Regulating Blockchains While Protecting Decentralization

Originally posted on the Peterson Institute for International Economics website.

Blockchain technology was first introduced in 2009 with the invention of bitcoin, a so-called cryptocurrency designed to facilitate an entirely peer-to-peer electronic monetary and payment system. This first experiment securely transferred virtual tokens used as money between buyers and sellers within the bitcoin network without need for an official or government-sponsored notarizing authority.

In traditional financial systems, trusted third parties such as banks are tasked with preventing abuse or fraud. After all, electronic cash is just data: In principle, anyone can make themselves richer by cheating the system and adding zeroes at the end of their account balance. In bitcoin, balances are validated not by a trusted financial institution but collectively by users through a consensus mechanism regulated by computer code. This is called a decentralized model.

Bitcoin tokens never succeeded as money. They are a bad store of value: Their dollar price, determined exclusively by supply and demand in unregulated and opaque markets, was always unstable. They don’t work well as a means of payment because the processing of transactions is slow. Their popularity endures among three groups, however: activists who do not like banks, criminals who appreciate how hard it is to trace user IDs to physical identities, and speculators who want to profit from bitcoin price volatility.

While bitcoin use has lost luster, blockchain technology has been gaining mainstream attention, especially after the original implementation was improved upon in post-bitcoin platforms such as Ethereum and EOS.

Several large companies, especially in the financial sector, are showing an interest; governments around the world are on board as well, following a common “bitcoin bad, blockchain good” script. China provides the most striking example: Officials took a hard line on bitcoin on grounds of crime prevention and consumer protection, but President Xi Jinping emphasized the potential of blockchain technology in a May 2018 speech. Soon after, the Ministry of Industry and Information Technology encouraged widespread adoption.

THE PROMISES…

Conceptually separable from virtual currencies, blockchains can in principle authenticate any form of digital data and decentralize all sorts of tasks, from land registration to supply chain management. Compared with centralized systems, they might deliver savings and better cybersecurity: Most importantly, they may offer a new way to prevent concentrations of power.

Social media provides a good illustration of why this technology could succeed. Today, consumers unload vast amounts of information to corporations such as Facebook and Twitter, including personal characteristics and preferences, connections to others, photos, videos, etc. Recent laws and regulations, such as the EU General Data Protection Regulation (GDPR) and the California Consumer Privacy Act, grant users a measure of control over who gets to see and analyze their data. But these statutes cannot ultimately stop the buildup of huge, privately owned, deeply granular information troves. This amassing of data by technology giants can hamper competition, distort political debate, and ultimately reduce human agency by giving a handful of companies the capacity to influence thoughts and opinions on a planetary scale.

A blockchain-based social platform would look very different from such a system. It would have designers but no owners. The web interface might look identical to existing ones, yet data would not be kept on corporate servers. Data would instead be dispersed among a network of peers, each providing a share of the computing resources needed to keep the system running. Encryption schemes could ensure that every social platform user decides exactly who gets to view a certain post, without any CEO being able to look at everything.

…AND THE PITFALLS

Given these advantages, why hasn’t this technology become more widespread already? Why are decentralized applications, or DApps, still few and far between? Part of the answer lies in the technical limits to scalability and sparse awareness of the technology, but it mostly comes down to unresolved governance issues.

Decentralized models for data validation work a lot like markets: They achieve their intended aims only provided that no participant has a strong dominant position. In bitcoin, for example, the integrity of token balances is no longer guaranteed if any single user or group of colluding users commands more than half of the network’s total computing power.

Blockchains are good at doing away with out-of-network power concentrations only if their protocols, i.e., the computer programs that govern their functioning, can prevent the emergence of within-network ones.

This is not the case right now. None of the projects for corporate or governmental blockchains are truly decentralized: They share some technical characteristics with the original implementation but ultimately have owners who set the rules and decide who can participate in the system.

Bitcoin, though public and open to everyone, has its own concentration problems. China has means to damage it because Chinese citizens happen to provide — by chance, not design — the majority of computing power. If officials in Beijing pressure them to collude, they could compromise key properties of the system, such as user anonymity and finality of payments. The Chinese government may go down this path for a variety of reasons, ranging from enforcement of capital controls to destabilization of foreign cryptocurrency markets to destruction of any potential rivals to a future state-controlled national blockchain.

While Ethereum and Eos may not have a Chinese problem, their founders and developers tend to exert significant influence. They have means to ultimately overrule the consensus of network participants, which makes technical decentralization moot.

Recently, economist Nouriel Roubini radically condemned blockchains because of this contradiction between their stated goal — the end of centralization — and their inability to neutralize attempts at power grabs. But is it inevitable to conclude, as he asserts, that “blockchains are a lie”?

A BARE-BONES POLICY PLAYBOOK

No, they are not, just as markets are not a lie just because cartels have emerged in history. Decentralized systems can make a positive contribution to social and economic welfare. They can empower individuals, increase transparency and trust, and cut intermediation and coordination costs. They just need to have better governance rules. Since such rules have not emerged autonomously, policy interventions by international organizations may have to supplement research already taking place within the blockchain community.

Blockchains are intrinsically cross-border; no single jurisdiction can achieve significant results on its own. Taking a leaf out of the book of internet governance, a bottom-up, international multistakeholder model should be followed, with a coordination forum tasked with drafting principles for good protocol definition. These principles should be like a guide to constitution writing: Which checks and balances should be featured? What is the equivalent of separation of powers, and how should it be implemented?

A nonprofit public-private partnership like ICANN could be established for auditing protocols. To encourage and protect innovation, compliance with the principles should not be mandatory for all applications; regulators should be able to selectively ban the use of DApps on noncompliant blockchains, e.g., in certain sectors and/or above a certain scale.

It remains to be seen if such a regulatory scheme can be implemented at the United Nations level or among groups of like-minded countries, such as the Group of 7 leading industrial democracies. Lessons learnedfrom international cybersecurity policy suggest that only the latter solution may be viable in a world where key philosophical differences exist over the level of control that states can legitimately exert over the digital space.

Indeed, authoritarian regimes are likely to oppose the very idea of undermining concentrations of power. If like-minded industrialized countries choose to regulate blockchains, a way should be found to avoid excluding citizens of non-G-7 (or non-OECD or non-NATO) countries from the benefits of decentralization.