a16z evaluates the regulation of Web3 in the United States The regulatory situation is much more optimistic

Assessing Web3 Regulation in the United States a16z's Positive Outlook

Authors: Miles Jennings and Brian Quintenz, a16z crypto

Translation: Peng SUN, Foresight News

Recent major enforcement actions and court rulings indicate different views on Web3 regulation among various entities of the US government. As new legislation has yet to emerge, Web3 already faces different forms of regulation. However, this also shows us how to formulate new laws to regulate Web3 appropriately, achieving policy goals and paving the way for Web3 development in the United States.

We believe that a framework based on “Regulate Web3 Applications, Not Protocols” (RANP) will be helpful in reviewing, analyzing, and rating regulatory actions involving companies such as Coinbase (Wallet), Uniswap, ZeroEx, OPYN, and Deridex. We examine whether these regulatory actions appropriately target businesses rather than software and its developers (which is a key principle of RANP) and evaluate them based on their compliance with RANP and their application to existing laws. Overall, they are generally aligned with RANP’s emphasis on businesses rather than software, but there are differences in the application of existing laws. Therefore, we are more optimistic about the current regulatory situation in the United States.

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Rating Methodology

As described in Part 4 of RANP, our approach to evaluating how existing regulations or new legislation should apply to Web3 projects starts with reviewing the nature of the underlying software protocols of the projects and whether they may be subject to regulation. If regulation is involved, we will analyze the appropriate degree of regulatory intervention or supervision (or responsibility) for specific applications that reference those protocols.

As discussed in Part 2 of RANP, even if Web3 protocols enable decentralized governance, the regulatory focus of governments or institutions should always balance the benefits and drawbacks of additional regulation. In general, governments should not infringe on the freedom of individuals to publish open-source code software. Instead, governments should focus regulatory efforts on activities related to businesses within their jurisdictions, including the facilitation of illegal activities or evasion of existing regulations through the use of new technologies.

Step 1: Protocol Evaluation

We evaluate the nature of a protocol by determining whether it is: open-source, decentralized, autonomous, standardized, resistant to censorship, and permissionless. Recognizing the importance of these characteristics and motivating regulations that encourage open, free, and trust-neutral internet protocols, in fact, the foundational layer of the current internet was designed this way, and governments also view responsibility in the use of the network in this manner. When a protocol exhibits these features, it reduces the likelihood of being used for regulatory arbitrage, such as centralized businesses attempting to evade regulation by employing smart contracts deployed on a blockchain they control.

In our case studies, we evaluate each protocol based on criteria such as charges brought by relevant regulatory agencies (regardless of whether the charges are factual), industry knowledge, and investigation results of the presiding judges.

Step 2: Application Evaluation

The second step in our analysis requires evaluating the risks and regulatory levels that the application or business utilizing the protocol should bear, based on the characteristics of the application or business. We rely on the standards established in Part Four of the RANP for centralized and decentralized exchanges as guidance. In our research, regulatory application or responsibility assignment only applies to situations where the risks associated with the characteristics of the application or business are addressed.

In our analysis of the practical implications of existing regulations, we assess whether it is reasonable to extend such regulations to Web3 in the context of the RANP, or whether it is necessary to establish more targeted regulations considering the uniqueness of blockchain technology. In other words, is the concept of “same user activity, same user risk, same rules” appropriate? Or does the underlying technology imply that similar user activities bring different risks and require specialized rules to address these differences?

Rating: Analysis Summary

The regulatory framework for Web3 activities in the United States is not yet perfect, but there are signs of potential maturity that are not as terrifying as many industry insiders claim. It is crucial to note that none of the analyzed cases provide conclusive evidence of regulatory agencies or courts solely targeting developers based on the development, release, or deployment of code. Instead, substantial evidence indicates that regulatory agencies and courts generally target businesses engaged in illegal activities (which incidentally involve the use of code), which aligns with the principles of the RANP. This distinction is crucial: solely targeting developers who publish code would undermine the development potential of Web3 and ruin the future of Web3 in the United States, while targeting businesses that foster violations of existing laws (or the intent of existing laws) paves the way for reasonable regulation of Web3, thereby facilitating the vibrant development of underlying technology.

