The Inevitability Of Regulations In Web3

For any state that runs a relatively free market, the matter of regulations is always a contentious issue. How much regulation is too much? How much regulation is too little? How much regulation will provide the perfect balance of safety and competition?

For goods like food and drugs, the answer is usually simple. They simply must be safe and healthy to be ingested by a human being. For other goods like cars or heavy machinery, it is a little bit more difficult, but doable nonetheless.

The Question of Regulations

Governments use regulation as a way to ensure that people do not have access to goods or services that can be harmful to them. In a way, regulations in the free market are like laws that outline what goes and what does not go.

If you were cynical, you'd argue that regulations are simply a way for governments to exert undue control on the free market. But in some cases, that control is warranted. Of course, regulations could become redundant or outdated — as evidenced by the way Uber took over taxis. But this doesn't make the idea of regulations themselves obsolete.

One problem with the question of regulations in the crypto-verse is regulations, as we know, don't translate well into a decentralized economy. After all, you can track goods. You can know who is making them. In other words, goods and services are centralized. You can trace them to their source to crack the policy whip.

The fortunate, or unfortunate thing as the case might be, is that cryptocurrency is not a good or service that can be easily regulated. It is nothing like anything that any state has ever tried to regulate. The crypto economy is essentially a shadow financial system that seeks to subvert the old order.

This means two contradictory things. The first is that governments now have every incentive to regulate it. After all, the success of decentralized finance is directly linked to the death of traditional finance and central banks. That is a proposition that no state, regardless of how liberal or laissez-faire they are, will accept. The fact that crypto, like every other industry, has its fair share of mischievous players means it should be the number one target for regulation by the state. And it is, as many countries have either outrightly banned it or are looking at ways to heavily regulate it.

The second contradictory thing is that due to the nature of crypto, it is nearly impossible to regulate — or ban. Ever since law enforcement saw the possibilities of crypto, especially in terms of crime financing, they’ve tried to regulate or ban it. One thing they’ve probably discovered, right from the days of fighting the silk road, is this; regulating or banning crypto is an extremely difficult task.

But does that mean they will give up? No, far from it. It only means that the state will find other sustainable ways to regulate crypto.

The Future of Regulated Crypto

In the last few months, the European Union and America have shown great interest in creating a holistic regulatory framework for crypto. The good, and perhaps surprising news, is that some crypto exchanges have welcomed this development.

Centralized exchanges (CEXs), which are centralized banks with records on a single ledger on the blockchain, have welcomed the idea of regulation with open arms. It does not take a genius to know that this position is antithetical to the development of a decentralized world. But these exchanges are not supporting these attempts at regulation because they think regulation itself is a great idea. Instead, they are doing it because it allows the state to cut decentralized exchanges to size.

CEXs essentially support regulations because it legitimizes their business model, they also support regulations because it allows them to take the lunch of DEXs. Despite the popularity of centralized exchanges like Binance, DEXs have been having a swell time in the crypto-verse. For example, they have 55% of the market share by trading volume. Because of their particularly lax attitude towards identity verification, DEXs are the perfect mules for money laundering and other illegal activities. But criminals are not the only ones who use DEXs. People who need greater anonymity also use them, and it is this share of the market that CEXs don’t want to lose.

The rationale of CEXs is that if the state could find a way to regulate both types of exchanges, DEXs would suddenly find themselves in an environment where they have to properly compete with CEXs.

While it is theoretically difficult to regulate a decentralized exchange – after all that is the goal of their decentralization – it is not that difficult in the practical sense. Almost all DEXs have big and public players that could be potentially held accountable. Asides from that, about 85% of DeFi trading is done by just five players. This means that DeFi is certainly not as decentralized as one might be led to believe.

Regulation Is Inevitable

Despite the promises of a cryptosystem existing outside the scope of a non-market regulator, it appears that regulation will eventually come for crypto.

Of course, this does not mean that crypto will lose its utility. After all, regulations cannot mandate centralization. At most, they can erect barriers around the market and stifle innovation. But as we all know, the world of crypto and DeFi is still very much in its infancy. There are still so many spaces to expand into and so many questions to answer.

While regulations may be inevitable today, it's not clear that they will always be so. It's not even clear that the regulations will do much to dampen the core promises of a Web3 economy.