Validators in the Crosshairs. An analysis of the conceptual fallacies on the BIS DeFi paper.

This article contains the analysis of the BIS: Cryptocurrency and Decentralized Finance (DeFi)
Its full text can be found on the BIS website

“If validators accept transactions from every party, the most regulators could hope for is to separate the network into “regulated” and “unregulated” parts.” - BIS Monetary Economic Department

The idea that regulation is coming to blockchain technology is widespread. Many efforts at regulation are being worked on by authorities on many fronts. However the depth and complexity of this regulation (or over-regulation) is still cause of concern. One such case is the new work of the BIS’ Monetary Economic department. Where, despite, deep research on the topic, misses the mark on many points. Here we present the analysis of the paper and a warning for developers and validators of PoW and PoS blockchains concerning about the possible use of over-regulation in the field. Mainly due to the proposed recommendations: “to regulate validators and developers as financial intermediaries”.

What the BIS gets right.

Surprisingly, the analysis on oracles is on point. The description of oracles as an important problem for deterministic blockchains is of great quality. Stablecoins, algorithmic or cash based are being looked up closely and defined optimally. Moreover, a closer look at centralized stablecoins’ reserves and proof of reserves is something that the top stablecoin providers already fulfill to some extent. It is natural for authorities to want to ensure that their issuance is realistic.

Automatic Money Makers, DEXes and liquidity providing are concepts that are clear in the view of the BIS, so that it can make a good guess for what the financial risks of such platforms are. Now, the idea that transactions can be tracked and reported is nothing new and has been happening to this day, so anything beyond this point, in the DeFi arena is the subject of public debate.

What the BIS is on shaky ground.

Pilling up all L0s, L1s, L2s, , interoperability chains, etc. into the category of “smart contract platform” is detrimental for the discussion as we are about to discover. Ethereum, appchains, parachains, relay chains, fulfill very different roles than providing smart contracts in a generic manner, in fact, they can exist without them. As not all of these are mean to host DeFi naively as the title paper suggests. Something that will become more relevant as we will discover, later on.

Allowing efficient capital and fractional issuance is a supposed goal which can only be attained by heavy regulatory oversight, according to the BIS. This might hold some truth in the incumbent banking system, However, in the native blockchain experimentation, we have already seen that fractional and capital efficient markets are possible within and without the DeFi ecosystem without heavy regulatory oversight. The most obvious examples are FRAX and stablecoin derivatives. This is still area of heavy research which is moving at a quite fast speed.

Moreover, the need for regulatory oversight has historical reasons, which to some extent are valid, like preserving the privacy for customers while allowing authorities to go after bad actors in accordance to the law. This already happens and it’s possible, even better because of the public ledger. But believing that modern KYS and AML are extremely efficient tools is, to say the least, debatable. It is however, possible to fulfill all regulatory obligations with the current framework, which relies on the banking custodians and exchanges for information. Which have already the tools and capital to do so. The reason for the increased regulatory oversight suggested by the BIS is mind-blowing, however. It’s due to costs on the intermediary and authorities which should, in their view, go onto validators and developers.

The fallacies.

However, the erroneous conclusions reached by the BIS working group are based on smaller concepts which are fallacious in nature.

The fallacy that all blockchains are exclusively used for DeFi is the most detrimental of the ideas presented by the BIS. Ignoring the fact that, blockchains are technology, that may or may not be used for other, non-financial purposes, is what allows creating such overreaching and overregulating conclusions such as the denomination of validators and developers as “financial intermediaries” akin to a bank or a banking-licensed institution.

Appchains offering non-financial and decentralized products such as: Relay Chains / Intrachain Security (Polkadot/Kusama/Cosmos) Carbon Credit Issuance (Regen Network), Gaming – Art - Collectibles (Sorare, Flow), Decentralized Social Networks (Steemit, Minds), Prediction Markets (Augur, Zeitgeist), Identity (Kilt) among many others have different characteristics when compared to DeFi. It makes it illogical to regulate all blockchains with the same rules that you would financial products. Why? Because blockchain technology is generic and can be used to build many different applications outside financial ones commonly referred to as DeFi.

The fallacy that contracting parties rely on intermediaries such as developers, even though, the BIS paper accurately describes smart contracts to be self-executing. The proposal of forceful inclusion of developers of such contracts as the intermediaries, even though this has never happened in all of DeFi’s history, is a forced proposal for regulatory oversight. As all crypto developers already know, these contracts function despite of who wrote them or even if such contracts are maintained. In addition, this mental framework, excludes other more complex sets of blockchain infrastructure such as: parachains, parathreads, appchains, subnets, decentralized oracles, prediction markets. As all these, don’t need smart contracts to work, these are infrastructure by themselves. Fitting them into a “smart contract framework” would be ill suited as it’s not the best description for them as it has all the characteristics of software operating autonomously.

For instance, in the case of appchains or parachains, these are much more decentralized in execution than a simple smart contract according to this view. With more entities involved in an equal manneer which increases decentralization.

The fallacy of the assumption that smart contracts will take all the similarities of the regular legal system and not as pieces of software that may or may not be of financial nature.

The fallacy of observability on all applications. Anyone who has been at the front of blockchain tech development, knows that there are many efforts to encrypt data on-chain an off-chain. Primarily by zk-proofs and secondarily by TEEs (CPU Trusted Environments). This might be a technological solution for all cases where observability of the data is detrimental.

The fallacy of thinking that validators are able to create “different nationally regulated forks” which may or may not interoperate with one another depending local laws. Blockchains were not created to have different versions of THE blockchain. In such cases a consensus problem is created. Even though, regulation enthusiasts on Ethereum and other chains began censoring and blacklisting addresses related to Tornado Cash, a sanctioned address, creating a new architecture where various versions of public blockchains exist in order to honor regulators is laughable. Consensus exists for a reason. That regulation, if implemented, would simply render all public blockchains useless.

The fallacy of mutating permissionless blockchains into permissioned blockchains. Despite not being said explicitly, all these recommendations create an environment where blockchains are forced to become permissioned by the government to remain compliant with the law, whose operators also operate because of the government. Removing one of the core tenets of public blockchains, open participation, not only restricts participation through governmental approval but also removes all the value of public blockchains altogether. By allowing backdoors to governments at the core level, we can safely say that all new allowed technology has to maintain the same architecture of the incumbents. Which is by definition “hampering the development of new, bleeding edge technology”.
Re-engineering blockchains for such compliance level requires a technology that is not here. If that regulation were to pass, it would mean the removal of all public and permissionless blockchains, in favor or centralized databases (incumbent tech or incumbent tech equivalents).

Hence, “Too-big-to-regulate” is a non-issue. Blockchain tech is still nascent tech that requires the same liberties that the Internet enjoyed and still enjoys today. Maybe because it’s just technology that doesn’t require DeFi to exist but requires a thoughtful regulatory tough so that it doesn’t get smothered.

Published by: Saxemberg on Jan. 12, 2023