Globalize Me: Regulating Distributed Ledger Technology.

• Author: Sarel, Roee

TABLE OF CONTENTS I. INTRODUCTION 437 II. DISTRIBUTED LEDGER TECHNOLOGY (DLT): OVERVIEW AND REGULATORY LANDSCAPE 442 A. What Is Distributed Ledger Technology? 442 B. Public and Private Blockchains 445 C. Why Should We Care about DLT? 446 D. The Regulatory Landscape of DLT 449 III. CLASSIFYING DLT 455 A. The Taxonomy of Economic Goods 455 B. Public Blockchains as a Non-Excludable Good 457 IV. INCENTIVE PROBLEMS WITH NON-EXCLUDABLE DLTs 460 A. Two Incentive Problems with Non-Excludable Goods 460 B. General Solutions to the Incentive 462 Problems 464 V. GLOBAL REGULATION OF DLT 464 A. Going Global: Existing Arguments B. Possible Paths to a Global Regulation 468 DLT 468 1. Centralized Global Regulator 470 2. Decentralized Global Regulation 3. Coordination and Global Standards Backed by 472 Administrative Law 474 C. Is Global Regulation Reallv Necessary? 477 VI. IMPLEMENTING GLOBAL REGULATION 477 A. Off-Chain and On-Chain Regulation 478 B. Three Principles of Implementation 478 1. Embedded Regulation 2. Embedding a Cost for 481 Non-Compliance 481 3. Autonomous Enforcement 482 VII. CONCLUSION I. INTRODUCTION

Distributed ledger technology (DLT) has received much attention in recent years due to its central role in the operation of cryptocurrencies. (1) Although the technology itself is somewhat complex, (2) its value proposition is rather simple: preventing data manipulation. (3) DLT achieves this through decentralization: instead of authorizing a single entity to overwrite the data, new additions can only be made through a validation process that includes multiple actors and adherence to a strict set of algorithmic conditions. (4) Consequently, attempts by any one entity to unilaterally manipulate the data are unlikely to succeed-the attempts would be blocked by the decentralized mechanism. (5)

It is easy to see why such technology is beneficial for monetary transactions, as it overcomes the double-spending problem (6)--no one can manipulate his currency balance in order to claim he still owns money that has already been spent. (7) Indeed, this is the key role of the technology in the world of cryptocurrencies: by creating a decentralized database (a ledger), and documenting who has transferred which cryptocurrency to whom, DLT protects the market from malicious agents who might otherwise manipulate their balance. (8) In the context of cryptocurrencies, the technology does so by creating a chain of digital blocks, yielding its colloquial nickname "blockchain." (9)

However, the promise of DLT goes far beyond financial transactions: whenever data integrity is important, one might turn to DLT as a solution that creates a "trustless" environment, (10) eliminating the need to trust a central authority not to manipulate the data. Examples are abundant and include the registration of property rights, (11) intellectual property rights, (12) movements of items in supply chains, (13) and even cap-and-trade systems for gas emissions. (14)

Notwithstanding the potential of DLT to solve many problems, the technology has, thus far, struggled to reach mass adoption outside the context of cryptocurrencies and finance. (15) In fact, the only alternative use for DLT that has gained significant traction so far seems to be supply chains, (16) where the ledger keeps track of units exchanging hands along the delivery route.

The most important difference between the use of cryptocurrencies and that of supply chains lies in the type of DLT used: cryptocurrencies are supported by a public blockchain whereas supply chains are supported by a private blockchain (a.k.a. "permissioned blockchain"). (17) The difference between the two is the following: Public blockchains are open for anyone to join--a feature much needed to facilitate an open market. Conversely, a private blockchain allows (at least) one decision-maker to exclude users from the network (18)--a necessary feature for a company that does not want to publicly disclose the precise details of its logistics. (19)

Our main insight is that the distinction between public and private blockchains is critical for understanding both the technological development and the regulatory landscape of DLT. Specifically, we propose to view DLT and its regulation through the lens of law and economics by focusing on the traditional taxonomy of economic goods. (20) Importantly, this taxonomy differentiates between excludable and nonexcludable goods, (21) which precisely reflects the difference between public and private blockchains.

