Effective crypto regulation starts at layer 1

Take the time to empathize with cryptocurrency regulators. We have tasked them with managing an ever-changing ecosystem that is both plagued by lawlessness and built on top of blockchain technology that prevents outside control. The effort required to identify and apprehend pseudonymous criminals makes enforcement impractical for most blockchain crimes, and no amount of effort can stop an automated decentralized autonomous organization like Tornado Cash.

As a result, regulators are primarily referred to know-your-customer processes via fiat on/off ramps to achieve enforcement. In a decentralized, permissionless environment, relying on KYC alone is like trying to tame the ocean by damming a few rivers. Effective regulation requires the full capacity of law enforcement to protect property rights, remedy breaches of contract and intervene to stop crimes in progress.

Such capabilities are available through layer 1 protocols that enforce the law on the chain. These protocols avoid the need to seize private keys from pseudonymous criminals by enabling direct action on wallets and smart contracts. Officials invoke these protocols by obtaining a court order, just as they would for off-chain enforcement. For example, the US Treasury could shut down Tornado Cash by demonstrating cause to enforce its smart contracts, or could seize assets by obtaining a warrant.

On-chain enforcement was unthinkable to most even a year ago, but after enduring weekly hacks for hundreds of millions of dollars and frauds for tens of billions more, the blockchain community is ready to embrace it. Most market players not only recognize the need for effective law enforcement, but demand it. Many see on-chain enforcement as the best hope for thawing the crypto winter and establishing blockchain as the backbone of mainstream commerce and the decentralized internet.

Adoption is already underway. Bitcoin SV (a top-50 blockchain that proclaims dedication to ‘Satoshi’s vision’) recently implemented a protocol for blockchain authorities to enforce court-ordered transfers of BSV coins. The community hopes this development invites regulators and diverts users from older bitcoin. Similarly, Jurat’s layer 1 protocol enables consensus on the meaning of court orders so that nodes can execute them autonomously. The prerequisite for enforcement in the chain is strong. More blockchains will follow.

There are several objections to enforcement in the chain, but none should give regulators pause.

First is the fear that tyrannical officials will seize digital assets. It is worth noting that those who express this concern also own houses, cars and bank accounts, which the authorities ignore. Due process is an excellent protector of property rights, so limiting enforcement in the chain to valid court orders will keep digital property as sacred as physical property.

The potential for abuse by intermediaries is another objection, but an exaggerated one. Bitcoin SV chooses trusted ‘notaries’ (presumably lawyers) to interpret and publish court orders to the network. Jurat, on the other hand, eliminates the middleman by generating machine-readable hashes for judges to include in their docketed orders.

Third are concerns about the immutability of the ledger. These misunderstand the enforcement process on the chain. Courts do not rewrite ledgers. Rather, they enforce the law through a new remedial transaction that changes the effect of an earlier (illegal) one. They do not change the ledger itself.

Regulators have several ways forward. Mandating minimum enforcement standards is one, but the multi-jurisdictional nature of public blockchains makes this impractical. Another option is to do nothing. Self-interest should drive adoption given that property becomes more valuable as legal protections are strengthened. A third is that influential agencies such as the US Treasury and the Securities Exchange Commission offer a regulatory sandbox when providers use blockchains with on-chain enforcement. The move is justified because oversight is reduced when private actors can enforce legal rights (think shareholder lawsuits for fraud). This approach will also accelerate legal protection on the chain – the ultimate goal of any regulatory scheme.

Michael Kanovitz is CEO of Jurat.

This article was originally published in the Digital Monetary Institute Annual 2023.