Web3 Needs Good Regulation to Save It From Itself. What Good Regulation Looks Like

Web3 needs good regulation to save it from itself.

What good regulation looks like:

I’m passionate about having good regulations in web3. The industry is too important not to.

On a macro level, web3 has potential to help the world solve its income distribution problem exacerbated by AI:

Economies have long used labor and capital incomes as two dominant ways to distribute output to  participants, typically along a 70/30 split. E.g, you may make 70% of your money from clocking time in an office and 30% from saving/investment gains.

Unfortunately this framework is working less & less well.

Over past decades wealth & income distribution have tilted in favor of those earning capital incomes. Distribution will look even worse once our robot overlords take over— studies estimate around 1/4 to 1/2 of full-time jobs in advanced economies may be replaced by AI.

One can argue new types of jobs will be created. I’m sure they will be. But “jobs” of the future— if we still call them jobs— won’t bear much resemblance to jobs of today or be undertaken by same types of people.

If the number of full-time labor contracts as we know them will shrink, it begs the question: how is society going to distribute resources to most of its members, without a regular pay slip from an employer?

Before we get to things like universal basic income, one obvious solution is it’ll need to start distributing incomes according to *other contributions* a person makes to the economy, aside from their labor and capital investment contributions.

What are these?

You contribute to the economic system through many activities— by producing, investing, consuming, creating, communicating, etc. Even though the income distribution mechanisms we have today mostly only reward the first two activities.

But how economies work are changing. For example, modern economies are becoming increasingly *consumer-centric*.

Across advanced economies, working hours are declining…

…while the importance of consumption as driver of economic growth is rising.

If you live in a country like the US, your contribution to the economy as a worker has been going down over past decades while your contribution as a consumer is going up, as far as the usage of your time is concerned.

Your action as a consumer not only drives US economy, but also a slew of emerging market countries that rely on consumer exports to grow.

Consumer actions also drove growth of most successful inventions of web2 internet— social media and online marketplace platforms— both relied on massive retail engagement for their business model to work.

Given structural changes in the economy, it only makes sense that we create new distribution mechanisms to reward people for their contribution as consumers.

Especially since wages & salaries will likely become less effective as income distribution tools in the age of AI, as more and more jobs are replaced or need to evolve.

In fact, not only consumption, production & investment. new mechanisms need to be created to reward economic participation of all types.

To me this is where the systemic relevance of web3 comes in— it provides scalable ways to design & implement such mechanisms through tokenization.

For example, tokenized rewards for consumer purchases or other engagements create the possibility for consumers to share the upside of the product’s growth like shareholders, without affecting company’s current cash flow.

I wrote more on the macro potential of tokenizing economic values a while ago. You’re welcome to check it out. But that’s not what I want to focus on today.

Next wave of crypto adoption will come from utility tokens of real-world companies.

Why & how:

— Tascha (@TaschaLabs) June 30, 2022

Because despite all the potential for tokenization to transform economy, its most prevalent use case to date— I don’t have a more polite way to put it— is a shortcut for companies with no legit product or purpose to raise money easily and quickly.

For many so-called web3 companies, the token became the product and financial engineering became the purpose.

Even if the company originally set out on a different vision, it soon realized making a business out of tokens is much easier than out of an actual product, at least in the sweeping frenzy of bull market and without the least bit of regulation.

This does not even include those that set out to be outright frauds, which are plenty.

Tokenization is powerful. But without good regulations to help establish trust and protocols in web3, it’d be like leaving your kitchen knifes with a bunch of toddlers at home without adult supervision. Your house would descend into chaos quickly.

I’ve come to believe without good regulation it’d be difficult for web3 to grow up to be more than a cottage industry. At best it would take longer.

The problem is at least in the US, which is the main source of early-stage web3 funding and one of the largest crypto user base— there’s still no specific regulation on tokenization.

Financial supervisors’ toolbox for regulating the space is still the Securities Act of 1933, which is in no way capable of handling the complex reality of digital tokens today.