Non-excludable goods are challenging to manage because they invoke two classical incentive problems. First, such goods run the risk of overconsumption: if individuals can simply use the good without paying for it (as they cannot be excluded), they will intuitively overconsume. (22) When everyone behaves this way, there is a risk of depletion of the common good. (23) This problem is known as the tragedy of the commons. (24) Second, non-excludable goods might suffer from undersupply: if owners cannot exclude others, it will be difficult for them to charge money for the use. Consequently, producing such goods--or otherwise maintaining them--is potentially less profitable, so that there is a concern that not enough goods are produced. (25) As every producer prefers that others will invest in production--a typical free-rider problem (26)--there might be no production at all.

In the context of public blockchains, these problems arise both at the technology-production level and at the regulatory level. At the technology level, public blockchains are known to suffer from congestion, (27) which occurs because too many users utilize the network at the same time. Consequently, the speed of transaction processing decreases, (28) which has a negative effect on everyone. In other words, there is a tragic over-use (i.e., over-consumption) of the technology. (29) Furthermore, there is an under-supply of public blockchains: currently, they exist primarily in finance-related contexts (with cryptocurrencies as the main example) but have failed to develop in other fields. (30)

The same problems are then mirrored in regulation: with public blockchains, anyone in the world can access them, such that everyone uses the same infrastructure. However, no regulator can simply fence off a part of the technology and subject it to local rules. Thus, local regulation can directly affect the entire network of users (e.g., cryptocurrency traders), but a local regulator does not have the power to exclude other (foreign) regulators from intervening. Figuratively speaking, local regulators each take a bite and consume some of the benefits of regulation, potentially leading to depletion in the form of an over-regulated and non-functioning market. (31) In particular, a stark concern is that the different regulations might clash with each other, applying contradictory rules and creating legal uncertainty. (32) In other words, regulators' behavior can result in a problem akin to the tragedy of the commons. (33) Respectively, there is also under-supply of efficient regulation, meaning a regulation that protects the entire (global) public. This occurs due to the free-rider problem: local regulators only have an incentive to adopt rules to protect the local set of users but have no reason to exert effort to protect the entire globe.

Given this diagnosis, the most straightforward remedy is global regulation of public blockchains--that is, regulation that aims to protect the entire public and not any specific jurisdiction. There are reports of early initiatives to create a global regulation for cryptocurrencies. (34) The United States, in particular, is now pushing this idea forward. (35) However, it is not fully clear whether global regulation would actually be adopted and even less clear in which form.

We explore three different paths to a global regulation: (i) a centralized global regulator, (ii) decentralized (global) regulation, and (iii) international standards. We also discuss the need to lubricate negotiations between countries by reducing their transaction costs. (36) Our analysis points at advantages and disadvantages for every path and discusses how to potentially implement the regulation. To the best of our knowledge, this is the first article to explain the problem of global regulation using law and economics and to compare potential remedies.

As regulators around the world are currently focusing on cryptocurrencies, our analysis will also use the crypto-market as a leading test case. Many of the insights developed in this Article apply to other types of DLT as well, with the necessary adjustments. The remainder of the Article is organized as follows: Part II briefly reviews the development and current state of affairs with respect to DLT. Part III summarizes the traditional taxonomy of economic goods and how it applies to DLT. Part IV reiterates the two incentive problems--the tragedy of the commons and the free-rider problem--and explains in further details how they apply to both the technology and the regulation. Part V entails an extensive discussion on the different paths to global regulation. Part VI describes implementation, differentiating between on-chain and off-chain regulation. Part VII concludes.

2. DISTRIBUTED LEDGER TECHNOLOGY (DLT): OVERVIEW AND REGULATORY LANDSCAPE

   1. What Is Distributed Ledger Technology?

      In 2008, a mysterious person (or persons) using the pseudonym "Satoshi Nakamoto" released a paper titled "Bitcoin: A Peer-to-Peer Electronic Cash System," (37) which described a new version of "electronic cash"--Bitcoin. (38) The idea behind Bitcoin was to allow individuals to make online payments without having to go through a financial institution. However, without an intermediary that can verify whether a transaction took place, how can individuals be certain that money was actually transferred from A to B (and thus will not be double spent via another transfer from A to...