The actions taken by the U.S. Securities and Exchange Commission (SEC) against Coinbase and the judicial analysis of the Uniswap incident clearly demonstrate that the focus is on businesses rather than protocols. Although the language used in the actions taken by the U.S. Commodity Futures Trading Commission (CFTC) is ambiguous and problematic, it is difficult to arrive at the same conclusion. After analyzing all the actions and settlements carried out by the CFTC in the Web3 field so far, we found that despite the existence of many opportunities, they have not targeted developers or protocols. However, both the CFTC and SEC actions are graded relatively low because their regulatory approaches involve enforcement and have failed to promote innovation.

In addition, the actions of the SEC and CFTC are easily distinguishable. The action taken against Coinbase’s wallet by the SEC is a step in the wrong direction – regulatory guidance and targeted rulemaking would be more beneficial for investor protection and fostering financial innovation. Furthermore, because there are no clear regulations governing the questionable behavior or providing compliance pathways, this action expands the scope of existing regulations to the point where it challenges fundamental fairness and due process.

However, the CFTC is a bit more principled, and its regulations apply to questioned commercial activities. Based on our assessment, these actions did not violate fair and due process. However, we agree with Commissioner Summer K. Mersinger’s dissenting opinion that the best solution would be to include these businesses in sandboxes or new regulatory structures to foster innovation. But since the CFTC does not accept new derivative structures that can bring tangible benefits to consumers, they also struggle to bring about responsible innovation.

Enforcement Case Examples

Based on an analysis of the actions taken against Coinbase (Wallet), Uniswap, ZeroEx, OPYN, and Deridex, we have formulated the following ratings and provided a brief analysis of the outcome of each action.

Case: SEC vs. Coinbase (Wallet)

Rating: F

Status: Pending

The SEC accuses Coinbase of acting as an unregistered broker in violation of the Securities Exchange Act of 1934, enabling Coinbase Wallet users to exchange digital assets through software protocols deployed on the blockchain. This complaint is similar to RANP’s focus on Coinbase’s wallet-related business activities, rather than the development of the underlying code of the wallet or its use for decentralized autonomous protocols.

Although RANP believes there are sufficient reasons to regulate wallet exchange functionalities and similar applications, current U.S. regulations do not explicitly prohibit such activities. While the SEC has always emphasized that determining whether an activity constitutes broker activity typically requires an examination of the facts and circumstances, this regulatory case does not encompass the wallet. In such a situation, RANP strongly opposes attempts to overextend existing regulations to address “regulatory loopholes,” especially when the targeted activities and risks differ fundamentally from the activities and risks addressed by existing regulations and guidelines. Unfortunately, this is precisely what the U.S. Securities and Exchange Commission accuses Coinbase of through its wallet’s provision of brokerage services.

Therefore, the SEC’s accusation is one of the cases where regulatory action has backfired, and regulatory guidance and targeted rulemaking would be more conducive to protecting investors and promoting financial innovation.

Case: Risley vs. Uniswap

Rating: A

Status: Judge approves dismissal motion in final order and opinion

Judge Failla dismissed a class-action lawsuit brought against Uniswap Labs and other defendants, attempting to hold the defendants accountable for the operations of the Uniswap decentralized trading protocol and the Uniswap.org website interface. Failla Judge rejected the plaintiffs’ request, which aligns with RANP’s position. In particular, she reasoned that smart contract protocols and developers should be excluded from regulation and liability, but as the risks posed by Web3 applications to users increase, we also have reason to increase the obligations of these applications.