As a result, regulatory dialogue becomes an argument about how to interpret the law that runs in circles—

SEC lawyer: Your token is an unregistered security.

Crypto lawyer: It’s not. Most of the tokens were airdropped to users. There’s no investment contract.

SEC lawyer: You’re giving token holders a yield. They have profit expectations.

Crypto lawyer: But we’re not an enterprise. The yield was decided by decentralized governance vote.

SEC lawyer: You have a team responsible for running the project. How is that not an enterprise? Their effort affects token price.

Crypto lawyer: Actually the token holders also provide validation service. So their profit comes from their own effort.

SEC lawyer: You did sell the tokens directly to investors.

Crypto lawyer: We didn’t. It was airdropped to investors who invested in our stocks.

SEC lawyer: You just claimed you were not an enterprise. Now you have stocks?

To me the whole circus about “unregistered securities or not?” is a huge distraction from what  financial supervisors and web3 industry both actually need— new regulations written specifically for digital tokens that accommodate new realities.

In particular, the new reality that tokenization is a general-purpose tool unlike any traditional financial instruments.

14/ For the longest time, SEC and some other financial regulators have chosen to ignore a fundamental fact about crypto— that tokenization is a *general purpose technology*, not a specialized financial instrument.

— Tascha (@TaschaLabs) July 16, 2023

New regulation needs to acknowledge that the token holder – issuer relationship can be of various sorts,  and stop trying to contort it to fit the old box of investor – corporate relationship.

But at same time, it needs to provide basic legal protection for token holders and indeed stop opportunistic companies from using tokens to skirt the rules on startup fundraising.

What would good regulation look like?

To me it needs to cover at least these 3 things:

One, the token issuer— whether corporate or not— needs to clearly lay out how token holders would benefit from issuer’s business operations, e.g. through product redemption, service perks, token buyback, yields (paid from the project’s cashflow, not by issuing more tokens).

When airlines issue flyer miles and credit card companies issue points, the idea is you’ll redeem those for future flights or cash backs.

Imagine if these companies tell you, “Here are some points. We don’t know what they’re good for. We are not responsible for them. But you can take them and go gamble the lights out on secondary market.”

And yet that’s what crypto non-companies do all the time. It worked for creating a seasonal hype. But it won’t work for getting web3 to the adult table.

Two, initial token sales through crypto launchpads and DeFi exchanges need to comply with  disclosure and registration rules similar to normal startup fundraising.

In the US, small startups raising money need to comply with Regulation D, Regulation A, or Regulation Crowdfunding, depending on how, how much, and from whom the company’s getting the funds. Why initial token sales should be an exception to these I don’t see.

Blockchains are global. No regulators can stop tokens from being issued on-chain. But they can stop a token from being listed on centralized exchanges operating in the country if it doesn’t follow the rules. That’s severe enough if coming from big countries like the US.

Three, regulations should clearly discourage companies from using tokens as just another fundraising tool.

We already have financial instruments for companies to raise money— they are called equities and debts, which have been around for centuries. If tokens become simply glorified digital securities, then there’s nothing new or innovative at all.

For web3 to realize its true potential, digital tokens really need to differentiate themselves from traditional financial instruments, by offering the world new use cases for representing and distributing values.

Regulations can help encourage these innovations by specifying, for example, > 90% of the token supply needs to be disseminated through means other than direct sales to investors— otherwise it will be classified as a security!

In sum, regulations that support web3 growth need to cover:

1. Token issuers should specify how holders would benefit from issuer’s business ops
2. IDOs and other initial token sales should comply with same rules as normal startup fundraising
3. Tokens should have dominant use cases other than being a corporate fundraising tool

Plenty of crypto evangelists would tell you no regulation is good regulation. Of course they do. They’re profiting from chaos.

The reality is an industry that deals so much money but with no clear enforcement of trust and accountability simply breeds deception and fraud, which increases cost of doing business for everyone and destroys the industry from inside.

Without good regulation, web3 won’t die, but it won’t go world class either. It’s time for the industry to come to consensus on that.

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