michael Patryn, who has a history of financial fraud and was cofounder of Quadriga CX, a Canadian cryptocurrency exchange that absconded with hundreds of millions of dollars of user funds. (39)

   When sizeable attacks and fraud are so common, and yet investors appear to shrug them off entirely, there is something wrong. Researchers on trust generally identify ability, benevolence, and integrity as the three pillars for establishing trustworthiness. (40) When digital asset and DeFi firms demonstrate their inability to safeguard assets and engage in behavior that suggests ill intent or inconsistency, it should result in a drop in trust. The fact that many such firms, and the market as a whole, do not experience such a reaction indicates that investors may not rationally be assessing risks. This could be a recipe for disaster.

   In addition to hacks, scams, and thefts, there are many reasons to be concerned that the digital asset market is subject to manipulation. Practices that are routinely banned for other asset classes are widespread. A study in 2019 found that for lightly regulated digital asset exchanges outside the United States, approximately 95 percent of volume was faked due to artificial wash trading. (41) Wash trading is also rampant in the ballooning NFT market, (42) along with infringement, fakes, and spam. (43) Researchers found evidence that the Tether stablecoin was used systematically to pump up the price of Bitcoin in 2017. (44) Others found that bots on the Mt. Gox exchange engaged in suspicious trading activity that drove the run-up in Bitcoin in 2013. (45)

   There are many openly operating pump-and-dump schemes for digital assets, a canonical form of illicit market manipulation. One study identified 355 such schemes involving 197 different coins, $350 million of trading volume, and touching up to twenty-three million individuals. (46) And that was in 2018, (47) when the market was orders of magnitude smaller than it is today. Researchers have found evidence that public blockchain consensus mechanisms are subject to potential collusion among miners to influence prices. (48) And a January 2022 report revealed that Coinbase, the largest U.S.-based digital asset exchange, frequently decided to list tokens that it previously invested in without disclosure--a conflict of interest that would be prohibited for traditional exchanges...