Case: CFTC vs ZeroEx

Rating: C

Status: CFTC charges resolved

CFTC took action against ZeroEx, Inc. for facilitating certain leveraged digital asset trades through the 0x smart contract protocol and Matcha.xyz website interface, in violation of the Commodity Exchange Act (CEA). While CFTC’s use of ambiguous language and reliance on its enforcement authority has caused unnecessary confusion in its overall regulation approach to Web3, the action taken aligns with the Regulatory Action Non-Prosecution Policy (RANP) in general. This action clearly demonstrates that CFTC’s main focus remains on companies operating applications rather than autonomous software protocols. For instance, CFTC frequently mentions the Matcha interface and the agreement reached with ZeroEx, which ensures that infringing assets are delisted from Matcha but remain accessible to US individuals. Furthermore, the infringing assets can still be traded outside the United States.

However, CFTC’s approach did fall short of promoting innovation as required by RANP. Non-profit applications like the Matcha interface should have flexibility under applicable regulations to foster innovation, especially in cases where leveraged assets can be safely provided and when leveraged assets only represent a small portion of available assets, as is the case with Matcha interface.

Nevertheless, CFTC’s application of CEA to the Matcha interface largely aligns with the regulatory focus of RANP. It is a reasonable application of existing laws, making it fully predictable and preventing potential regulatory arbitrage.

Case: CFTC vs Opyn

Rating: B

Status: CFTC charges resolved

CFTC took action against Opyn for facilitating the creation, purchase, sale, and trading of blockchain-based derivatives through smart contract protocols and the opyn.co website interface, in violation of the CEA. Similar to the case against ZeroEx, CFTC also used ambiguous language and exercised enforcement authority. Nonetheless, this action largely adhered to RANP and further emphasized that CFTC’s focus is on companies rather than software: after reaching a settlement with Opyn, CFTC seemed satisfied with a stronger intellectual property blockade against Opyn. Meanwhile, the product remains usable outside the United States.

However, CFTC still failed in supporting innovation. Opyn’s product indeed showcases innovation by effectively mitigating many risks associated with derivatives and perpetual futures from history through programmable blockchains.

Despite this, CFTC’s action aligns with the regulatory focus of RANP. The Opyn website interface promoted unlawful activities in the United States, failed to effectively prevent US individuals from using the website, and Opyn and its investors endorsed their product on forums accessible to Americans. Additionally, CFTC’s action is a reasonable application of existing laws, without any unknown circumstances.

Case: CFTC v. Deridex

Rating: B+

Status: CFTC charges resolved

The CFTC took action against Deridex, Inc. for operating a leveraged digital asset and derivatives trading platform through smart contract protocols and the app.deridex.org website interface, in violation of CEA regulations. While this case shares similar issues regarding vague language and strong regulatory enforcement with the ZeroEx and Opyn cases, overall the CFTC’s actions align with RANP and are consistent with its regulatory focus. The interface operated by Deridex facilitated illegal activities in the United States, and it is claimed that the company openly disregarded US laws and made no attempt to block US users. Therefore, the CFTC’s actions are a reasonable application of existing laws and were completely predictable.

The regulatory landscape of Web3 is full of opportunities. Different entities within the US government seem to be collectively focused on corporate activities rather than developers, which aligns with the core premise of RANP.

In addition, RANP believes that when formulating new regulations or applying existing regulations to Web3, the opportunities and risks associated with blockchain technology must be taken into account. Similar user activities can lead to different risks, thus requiring different rules to achieve the same regulatory outcomes.

The CFTC seems to be better positioned to perform in the next regulatory steps, as their actions align more with their legal authority and regulations. However, this should not serve as an excuse for the organization’s failure to establish a policy framework around decentralized derivatives. Promoting responsible innovation is a provision written into the CFTC’s responsibilities, but the agency has clearly not fulfilled this duty. The authority to review new approaches to the derivatives market and grant exemptions to existing rules is crucial for consumer choice in participating in new technologies, as these technologies not only have unique advantages but also help mitigate different risks.

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